**Exhibit 99.1**

 

A.D.A.M., Inc.

ConsolidatedBalance Sheets

(In thousands, except share data)

 
| ** **                                                                                                                                                                                      | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| **Assets**                                                                                                                                                                                      | ** ** | ** **            | ** ** | ** **            | ** ** |
| Current  assets                                                                                                                                                                                 |       |                  |       |                  |       |
| Cash and  cash equivalents                                                                                                                                                                      |       | $                     | 3,242      |                  | $          | 4,554 |   |
| Investments,  short term                                                                                                                                                                        |       | 2,726                 |       | —                |       |
| Accounts  receivable, net of allowances of $103 and $111, respectively                                                                                                                          |       | 2,112                 |       | 1,407                 |       |
| Inventories,  net                                                                                                                                                                               |       | 107                   |       | 66                    |       |
| Note  receivable from related party                                                                                                                                                             |       | 39                    |       | —                |       |
| Interest  bearing note receivable                                                                                                                                                               |       | —                |       | 50                    |       |
| Prepaids and  other assets                                                                                                                                                                      |       | 398                   |       | 278                   |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total  current assets                                                                                                                                                                           |       | 8,624                 |       | 6,355                 |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Property and  equipment, net                                                                                                                                                                    |       | 184                   |       | 185                   |       |
| Investment,  long term                                                                                                                                                                          |       | 1,000                 |       | —                |       |
| Intangible  assets, net                                                                                                                                                                         |       | 1,278                 |       | 1,636                 |       |
| Goodwill                                                                                                                                                                                        |       | 2,043                 |       | 2,043                 |       |
| Restricted  time deposits                                                                                                                                                                       |       | 115                   |       | 238                   |       |
| Note  receivable from related party                                                                                                                                                             |       | —                |       | 39                    |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total assets                                                                                                                                                                                    |       | $                     | 13,244     |                  | $          | 10,496 |   |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                                                                  |       |                  |       |                  |       |
| Current  liabilities                                                                                                                                                                            |       |                  |       |                  |       |
| Accounts  payable and accrued expenses                                                                                                                                                          |       | $                     | 726        |                  | $          | 634 |   |
| Deferred  revenue                                                                                                                                                                               |       | 3,615                 |       | 2,295                 |       |
| Current  portion of capital lease obligations                                                                                                                                                   |       | 17                    |       | 11                    |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total  current liabilities                                                                                                                                                                      |       | 4,358                 |       | 2,940                 |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Capital  lease obligations, net of current portion                                                                                                                                              |       | 37                    |       | 36                    |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total  liabilities                                                                                                                                                                              |       | 4,395                 |       | 2,976                 |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Commitments  and contingencies                                                                                                                                                                  |       |                  |       |                  |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Shareholders’  equity                                                                                                                                                                      |       |                  |       |                  |       |
| Preferred  stock, no par value; 10,000,000 shares authorized; no shares issued and  outstanding                                                                                                 |       | —                |       | —                |       |
| Common  stock, $.01 par value; 20,000,000 shares authorized; 8,040,906 shares issued  and 7,860,535 shares outstanding at 12/31/2004 and 7,710,728 shares issued  and outstanding at 12/31/2003 |       | 80                    |       | 77                    |       |
| Common stock  warrants                                                                                                                                                                          |       | 86                    |       | 353                   |       |
| Treasury  stock, at cost, 180,371 shares at 12/31/2004                                                                                                                                          |       | (592                  | )          | —                |       |
| Additional  paid-in capital                                                                                                                                                                     |       | 48,843                |       | 48,306                |       |
| Note receivable  from shareholder                                                                                                                                                               |       | (291                  | )          | (291                  | )          |
| Deferred  compensation for services                                                                                                                                                             |       | (23                   | )          | (50                   | )          |
| Accumulated  deficit                                                                                                                                                                            |       | (39,254               | )          | (40,875               | )          |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total  shareholders’ equity                                                                                                                                                                |       | 8,849                 |       | 7,520                 |       |
|                                                                                                                                                                                            |       |                  |       |                  |       |
| Total  liabilities and shareholders’ equity                                                                                                                                                |       | $                     | 13,244     |                  | $          | 10,496 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

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A.D.A.M., Inc.

Consolidated Statements ofOperations

(In thousands, except per share data)

 
| ** **                                                           | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                           | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| ** **                                                           | ** ** | ** **            | ** ** | ** **            | ** ** |
| Revenues,  net                                                       |       | $                     | 8,433      |                  | $          | 7,889 |   |
| ** **                                                           | ** ** | ** **            | ** ** | ** **            | ** ** |
| Operating  costs and expenses                                        |       |                  |       |                  |       |
| Cost of  revenues (exclusive of depreciation shown seperately below) |       | 1,717                 |       | 1,668                 |       |
| General and  administrative                                          |       | 1,497                 |       | 1,774                 |       |
| Product and  content development                                     |       | 1,414                 |       | 1,375                 |       |
| Sales and  marketing                                                 |       | 1,704                 |       | 1,743                 |       |
| Depreciation  and amortization                                       |       | 562                   |       | 767                   |       |
|                                                                 |       |                  |       |                  |       |
| Total  operating costs and expenses                                  |       | 6,894                 |       | 7,327                 |       |
| ** **                                                           | ** ** | ** **            | ** ** | ** **            | ** ** |
| Operating  income                                                    |       | 1,539                 |       | 562                   |       |
| Interest  income, net                                                |       | 82                    |       | 46                    |       |
| Net Income                                                           |       | $                     | 1,621      |                  | $          | 608 |   |
| ** **                                                           | ** ** | ** **            | ** ** | ** **            | ** ** |
| Basic net  income per common share                                   |       | $                     | 0.21       |                  | $          | 0.08 |   |
|                                                                 |       |                  |       |                  |       |
| Basic  weighted average number of common shares outstanding          |       | 7,879                 |       | 7,306                 |       |
|                                                                 |       |                  |       |                  |       |
| Diluted net  income per common share                                 |       | $                     | 0.19       |                  | $          | 0.07 |   |
|                                                                 |       |                  |       |                  |       |
| Diluted  weighted average number of common shares outstanding        |       | 8,742                 |       | 8,169                 |       |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

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A.D.A.M., Inc.

Consolidated Statements of Changesin Shareholders’ Equity

(In thousands, except share data)

 
| ** **                                                                                                                       | ** ** | ** **       | ** ** | ** ** | ** ** | ** **   | ** ** | ** **  | ** ** | ** **     | ** ** | **Note**         | ** ** | ** **       | ** ** | ** **  | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|------------|------------|--------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|------------|------------|
| ** **                                                                                                                       | ** ** | ** **       | ** ** | ** ** | ** ** | **Common**   | ** ** | ** **  | ** ** | **Additional** | ** ** | **Receivable**   | ** ** | **Deferred**     | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                                                                                                       | ** ** | **Common Stock** | ** ** | **Stock**  | ** ** | **Treasury** | ** ** | **Paid-in** | ** ** | **from**       | ** ** | **Compensation** | ** ** | **Accumulated**  | ** ** | ** **  | ** ** |
| ** **                                                                                                                       | ** ** | **Shares**       | ** ** | **Amount** | ** ** | **Warrants** | ** ** | **Stock**   | ** ** | **Capital**    | ** ** | **Shareholder**  | ** ** | **for Services** | ** ** | **Deficit** | ** ** | **Total**  | ** ** |
| **Balance at December 31, 2002**                                                                                            |       | 7,041,384        |       | $          | 70         |         | $          | 353         |       | $              | —     |             | $          | 47,363           |       | $           | (291       | )          | $          | — |   | $ | (41,483 | ) | $ | 6,012 |   |
| Net income                                                                                                                       |       | —           |       | —     |       | —       |       | —      |       | —         |       | —           |       | —           |       | 608         |       | 608        |       |
| Issuance of restricted shares and related deferred  compensation in connection with stock purchase agreement for services        |       | 152,778          |       | 1          |       | —       |       | —      |       | 202            |       | —           |       | (103             | )          | —      |       | 100        |       |
| Stock compensation for services                                                                                                  |       | —           |       | —     |       | —       |       | —      |       | —         |       | —           |       | 53               |       | —      |       | 53         |       |
| Exercise of common stock options                                                                                                 |       | 30,000           |       | 1          |       | —       |       | —      |       | 13             |       | —           |       | —           |       | —      |       | 14         |       |
| Sale of common stock under equity purchase agreement                                                                             |       | 486,566          |       | 5          |       | —       |       | —      |       | 728            |       | —           |       | —           |       | —      |       | 733        |       |
| **Balance at December 31, 2003**                                                                                            |       | 7,710,728        |       | 77         |       | 353          |       | —      |       | 48,306         |       | (291             | )          | (50              | )          | (40,875     | )          | 7,520      |       |
| Net income                                                                                                                       |       | —           |       | —     |       | —       |       | —      |       | —         |       | —           |       | —           |       | 1,621       |       | 1,621      |       |
| Issuance of restricted shares and related  deferred  compensation in connection  with stock purchase agreement for services |       | 50,000           |       | 1          |       | —       |       | —      |       | 119            |       | —           |       | (35              | )          | —      |       | 85         |       |
| Stock compensation for services                                                                                                  |       | —           |       | —     |       | —       |       | —      |       | —         |       | —           |       | 62               |       | —      |       | 62         |       |
| Warrants, expired                                                                                                                |       | —           |       | —     |       | (267         | )          | —      |       | 267            |       | —           |       | —           |       | —      |       | —     |       |
| Treasury stock purchased                                                                                                         |       | (180,371         | )          | —     |       | —       |       | (592        | )          | —         |       | —           |       | —           |       | —      |       | (592       | )          |
| Exercise of common stock options                                                                                                 |       | 280,178          |       | 2          |       | —       |       | —      |       | 151            |       | —           |       | —           |       | —      |       | 153        |       |
| **Balance at December 31, 2004**                                                                                            |       | 7,860,535        |       | $          | 80         |         | $          | 86          |       | $              | (592       | )                | $          | 48,843           |       | $           | (291       | )          | $          | (23 | ) | $ | (39,254 | ) | $ | 8,849 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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A.D.A.M., Inc.

Consolidated Statements of CashFlows

(In thousands)

 
| ** **                                                                         | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                         | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| Cash flows from operating activities                                               |       |                  |       |                  |       |
| Net income                                                                         |       | $                     | 1,621      |                  | $          | 608 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                  |       |                  |       |
| Depreciation  and amortization                                                     |       | 1,151                 |       | 1,393                 |       |
| Writeoff of  interest bearing note receivable                                      |       | 50                    |       | —                |       |
| Gain on sale  of assets                                                            |       | (2                    | )          | (9                    | )          |
| Stock  compensation for services                                                   |       | 62                    |       | 53                    |       |
| Other, net                                                                         |       | (21                   | )          | (21                   | )          |
| Changes in  assets and liabilities                                                 |       |                  |       |                  |       |
| Accounts  receivable                                                               |       | (705                  | )          | (168                  | )          |
| Inventories                                                                        |       | (41                   | )          | 19                    |       |
| Prepaids and  other assets                                                         |       | (80                   | )          | (61                   | )          |
| Accounts  payable and accrued liabilities                                          |       | 90                    |       | (63                   | )          |
| Deferred  revenue                                                                  |       | 1,320                 |       | 379                   |       |
| Net cash  provided by operating activities                                         |       | 3,445                 |       | 2,130                 |       |
| Cash flows  from investing activities                                              |       |                  |       |                  |       |
| Purchases of  property and equipment                                               |       | (101                  | )          | (85                   | )          |
| Proceeds  from sales of property and equipment                                     |       | 2                     |       | —                |       |
| Repayments  on notes receivable                                                    |       | —                |       | 94                    |       |
| Net change  in restricted time deposits                                            |       | 123                   |       | 12                    |       |
| Software  product and content development costs                                    |       | (691                  | )          | (645                  | )          |
| Purchase of  investments:                                                          |       |                  |       |                  |       |
| Available  for sale                                                                |       | (2,726                | )          | —                |       |
| Held to  maturity                                                                  |       | (1,000                | )          | —                |       |
| Net cash  used in investing activities                                             |       | (4,393                | )          | (624                  | )          |
| Cash flows  from financing activities                                              |       |                  |       |                  |       |
| Proceeds  from sales of common stock                                               |       | 85                    |       | 833                   |       |
| Proceeds  from exercise of common stock options                                    |       | 153                   |       | 14                    |       |
| Repurchase  of common stock to be held as treasury stock                           |       | (592                  | )          | —                |       |
| Repayments  on capital leases                                                      |       | (10                   | )          | (19                   | )          |
| Net cash  provided by (used in) financing activities                               |       | (364                  | )          | 828                   |       |
| Increase  (decrease) in cash and cash equivalents                                  |       | (1,312                | )          | 2,334                 |       |
| Cash and  cash equivalents, beginning of year                                      |       | 4,554                 |       | 2,220                 |       |
| Cash and  cash equivalents, end of year                                            |       | $                     | 3,242      |                  | $          | 4,554 |   |
| Interest  paid                                                                     |       | $                     | 10         |                  | $          | 7 |   |
| Supplemental  disclosure of non-cash activities Incurred capital lease obligations |       | $                     | 19         |                  | $          | — |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**A.D.A.M., Inc.**

**Notes to Consolidated Financial Statements**

 

**1. Description of Business and Summary ofSignificant Accounting Policies**

 

**Business**

 

We specialize in the creationand delivery of interactive health information and decision support toolsprimarily marketed to healthcare organizations, public and restricted accessInternet websites, and educational applications that are primarily marketed toeducational institutions.

 

Our products for healthcare aredesigned to educate and inform healthcare consumers on various aspects of theirhealth and wellness. These products can be used for learning about generalhealth concerns, specific diseases and treatments, surgical procedures, druginformation, specialty health subjects (such as women’s health and children’shealth), nutrition, alternative medicine and more. We sell our health productsand decision support tools primarily through annual licensing agreements tomany different types of healthcare and health-related organizations includinghospitals, health plans, pharmaceutical companies, disease management vendors,health-oriented Internet websites, healthcare technology companies and largeemployers. Our health information tools can be incorporated into a customer’swebsite, imbedded in healthcare applications such as an electronic medicalrecord or disease management application, contained in a printed format, orcombined with other products that may be offered to a healthcare consumer.

 

Our educational products include applications designed to teachstudents gross anatomy and physiology as well as to allow educators to developinteractive, multimedia-based classroom curriculum.

 

**Basis of Presentation**

 

**Principles of consolidation**

 

The accompanying consolidatedfinancial statements include the accounts of A.D.A.M., Inc. and its whollyowned subsidiaries, Integrative Medicine Communications, Inc. (“IMC”) and NidusInformation Services, Inc. (“Nidus”). All inter company transactions and balances have been eliminated.

 

**Use of estimates**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of net revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

**Revenue recognition**

 

We generate revenues mainly in two ways – Internet-based licensing andshipped product sales. Internet revenues consist primarily of license fees thatusually consist of an annual, up-front fee that is initially recorded asdeferred revenue. This revenue is recognized ratably over the term of thelicense agreement beginning after delivery has occurred, upon customeracceptance, when we have determined that the fees from the agreement are fixedand determinable, and there are no significant return or acceptance provisions.When a contract includes multiple elements, such as services, the entire fee isallocated to each respective element, based on vendor specific objectiveevidence of fair value, and recognized when the revenue criteria for eachelement is met. Service revenues are generally recognized upon completion andacceptance by the customer.  For Internetrevenue arrangements in which we sell through a reseller, we do not recognizeany revenue until an agreement has been finalized between the customer and ourauthorized reseller and the content has been delivered to the customer by thereseller. Revenue is not recognized under any circumstances unlesscollectibility is reasonably assured. Shipped product revenues represent thesales of software products and revenues earned under certain royaltyagreements. Revenues from product sales are generally recognized at the timetitle passes to customers, distributors or resellers. Revenues from royaltyagreements are recognized as earned based upon performance or product shipment.We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, “RevenueRecognition in Financial Statements,” as amended by SAB 101A and 101B and asrevised by SAB 104, “Revenue Recognition” and Statement of Position No. 97-2, “SoftwareRevenue Recognition.” Accordingly, we recognize revenue when: (1) persuasiveevidence of an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonablyassured.

 

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Allowances for estimated product returns are provided at the time ofsale. We evaluate the adequacy of allowance for returns based upon ourevaluation of historical and expected sales experience and by channel ofdistribution. As certain conditions change, such as sell-through experience,channels of distribution, and general economic conditions, the estimatedreserve required for returns may also change.

 

**Concentration of sales and credit risk**

 

Financial instruments that potentially subject us to concentration ofcredit risk consist primarily of trade receivables and a marketable debtsecurity.  For the years ended December 31,2004 and 2003, no one customer accounted for more than 10% of netrevenues.  The marketable debt securityconcentration is identified in Note 2.

 

**Fair value of financial instruments**

 

The carrying amounts of our financial instruments, including cash andcash equivalents, investments, accounts receivable, restricted time deposits,accounts payable, accrued expenses and other liabilities, approximate fairvalue due to their short maturities.

 

**Cash and cash equivalents**

 

Cash and cash equivalents include cash on hand and deposits and highlyliquid investments with an original maturity of three months or less.

 

**Investments**

 

Mutual funds are categorized asavailable-for-sale which requires the securities to be reported at fair value,with unrealized gains and losses reported as a separate component ofshareholders’ equity, if significant. Realized gains or losses, if any, are recorded within the statement ofoperations as other income.  For thepurpose of computing realized gains and losses, cost is identified on aspecific identification basis.

 

The marketable debt security is classified asheld-to-maturity as we have the positive intent and ability to hold it tomaturity.  Securities held-to-maturityare stated at cost, with corresponding premiums or discounts, if any, amortizedover the life of the investment to interest income.

 

**Equity investment**

 

As of December 31, 2004 and 2003, we had an approximate 34% votinginterest in ThePort Network, Inc., a related party company (see Note 13).  This investment is accounted for under theequity method.  As of December 31,2004 and 2003, the carrying value of this investment was $0. We have no futureobligations to fund ThePort Network, Inc.

 

**Cost Investment**

 

As of December 31, 2004 and 2003, we held a less than 20%ownership in BeBetter Networks, Inc., a related company (see Note 13).This investment is accounted for under the cost method and at December 31,2004 and 2003 its carrying value was $0.

 

**Accounts receivable**

 

Accounts receivable are stated at the amountmanagement expects to collect from outstanding balances.  Management provides for probableuncollectible amounts through a charge to earnings and a credit to a valuationallowance based on its assessment of the current status of individualaccounts.  Balances that are stilloutstanding after management has performed reasonable collection efforts arewritten off through a charge to the valuation allowance and a credit toaccounts receivable.  We grant credit toour customers without requiring collateral. The amount of accounting loss for which we are at risk in theseunsecured accounts receivable is limited to their carrying value.

 

**Inventories**

 

Inventories consist principally of computer software media, books andrelated shipping materials and are stated at the lower of cost or market. Costis determined using the first-in, first-out method. The valuation of inventoryrequires us to estimate net realizable value. We write down our inventory forestimated obsolescence or to the lesser of cost or market value.

 

**Property and equipment**

 

Property and equipment are recorded at cost and depreciated over theirestimated useful lives using the straight-line method. Property and equipmentheld under capital leases and leasehold improvements are amortized over theshorter of the lease term or the estimated useful 

 

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life of the related asset. Upon retirement or sale, the cost of assetsdisposed of and the related accumulated depreciation are removed from theaccounts and any resulting gain or loss is credited or charged to income.Repairs and maintenance costs are expensed as incurred.

 

**Intangible assets**

 

Intangible assets consist of purchased intellectual content, purchasedcustomer contracts, capitalized software product and content development coststo be sold, leased or otherwise marketed, and software development costs forinternal use software.

 

Capitalized software product and content development costs to be sold,leased or otherwise marketed consist principally of salaries and certain otherexpenses directly related to the development and modifications of softwareproducts and content capitalized in accordance with the provisions of SFASNo. 86, “Accounting for the Costs of Computer Software to be Sold, Leased,or Otherwise Marketed.” Amortization of capitalized software product andcontent development costs is provided at the greater of the ratio of currentproduct revenue to the total of current and anticipated product revenue or on astraight-line basis over the estimated economic life of the software, which wehave determined to generally be two years.

 

In accordance with the American Institute of Certified PublicAccountants’ (“AICPA”) Statement of Position (“SOP”) 98-1, “Accounting for theCosts of Computer Software Developed or Obtained for Internal Use,” we expensecosts incurred in the preliminary project planning stage and thereaftercapitalize costs incurred in developing or obtaining internal use software.Costs, such as maintenance and training, are expensed as incurred. Capitalizedcosts are amortized over their estimated useful life, generally three years.

 

**Impairment of long-lived assets and goodwill**

 

We evaluate impairment of long-lived assets, including property andequipment and intangible assets with finite lives, whenever events or changesin circumstances indicate that the carrying amount of such assets may not berecoverable. If the sum of the expected future undiscounted cash flows is lessthan the carrying amount of the asset, an impairment loss is recognized.Measurement of an impairment loss for long-lived assets is based on discountedcash flows and the fair value of the asset.

 

We evaluate goodwill for impairment on an annual basis. Additionally,goodwill is tested for impairment between annual tests if an event occurs orcircumstances change that would more likely than not reduce the fair value ofan entity below its carrying value. These events or circumstances would includea significant change in the business climate, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business or other factors. The carrying value of goodwill isevaluated in relation to the operating performance and estimated futurediscounted cash flows of the entity.

 

**Product and content development expenditures**

 

Product and content development expenditures include costs incurred inthe development, enhancement and maintenance of our content and technology.These costs have been charged to expense as incurred.

 

**Restricted time deposits**

 

In connection with our non-cancelable operating leases for our officespace and telephone system, we are required to purchase time deposits to secureletters of credit with the bank guaranteeing payments under the leases. Thetime deposits bear interest at an average rate of****approximately1.61% and are carried at cost, which approximates fair value. Theclassification of these investments is determined based on the expected term ofthe collateral requirement and not necessarily the maturity date of theunderlying securities.

 

**Income taxes**

 

We account for income taxes utilizing the liability method and deferredincome taxes are determined based on the differences between the financialreporting and income tax basis of assets and liabilities given the provisionsof the enacted tax laws. A valuation allowance is provided against deferred taxassets for which it is more likely than not that the asset will not berealized.

 

**Stock-based employee compensation**

 

We account for stock-based employee compensation using the intrinsicvalue method prescribed in Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related Interpretations and we provide thedisclosures required by SFAS No. 123, “Accounting for Stock-BasedCompensation.” Accordingly, compensation cost for stock options issued toemployees is measured as the excess, if any, of the quoted market price of ourstock at the date of the grant over the amount an employee must pay to acquirethe stock.

 

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We recorded no employee stock option compensation expense during 2004and 2003. Had we determined employee compensation costs using a fair valuebased methodology at the grant date for our stock options under SFAS  No. 123, our pro forma consolidated netincome (loss) would have been as follows (in thousands, except per share data):

 
| ** **                                                                                       | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                       | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                       | ** ** | **2004**              | ** ** | **2003**              | ** ** |
|                                                                                             |       |                  |       |                  |       |
| Net income  as reported                                                                          |       | $                     | 1,621      |                  | $          | 608 |   |
| Deduct total  stock-based employee compensation expense determined under fair-value base  method |       | (415                  | )          | (888                  | )          |
|                                                                                             |       |                  |       |                  |       |
| Pro forma  net income (loss)                                                                     |       | $                     | 1,206      |                  | $          | (280 | ) |
|                                                                                             |       |                  |       |                  |       |
| Basic net  income (loss) per share                                                               |       |                  |       |                  |       |
| As reported                                                                                      |       | $                     | 0.21       |                  | $          | 0.08 |   |
| Pro forma                                                                                        |       | $                     | 0.15       |                  | $          | (0.04 | ) |
|                                                                                             |       |                  |       |                  |       |
| Diluted net  income (loss) per share                                                             |       |                  |       |                  |       |
| As reported                                                                                      |       | $                     | 0.19       |                  | $          | 0.07 |   |
| Pro forma                                                                                        |       | $                     | 0.14       |                  | $          | (0.04 | ) |

####  

**Net income per common share**

 

Net income per share is computed in accordance with SFAS No. 128, “EarningsPer Share.” We compute basic net income per share by dividing net income by theweighted average number of common shares outstanding for each period. Dilutednet income per share is based upon the addition of the effect of common stockequivalents (stock options and warrants) to the denominator of the basic netincome per share calculation using the treasury stock method, if their effectis dilutive. The computation of net income per share for the years ended December 31,2004 and 2003 is as follows (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Year**                    | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                               | ** ** | **Ended December 31,** | ** ** |
| ** **                                                               | ** ** | **2004**                    | ** ** | **2003** | ** ** |
|                                                                     |       |                        |       |   |   |
| Net income                                                               |       | $                           | 1,621      |   | $ | 608 | ** ** |
| Weighted  average common shares outstanding                              |       | 7,879                       |       | 7,306 |   |
| Weighted  average common shares equivalents (stock options and warrants) |       | 863                         |       | 826 |   |
| Weighted  average shares in escrow                                       |       | —                      |       | 37 |   |
| Weighted  average diluted common shares outstanding                      |       | 8,742                       |       | 8,169 |   |
| Net income  per share:                                                   | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Basic                                                                    |       | $                           | 0.21       |   | $ | 0.08 |   |
| Diluted                                                                  |       | $                           | 0.19       |   | $ | 0.07 |   |
|                                                                     |       |                        |       |   |   |
| Anti-dilutive  stock options and warrants outstanding                    |       | 1,703                       |       | 2,611 |   |

 

**Comprehensive income**

 

Our comprehensive income for the years ended December 31, 2004 and2003, as required to be reported by SFAS No. 130 “Reporting ComprehensiveIncome,” was identical to the actual net income reported for those periods.

 

**Recent accounting pronouncements**

 

On December 16, 2004, the Financial Accounting Standards Board(FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,”which is a revision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation.”  Statement 123(R)supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” andamends FASB Statement No. 95, “Statement of Cash Flows.” The approach toaccounting for share-based payments in Statement 123(R) is similar to theapproach described in Statement 123. However, Statement 123(R) requires allshare-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues and no longer allows pro forma disclosure as an alternative to financialstatement recognition. We will be required to adopt Statement 123(R) at thebeginning of its quarter ending March 31, 2006.

 

We will adopt SFAS 123(R) using the modified prospective method andreflect compensation expense in accordance with the SFAS 123(R) transitionprovisions.  Under the modifiedprospective method, prior periods are not restated to reflect the impact ofadopting the new standard at earlier dates. Pro forma disclosures regarding the effect on our net income and netincome per common share in 2004 and 2003, had we applied the fair value methodof accounting for share-based compensation as prescribed by SFAS 123, arecontained in the “Stock-based employee compensation” section of Note1.  Based on share-based compensationgranted through December 31, 2004 and the fair values previouslycalculated under SFAS 123, we project we will record an immaterial amount ofadditional compensation expense in 2006 related to stock options upon theadoption of SFAS 123R compared to the existing accounting method under APBOpinion No. 25.  We are still evaluatingthe impact this new standard will have on its Stock Incentive Plan.

 

 

----

 

**2. Investments**

 

Short-term investments at December 31, 2004 included the following(in thousands):

 
| **Description**               | ** ** | **Balance** | ** ** | **Purchased** | ** ** | **Maturity** | ** ** | **Yield at   12/31/2004** | ** ** |
|-------------------------------|------------|-------------|------------|---------------|------------|--------------|------------|---------------------------|------------|
| Time Deposit                  |       | $           | 1,000      |          | 8/8/2004   |         | 8/8/2005   |                      | 2.33       | % |
| Time Deposit                  |       | 99          |       | 9/7/2004      |       | 3/7/2005     |       | 2.22                      | %          |
| Time Deposit                  |       | 127         |       | 2/24/2004     |       | 1/21/2005    |       | 1.61                      | %          |
| Mutual  Funds:                |       |        |       |          |       |         |       |                      |       |
| Eaton Vance  Floating Fund    |       | 1,000       |       | 6/15/2004     |       | 6/15/2005    |       | 3.54                      | %          |
| Eaton Vance  Floating Fund    |       | 500         |       | 11/16/2004    |       | 11/16/2005   |       | 3.54                      | %          |
|                          |       |        |       |          |       |         |       |                      |       |
| Total  Short-term Investments |       | $           | 2,726      |          |       |         |       |                      |       |   |

 

 

----

 

 

At December 31, 2004, the cost of the above investmentsapproximated fair value.

 

On June 15, 2004 we also purchased a General Motors AcceptanceCorp. bond in the amount of $1,000,000. The bond matures on July 15, 2006 and earns interest at an annualrate of approximately 4.50%. Interest is paid to us on a semi-annualbasis.  At December 31, 2004, theamortized cost of the bond approximated fair value.

 

**3. Property and Equipment**

 

Property and equipment are summarized as follows (in thousands):

 
| ** **                                        | ** ** | **Estimated**   | ** ** | ** **            | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|-----------------------|------------|------------|------------|
| ** **                                        | ** ** | **Useful Life** | ** ** | **December 31,** | ** ** |
| ** **                                        | ** ** | **(Years)**     | ** ** | **2004**              | ** ** | **2003**   | ** ** |
|                                              |       |            |       |                  |       |       |       |
| Computers                                         |       | 3               |       | $                     | 1,629      |       | $          | 1,741 |   |
| Equipment                                         |       | 5               |       | 500                   |       | 481        |       |
| Furniture  and fixtures                           |       | 5               |       | 539                   |       | 539        |       |
| Leasehold  improvements                           |       | 5               |       | 56                    |       | 56         |       |
|                                              |       |            |       |                  |       |       |       |
|                                              |       |            |       | 2,724                 |       | 2,817      |       |
|                                              |       |            |       |                  |       |       |       |
| Less -  accumulated depreciation and amortization |       |            |       | (2,540                | )          | (2,632     | )          |
|                                              |       |            |       |                  |       |       |       |
|                                              |       |            |       | $                     | 184        |       | $          | 185 |   |

 

Depreciation and amortization expense for the years ended December 31,2004 and 2003 was $101,000 and $134,000, respectively.

 

**4. Product and Content DevelopmentExpenditures**

 

Product and content development expenditures are summarized as follows(in thousands):

 
| ** **                                                               | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                               | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| ** **                                                               | ** ** | ** **            | ** ** | ** **            | ** ** |
| Total  product and content development expenditures                      |       | $                     | 2,105      |                  | $          | 2,020 |   |
| Less:  additions to capitalized software product and content development |       | (691                  | )          | (645                  | )          |
|                                                                     |       |                  |       |                  |       |
| Product and  content development expense                                 |       | $                     | 1,414      |                  | $          | 1,375 |   |

 

**5. Intangible Assets**

 

Intangible assets are summarized as follows (in thousands):

 
| ** **                                                                          | ** ** | **Estimated**     | ** ** | ** **            | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|------------|------------|
| ** **                                                                          | ** ** | **amortizable**   | ** ** | **December 31,** | ** ** |
| ** **                                                                          | ** ** | **lives (years)** | ** ** | **2004**              | ** ** | **2003**   | ** ** |
| ** **                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Capitalized  software products and content to be sold, leased or otherwise marketed |       | 2                 |       | $                     | 3,358      |       | $          | 3,048 |   |
| Software  developed for internal use                                                |       | 3                 |       | 352                   |       | 525        |       |
| Purchased  intellectual content                                                     |       | 3                 |       | 1,431                 |       | 1,431      |       |
| Purchased  customer contracts                                                       |       | 2                 |       | 333                   |       | 333        |       |
|                                                                                |       |              |       |                  |       |       |       |
| Intangible  assets, gross                                                           |       |              |       | 5,474                 |       | 5,337      |       |
|                                                                                |       |              |       |                  |       |       |       |
| Less  accumulated amortization:                                                     |       |              |       |                  |       |       |       |
| Capitalized  software products and content to be sold, leased or otherwise marketed |       |              |       | (2,426                | )          | (2,246     | )          |
| Software  developed for internal use                                                |       |              |       | (77                   | )          | (222       | )          |
| Purchased  intellectual content                                                     |       |              |       | (1,360                | )          | (906       | )          |
| Purchased  customer contracts                                                       |       |              |       | (333                  | )          | (327       | )          |
|                                                                                |       |              |       |                  |       |       |       |
| Accumulated  amortization                                                           |       |              |       | (4,196                | )          | (3,701     | )          |
|                                                                                |       |              |       |                  |       |       |       |
| Intangible  assets, net                                                             |       |              |       | $                     | 1,278      |       | $          | 1,636 |   |

# ** **

Amortization expense, which includes the amortization of capitalizedsoftware product and content development costs reported in cost of revenues,for the years ended December 31, 2004 and 2003 was $1,050,000 and$1,259,000, respectively.  Estimatedamortization expense for the years 2005, 2006, 2007 and 2008 is approximately$751,000, $418,000, $89,000 and $20,000, respectively, at which point these intangibleassets will be fully amortized.

 

**6. Goodwill**

 

The goodwill balance at December 31,2004 and 2003 was made up of the following (in thousands):

 
| ** **                | ** ** | **IMC** | ** ** | **Nidus** | ** ** | **Total** | ** ** |
|---------------------------|------------|---------|------------|-----------|------------|-----------|------------|
| Goodwill  carrying amount |       | $       | 1,367      |      | $          | 676       |       | $ | 2,043 |   |
|                           |            |         |            |           |            |           |            |  |  |  |

 

**7. Accounts Payable and Accrued Expenses**

 

Accounts payable and accrued expenses consist of the following (inthousands):

 
| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                        |       |                  |       |   |   |
| Accounts  payable                           |       | $                     | 1          |   | $ | 21 |   |
| Accrued  professional fees                  |       | 85                    |       | 117 |   |
| Accrued  compensation and employee benefits |       | 225                   |       | 168 |   |
| Other  accrued expenses                     |       | 415                   |       | 328 |   |
|                                        |       |                  |       |   |   |
|                                        |       | $                     | 726        |   | $ | 634 |   |

 

**8. Income Taxes**

 

The provision for income taxes differs from the amount computed byapplying the applicable U.S. statutory federal income tax rate of34 percent to income before income taxes as a result of the following (in thousands):

 
| ** **                                                                                | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                | ** ** | **2004**              | ** ** | **2003**              | ** ** |
|                                                                                      |       |                  |       |                  |       |
| Federal tax  provision on income before income taxes at statutory federal income tax rate |       | $                     | 551        |                  | $          | 207 |   |
| Research and  development tax credits                                                     |       | (305                  | )          | —                |       |
| Change in  valuation allowance                                                            |       | (281                  | )          | (235                  | )          |
| State taxes,  net of federal benefit                                                      |       | 65                    |       | 24                    |       |
| Other                                                                                     |       | (30                   | )          | 4                     |       |
|                                                                                      |       |                  |       |                  |       |
|                                                                                      |       | $                     | —     |                  | $          | — |   |

 

Thecomponents of our deferred tax assets and liabilities are as follows (inthousands):

 
| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                               |       |                  |       |   |   |
| Deferred tax  assets                               |       |                  |       |   |   |
| Accrued  expenses and other liabilities            |       | $                     | 91         |   | $ | 89 |   |
| Allowance  for doubtful accounts                   |       | 39                    |       | 41 |   |
| Intangible  assets                                 |       | 462                   |       | 493 |   |
| Fixed assets                                       |       | 203                   |       | 230 |   |
| Research and  development credits                  |       | 1,044                 |       | 739 |   |
| Capitalized  development                           |       | 1,071                 |       | 1,263 |   |
| Capital loss  carryforwards                        |       | 161                   |       | 161 |   |
| Net  operating loss carryforwards                  |       | 13,051                |       | 13,505 |   |
|                                               |       | 16,122                |       | 16,521 |   |
| Deferred tax  liabilities                          |       |                  |       |   |   |
| Software  product and content development costs    |       | (466                  | )          | (581 | ) |
|                                               |       |                  |       |   |   |
| Net deferred  tax asset before valuation allowance |       | 15,656                |       | 15,940 |   |
| Valuation  allowance                               |       | (15,656               | )          | (15,940 | ) |
|                                               |       |                  |       |   |   |
|                                               |       | $                     | —     |   | $ | — |   |

 

----

 

At December 31,2004, we had net operating loss (NOL) and R&D credit carryforwardsavailable for tax purposes of approximately $34.3 million and $1 million,respectively, which will expire on December 31 in years 2006 through 2022and 2007 through 2023, respectively.  We acquired approximately $10million of NOL carry forwards as a result of the acquisition of IMC in December of2001. Internal Revenue Code Section 382 limits the utilization of NOLcarryforwards when a change in ownership, as defined by the Internal RevenueService, occurs. The acquisition of IMC resulted in an ownership change withinthe meaning of Internal Revenue Section 382. The total annual Section 382limitation is approximately $60,000. Of the total $10 million pre-changed NOLsacquired from IMC, the pre-change NOLs estimated to be available for use afterthe application of the IRC 382 limitation is approximately $1.2 million.

 

Netoperating loss carryforwards expiring over the next five years are as follows(in thousands):

 
| **Year Ending  December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2006                               |       |       |       | $ | 541 |   |
| 2007                               |       |       |       | 2,877 |   |
| 2008                               |       |       |       | 2,922 |   |
| 2009                               |       |       |       | 3,452 |   |
|                               |       |       |       | $ | 9,792 |   |

 

AtDecember 31, 2004 and 2003, we had recorded a valuation allowance equal to ournet deferred tax assets as management believes it is more likely than not thatthe net deferred tax assets will not be realized.

 

AtDecember 31, 2004 approximately $478,000 of the valuation allowance wasattributable to the acquisition of IMC and, if reversed, would reduce goodwill.Also, at December 31, 2004 approximately $480,000 of the valuation allowancewas attributable to tax deductions for the exercise of employee stock optionsin excess of related compensation expense recorded in the financial statements.The reversal of this portion of the deferred tax asset would be recorded asadditional paid-in capital.

 

**9. Equity Purchase Agreements**

 

OnMay 22, 2002, we entered into a Common Stock Purchase Agreement withFusion Capital Fund II, LLC. Pursuant to this agreement, Fusion Capital agreedto purchase up to an aggregate of $12,000,000 of our common stock. We have theright to sell up to $15,000 of our common stock per trading day under thisagreement unless our stock price equals or exceeds $7.00, in which case thedaily amount may be increased at our option. Fusion Capital is not obligated topurchase any shares of our common stock on any trading days that the marketprice of our common stock is less than $1.00. Since we registered 3,500,000shares for sale to Fusion Capital pursuant to the agreement, the selling priceof our common stock to Fusion Capital will have to average at least $3.43 pershare for us to receive the maximum proceeds of $12,000,000 without registeringadditional shares of common stock, which we have the right but not theobligation to do. Assuming a purchase price of $1.00 per share and the purchaseby Fusion Capital of the full 3,500,000 shares under the agreement, proceeds tous would be $3,500,000. If we decided to sell more than the 1,352,100 shares toFusion Capital (19.99% of our outstanding shares as of May 22, 2002, thedate of the agreement, exclusive of the 160,000 shares issued to Fusion Capitalas a commitment fee), we would first be required to seek shareholder approvalof the agreement in order to be in compliance with Nasdaq rules. We may, butshall be under no obligation to, request our shareholders to approve thetransaction contemplated by the agreement. We may terminate the agreement atany time, and Fusion Capital may terminate the agreement at any time after August 2005,approximately 40 months following the date the purchase obligation underthe agreement became effective. During the year ended December 31, 2003,we sold 486,566 shares for aggregate proceeds of $733,000 under thisagreement.  During the year ended December 31,2004, there were no transactions under this agreement.

 

**10. Treasury Stock**

 

During the year ended December 31, 2004 we repurchased 180,371shares of our common stock under a stock repurchase plan approved by our Boardof Directors at the 2003 annual meeting. The average price of these shares was$3.28.

 

**11. Consulting Agreements**

 

On February 15, 2003, we entered into a Restricted Common StockPurchase Agreement with James T. Atenhan and Victor P. Thompson (each a “Purchaser”)in connection with a consulting agreement with a financial services firmcontrolled by the Purchasers. Each Purchaser purchased 37,500 shares of ourcommon stock at a purchase price of $.40 per share. The purchase price of ourcommon stock was discounted from the $.78 market price on the date we enteredinto the agreement. In connection with the sale, we recorded deferredcompensation for services of $28,500. This deferred compensation expense wasexpensed over the six-month service period.

 

On August 1, 2003, we entered into a second Restricted CommonStock Purchase Agreement with the Purchasers in connection with a twelve-monthextension of the consulting contract. Each Purchaser purchased 38,889 shares ofour common stock at a purchase price of $.90 per share. The purchase price ofour common stock was discounted from the $1.86 market price on the date weentered into the 

 

----

 

agreement. In connection with the sale, we recorded deferredcompensation for services of $74,667. This deferred compensation expense wasexpensed over the twelve-month service period.

 

On September 1, 2004, we extended the consulting contract foranother twelve months and entered into a third Restricted Common Stock PurchaseAgreement with the Purchasers. Each Purchaser purchased 25,000 shares of ourcommon stock at a purchase price of $1.70 per share. The purchase price wasdiscounted from the $2.40 market price on the date we entered into the agreement.In connection with the sale, we recorded deferred compensation expense forservices of $35,000. This deferred compensation expense is being expensed overthe twelve-month service period beginning September 1, 2004.  As of December 31, 2004, the remainingdeferred compensation expense for services was approximately $23,000.

 

**12. Common Stock Options and Warrants**

 

In 2002,our Board adopted and our shareholders approved our 2002 Stock Incentive Plan,under which we have reserved 1,500,000 shares of common stock pursuant to thegrant of incentive or non-qualified stock options to full-time employees andkey persons. Options are granted at an exercise price as determined by ourBoard of Directors, which may not be less than the fair market value of our commonstock at the date of the grant, and the options generally vest ratably over athree-year period. Options granted under the Plan generally expire ten yearsfrom the date of grant.

 

As of December 31,2004, we had options outstanding to purchase a total of 3,235,297 shares of ourcommon stock under our 2002 Stock Incentive Plan and our 1992 Option Plan.Under the 1992 Option Plan, we had reserved 4,500,000 shares of common stockand no additional options may be granted under the Plan.  At December 31, 2004, there wereapproximately 369,000 shares available for future option grants under the 2002Stock Incentive Plan.

 

The fairvalue of each option grant is estimated on the date of the grant using theBlack-Scholes option-pricing model with the following weighted-averageassumptions used for grants in the years ended December 31, 2004 and 2003:dividend yield of 0%; expected volatility of 107% and 125%, respectively;risk-free interest rates of 3.05% and 2.29%, respectively; and an expected lifeof 3.5 years, with the exception of options granted during 2004 and 2003 withone-year vesting periods, which have an expected life of two years.

 

Thefollowing table summarizes stock option activity for the years ended December 31,2004 and 2003:

 
| ** **                                     | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
|------------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | **Average**  | ** ** | **Average**  | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Fair**     | ** ** |
| ** **                                     | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Value**    | ** ** |
| Outstanding  at December 31, 2002         |       | 2,651,854  |       | $            | 4.67       |         | —     |   |
| Granted                                        |       | 1,278,750  |       | $            | 0.43       |         | $          | 0.43 |   |
| Exercised                                      |       | (30,000    | )          | $            | 0.46       |         | —     |   |
| Canceled or  expired                           |       | (198,428   | )          | $            | 1.98       |         | —     |   |
| Outstanding  at December 31, 2003         |       | 3,702,176  |       | $            | 3.34       |         | —     |   |
| Granted                                        |       | 65,000     |       | $            | 2.39       |         | $          | 1.64 |   |
| Exercised                                      |       | (280,178   | )          | $            | 0.55       |         | —     |   |
| Canceled or  expired                           |       | (251,701   | )          | $            | 4.03       |         | —     |   |
| Outstanding  at December 31, 2004         |       | 3,235,297  |       | $            | 3.52       |         | —     |   |
| Options  exercisable at December 31, 2004 |       | 2,652,701  |       |         |       |         |       |

 

The following table summarizes additional information about stockoptions outstanding at December 31, 2004:

 
| ** **                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-----------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | ** **              | ** ** | **Weighted**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Number**              | ** ** | **Average**             | ** ** | **Weighted** | ** ** | **Number** | ** ** | **Weighted** | ** ** |
| ** **                  | ** ** | **Outstanding at**      | ** ** | **Remaining**           | ** ** | **Average** | ** ** | **Exercisable at** | ** ** | **Average** | ** ** |
| **Range of**                | ** ** | **December 31,**   | ** ** | **Contractual**         | ** ** | **Exercise** | ** ** | **December 31,** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**         | ** ** | **2004**                | ** ** | **Life (years)**        | ** ** | **Price** | ** ** | **2004** | ** ** | **Price** | ** ** |
|                        |       |                    |       |                    |       |   |   |   |   |   |   |
| $  0.41 to $0.85  |       | 850,419                 |       | 8.01                    |       | $ | 0.42 |   | 444,027 |   | $ | 0.41 |   |
| $  1.58 to $2.94  |       | 742,649                 |       | 6.05                    |       | $ | 2.09 |   | 713,482 |   | $ | 2.08 |   |
| $  3.06 to $4.75  |       | 839,444                 |       | 6.47                    |       | $ | 3.32 |   | 692,407 |   | $ | 3.36 |   |
| $  5.00 to $5.91  |       | 370,936                 |       | 4.47                    |       | $ | 5.48 |   | 370,936 |   | $ | 5.48 |   |
| $  7.94 to $12.75 |       | 246,710                 |       | 4.21                    |       | $ | 8.55 |   | 246,710 |   | $ | 8.55 |   |
| $13.00 to  $20.63           |       | 185,139                 |       | 4.95                    |       | $ | 13.87 |   | 185,139 |   | $ | 13.87 |   |
|                        |       |                    |       |                    |       |   |   |   |   |   |   |
|                        |       | 3,235,297               |       | 6.29                    |       | $ | 3.52 |   | 2,652,701 |   | $ | 4.04 |   |

 

In January 1999,we provided employee holders of options with exercise prices from $3.50 andhigher the opportunity to cancel such options in exchange for an equal numberof options with a vesting period of one year at the then current market priceof $5.25. As a result of this election, 423,400 options were canceled andreissued in January 1999. As of December 31, 2004 and 2003, we had231,438 outstanding options with an exercise price of $5.25 that are consideredvariable. The new option exercise price equaled the market price on the date ofthe repricing and, correspondingly, compensation expense was not recognized.The vesting period of these options was one year. As a result of the issuanceof FASB Interpretation No. 44, “Accounting for Certain Transactionsinvolving Stock Compensation, an interpretation of APB Opinion No. 25,”these options are being treated as variable awards. Accordingly, compensationcost shall be adjusted for increases in the fair value of the awards above$5.25 until these options are either exercised or forfeited. As of December 31,2004, no compensation cost had been recognized for these options, as the fairvalue of our common stock had not exceeded $5.25 per share.

 

As of December 31, 2003, we had warrants outstanding to purchase atotal of 85,000 shares of our common stock at a weighted average exercise priceof $7.63 per share.  These warrants wereissued in conjunction with the issuance of notes on December 31, 1999 andare exercisable at any time at the election of the holders, expiring at variousdates through December 31, 2005.

 

During 2004, 50,000 warrants at an exercise price of $11.11 per shareexpired.  As of December 31, 2004,we had warrants outstanding to purchase 35,000 shares of our common stock at aweighted average exercise price of $2.66, expiring on various dates through December 31,2005.

 

----

 

**13. Related Party Transactions**

 

**Promissory Note with Our Chief Executive Officer**

 

OnMay 30, 2001, we received a full-recourse promissory note from our ChiefExecutive Officer for approximately $341,000 (the “Exercise Note”) for theexercise of 150,000 options at $1.94 per share and a $50,000 promissory note(the “Tax Note”) in connection with a loan to our Chief Executive Officer topay taxes related to the stock exercise. The notes accrue interest of 6.25% perannum and are due in full on or before May 29, 2006. Part of the ExerciseNote, $291,000, is secured by 150,000 shares of our common stock and isrecorded in shareholders’ equity. At December 31 2004 and 2003, $291,000of principal was owed under the Exercise Note and $39,000 of principal was owedunder the Tax Note.  At December 31,2004, there was also $21,000 in accrued interest outstanding.  Bonuses accruing under the ChiefExecutive Officer’s employment agreement will be used to repay the notes (seeNote 14).

 

**Investment and Sublease with BeBetter Networks, Inc.**

 

At December 31,2004 and 2003, we had a 3% investment in BeBetter Networks, Inc. (“BeBetter”),a company whose president is an A.D.A.M. board member that held an approximate15% voting interest in BeBetter at December 31, 2004 and 2003.  As of December 31, 2004 and 2003, ourChief Executive Officer also held an approximate 3% voting interest in thiscompany.  We account for the investmentunder the cost method, as we have less than a 20% ownership and do not exercisesignificant influence over the investee. In addition to our stock ownership in BeBetter, we also hold warrants topurchase 25,000 common shares of BeBetter at an exercise price of $2 per share,expiring December 31, 2005.  During2002 we recorded an impairment charge of $84,000 to write off our investmentbased upon management’s assessment that the decline in its carrying value was “otherthan temporary.”  We are currentlyleasing part of our office space to BeBetter on a month-to-month basis at $785per month.  We have the right to requireBeBetter to vacate the space upon 30 days notice.  At December 31, 2004 and 2003 thecarrying value of our investment was $0. We have no plans to provide additional investment in BeBetter in thefuture.

 

**Investment and Sublease with ThePort Network, Inc.**

 

Asof December 31, 2004 and 2003, we held an approximate 34% voting interestin ThePort Network, Inc. (“ThePort”). Our Chief Executive Officer, who currently serves as the Chairman of theBoard of Directors of ThePort, held an approximate 10% voting interest inThePort at December 31, 2004 and 2003 and held a convertible note andloans from ThePort in the amount of approximately $1,019,000 and $919,000 at December 31,2004 and 2003, respectively.  Two of ourother directors also own equity interests in ThePort.  The investment is being accounted for underthe equity method (see Note 1).

 

AtDecember 31, 2004 and 2003, after recording a permanent impairment chargeof $92,000 in 2002, the carrying value of our investment was $0.  We did not reduce our investment below zerofor our share of ThePort’s losses in 2004 and 2003 as we have not provided orcommitted to provide any additional financial support to ThePort.

 

Inconnection with our investment in ThePort, we entered into a five-yearagreement in 2001 whereby we had exclusive distribution rights to ThePort’sproducts within the healthcare industry. As of December 31, 2001, we had pre-paid $125,000 of the contractfee to be applied against future subscription fees.  We had committed to generate $1,500,000 insubscription fees during the initial term of the original agreement.  The initial term of the agreement commencedon August 20, 2001 and continued for five years from that date.  On February 14, 2003, ThePort agreed toaccept a payment of $125,000 to release us from the minimum guarantee in itsentirety.  ThePort retained the $125,000pre-payment previously made and we were granted non-exclusive rights to ThePort’sproducts within the healthcare industry.

 

During2004 and 2003 we leased space to ThePort on a month-to-month basis.  However, we did not receive any type ofconsideration as lease payments during that time. Beginning March 1, 2005we will be collecting $1,200 for monthly lease payments and other sharedservices.

 

 

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**14. Commitments and Contingencies**

 

We lease office space and equipmentunder non-cancelable lease agreements expiring on various dates through 2008.We also have capital lease commitments for certain equipment.  Additionally, we have entered into certainagreements to license content for our services from various unrelated thirdparties. At December 31, 2004, future minimum rentals for noncancelableleases with terms in excess of one year, total payments due under licenseagreements and bonus payments due under an employment agreement were as follows(in thousands):

 
| **Year Ending**                                                            | ** ** | **License**    | ** ** | **Annual** | ** ** | **Real Estate** | ** ** | **Other Operating** | ** ** | **Capital** | ** ** |
|----------------------------------------------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|---------------------|------------|-------------|------------|
| **December 31,**                                                      | ** ** | **Agreements** | ** ** | **Bonus**  | ** ** | **Leases**      | ** ** | **Lease**           | ** ** | **Lease**   | ** ** |
| ** **                                                                 | ** ** | ** **     | ** ** | ** ** | ** ** | ** **      | ** ** | ** **          | ** ** | ** **  | ** ** |
| 2005                                                                       |       | $              | 100        |       | $          | 105             |       | $                   | 229        |        | $          | 1 |   | $ | 24 |   |
| 2006                                                                       |       | —         |       | 105        |       | 234             |       | 1                   |       | 24          |       |
| 2007                                                                       |       | —         |       | —     |       | 239             |       | 1                   |       | 19          |       |
| 2008                                                                       |       | —         |       | —     |       | 182             |       | —              |       | —      |       |
| Total future minimum lease payments and  payments under license agreements |       | $              | 100        |       | $          | 210             |       | $                   | 884        |        | $          | 3 |   | 67 |   |
| Less - amounts representing interest                                       |       |           |       |       |       |            |       |                |       | (13         | )          |
|                                                                       |       |           |       |       |       |            |       |                |       |        |       |
| Present value of future minimum lease  payments                            |       |           |       |       |       |            |       |                |       | 54          |       |
|                                                                       |       |           |       |       |       |            |       |                |       |        |       |
| Less - current portion                                                     |       |           |       |       |       |            |       |                |       | 17          |       |
|                                                                       |       |           |       |       |       |            |       |                |       |        |       |
|                                                                       |       |           |       |       |       |            |       |                |       | $           | 37         |   |

 

Rent expense for the years ended December 31,2004 and 2003 was $220,000 and $269,000, respectively. Our headquarters arelocated in approximately 12,000 square feet of leased office space in Atlanta,Georgia.

 

On October 1, 2002, we enteredinto an employment agreement with our Chief Executive Officer, which wasamended on March 17, 2004. The employment agreement as amended providesfor bonuses in an aggregate amount of up to approximately $289,000 through 

 

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May 2006. Under the terms of theagreement, these bonuses will be paid by reducing the amounts outstanding underthe Exercise Note and Tax Note. During the year ended December 31, 2003,our Chief Executive Officer earned bonus payments totaling $78,866 under theagreement which were applied towards accrued interest and the outstanding NoteReceivable balance.  At December 31,2004 we had accrued bonuses to our Chief Executive Officer in the amount of$61,340, which will be applied as payment in May 2005 first to any accruedinterest and then to the outstanding Note Receivable balance.  At December 31, 2004, approximately$149,000 of bonuses had not yet been incurred under this agreement.

 

On April 25,1996, a shareholders’ class action lawsuit was filed in Fulton County SuperiorCourt in Atlanta, Georgia against us and certain of our then officers anddirectors. The complaint alleged violations of Sections 11, 12(2) and 15 of theSecurities Act of 1933 and violations of the Georgia Securities Act arising outof alleged disclosure deficiencies in connection with our initial publicoffering of common stock, which was completed on November 10, 1995. Thecomplaint sought compensatory damages in an unspecified amount. The courtdenied in substantial part the defendants’ motion to dismiss the complaint andcertified the case as a class action for all of the claims except for the claimunder the Georgia Securities Act. A settlement, which was fully covered by ourdirectors’ and officers’ liability insurance, was reached in March 2004.  As such, there is no further obligation by usfor this matter.

 

In November 2002,the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others” which clarifies disclosure, recognition and measurementrequirements related to certain guarantees. We indemnify our customers fromthird party claims of intellectual property infringement relating to the use ofour products. Historically, costs related to this guarantee have not beensignificant and we are unable to estimate the potential impact of thisguarantee on our future results of operations.

 

**15. Segment Information**

 

Weoperate in one segment comprised of three markets: healthcare, Internet, andeducation.

 

We sellour products through agreements, which grant territorial rights tointernational and domestic distributors. During the years ended December 31,2004 and 2003, we had net revenues from international sales of approximately$324,000 and $276,000, respectively. A summary of revenues based on geographiclocation of customers is as follows (in thousands):

 
| ** **            | ** ** | **Year Ended**        | ** ** | **Year Ended**        | ** ** |
|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **            | ** ** | **2004**              | ** ** | **2003**              | ** ** |
|                  |       |                  |       |                  |       |
| United  States        |       | $                     | 8,109      |                  | $          | 7,613 |   |
| Europe                |       | 33                    |       | 104                   |       |
| Pacific Rim  and Asia |       | 144                   |       | 135                   |       |
| Other                 |       | 147                   |       | 37                    |       |
|                  |       |                  |       |                  |       |
|                  |       | $                     | 8,433      |                  | $          | 7,889 |   |

 

Nocustomers contributed greater than 10% of total revenues for the years ended December 31,2004 and 2003.

 

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Report ofIndependent Registered Public Accounting Firm

 

To the Board of Directors and Shareholders

A.D.A.M., Inc.

 

We have audited the accompanying consolidated balancesheet of A.D.A.M., Inc. and subsidiaries (the “Company”) as of December 31,2004, and the related consolidated statements of operations, shareholders’equity, and cash flows for the year then ended. These financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of A.D.A.M., Inc. and subsidiaries as of December 31, 2004, and theresults of their operations and their cash flows for the year then ended inconformity with accounting principles generally accepted in the United Statesof America.

 

 
| /s/ Tauber &  Balser, P. C. |   |
|---------------------------------|--------|
| Atlanta, Georgia                |
| February 4, 2005                |

 

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## **Report of Independent Registered PublicAccounting Firm**

## ** **

To the Board of Directors and Shareholders

of A.D.A.M., Inc.:

 

In our opinion, the consolidated balance sheet as of December 31, 2003and the related consolidated statements of operations, of changes inshareholders’ equity and of cash flows for the year ended December 31, 2003present fairly, in all material respects, the financial position, results ofoperations and cash flows of A.D.A.M., Inc. and its subsidiaries (the “Company”)at December 31, 2003 and for the year then ended, in conformity with accountingprinciples generally accepted in the United States of America.  These financial statements are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements based on our audit.  We conducted our audit of these financialstatements in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audit provides a reasonable basis for our opinion.

 

 
| PricewaterhouseCoopers LLP |   |
|----------------------------|--------|
| Atlanta, Georgia           |
| March 25, 2004             |

 

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