UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-K





x Annual Report Pursuant to Section 13 or 15 (d) of the Securities


Exchange Act of 1934





For the fiscal year ended December 31, 2009 or





o Transition Report Pursuant to Section 13 or 15 (d) of the Securities


Exchange Act of 1934





For the transition period from ___________ to _________________





COMMISSION FILE NO. 000-24547





SCIENTIFIC LEARNING CORPORATION


(Exact name of registrant as specified in its charter)





DELAWARE
94-3234458(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification Number)





300 FRANK H. OGAWA PLAZA, SUITE 600


OAKLAND, CA 94612-2040


(Address of principal executive offices, including zip code)





510-444-3500


(Registrant’s telephone number, including area code)





Securities registered pursuant to Section 12 (b) of the Act:


Title of Each Class
Name of Each Exchange on which RegisteredCommon Stock, par value $0.001 per share
NASDAQ Capital Market





Securities registered pursuant to Section 12 (g) of the Act: NONE





Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes: o No: x





Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes: o  No: x





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes: x No: o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such filed).


Yes: o No: o





Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K. o







Page 1


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer a non-accelerated filer, or a smaller reporting company. (See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).





Large accelerated filer o    Accelerated filer o    Non-accelerated filer o


Smaller reporting company x





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


Yes: o No: x





The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on June 30, 2009 as reported on the Nasdaq Capital Market was approximately $21,700,450.  Shares of Common Stock held by each director and executive officer and persons who owned 5% or more of the registrant's outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.





As of January 31, 2010 the Registrant had outstanding 18,312,570 shares of Common Stock.





DOCUMENTS INCORPORATED BY REFERENCE





Portions of the Proxy Statement for the Registrant's 2009 Annual Meeting of Stockholders are incorporated by reference in Part III.


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TABLEOF CONTENTS





PART I

PAGE NO.Item 1.
Business
4Item 1A.
Risk Factors
19Item 1B.
Unresolved Staff Comments
24Item 2.
Properties
24Item 3.
Legal Proceedings
25Item 4.
Submission of Matters to a Vote of Security Holders
25PART IIItem 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
28Item 6.
Selected Financial Data
30Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
31Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
39Item 8.
Financial Statements and Supplementary Data
40Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
64Item 9A.
Controls and Procedures
64Item 9B.
Other Information
64PART IIIItem 10.
Directors and Executive Officers and Corporate Governance
65Item 11.
Executive Compensation
65Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
65Item 13.
Certain Relationships and Related Transactions and Director Independence
65Item 14.
Principal Accountant Fees and Services
65PART IVItem 15.
Exhibits and Financial Statements
66SIGNATURES
67


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Forward Looking Statements





Some of the statements contained in this Annual Report on Form 10-K are forward-looking statements that involve risk and uncertainties. The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “intends,” “estimates,” “predicts,” “potential,” or “continue” or the negative of these terms or other comparable terminology. These statements are subject to known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. Important factors that may cause actual results to differ from expectations include those discussed in “Risk Factors” beginning on page 19 in this Annual Report on Form 10-K. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us on the date thereof, and we assume no obligation to update any such forward-looking statements.





PARTI





ITEM 1. BUSINESS





Overview





We create educational software that accelerates learning by improving the processing efficiency of the brain. Based on more than 30 years of neuroscience and cognitive research, ourfamily of products improves brain fitness with technology-based exercises that build the cognitive skills required to read and learn effectively.





Our products are marketed primarily to K-12 schools.  We recommend our products to schools as a reading intervention solution for struggling, special education, and English language learners to help students reach grade level proficiency.Since our inception, learners have used our products over two million times, and they are now marketed in 45 countries around the world.





We are highly differentiated in our industry because of our foundation in and continuous incorporation of neuroscience and research-based learning approaches. The fact that the learning brain can improve through exercise - the concept of brain fitness - led us to create a novel approach to learning.  Brain fitness focuses on increasing learning capacity by strengthening cognitive skills through the rigorous and systematic application of neuroscience-based exercises.  Our approach uses technology based exercises because technology affords a scalable approach to effectively and consistently deliver individualized training to a large number of students simultaneously.





Our focus on science continues in our emphasis on generating rigorous proof that our products produce substantial improvements for different types of readers in a variety of settings. At December 31, 2009, over 220 efficacy studies, including the results from approximately 80,000 aggregate participants, demonstrated the academic gains achieved through our products. These studies show gains for students at all K-12 grade levels, for at-risk students, special education students, English language learners, Title One (low income, under achieving) students, and a variety of other demographic groups. Gains have been demonstrated throughout the United States and in ten other countries. Studies show that these gains endure over time.





To assist educators in getting the best results from their implementations, we offer an online data analysis and reporting tool that uses sophisticated algorithms to provide diagnostic and prescriptive information and intervention strategies.  To achieve the best results with our products, it is important that learners adhere to our protocols for product use. To support and encourage these best practices in the use of our products, we provide a variety of on-site, web-based and telephone-based services and support.


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Growth Strategy





Our strategic goal is to have our products become widely accepted by educators and parents as a solution that dramatically improves and sustains achievement patterns to meet the needs of a broad spectrum of learners across a variety of academic subjects.


Critical elements of our strategy include:





Ø
Broadening Awareness of Brain Fitness.  We intend to capitalize on the increasing awareness of our unique brain fitness approach to accelerating learning. In 2009, public television sponsored an overview of this approach titled “The New Science of Learning, Brain Fitness for Kids,” which began airing in June, 2009 and will continue to air in 2010.





Ø
Improving Product Access.We continue to look at ways to improve our product lines to enhance ease of use and product effectiveness.  We plan to introduce a SaaS (Software as a Service, SaaS, is a model of software deployment whereby a provider licenses an application to customers for use as a service on demand) version of our Fast ForWord products that is designed to improve product access, ease of use and protocol implementation to reach more learners anywhere, anytime.





Ø
Establishing Rigorously Proven Student Results as an Important Criterion in the Selection of Educational Products.  Educators select products for their students based on many factors. We believe that we have demonstrated our products’ positive impact on student achievement with an exceptionally high degree of scientific rigor. Our marketing strategy is designed to focus educators on our results, the depth of the science validating those results, and the importance of those results to their decision-making process.





Ø
Expanding the Number of School Districts Using our Products.  We plan on continuing to target those school districts that are struggling with academic under-achievement, have high levels of funding and are headed by strong leaders.





Ø
Expanding Within a School District.  We believe that student outcomes within a district drive greater product adoption. Therefore, we focus our support efforts on effective implementation of our products in compliance with our protocols to obtain the best student results. To help schools follow best practices in their implementations, we plan to continue to emphasize post-sales support, including implementation services and results monitoring, and innovative and cost-effective ways to provide these services.





Ø
Identifying and Expanding into New Markets.  We continue to identify and evaluate potential new applications for our neuroscience based technology.  We are developing additional products to be marketed to the direct to parent, virtual schools and learning center markets. In addition, we are researching new applications for early learning, English language learning and mathematics.





Ø
Increasing Our Global Presence.  As of December 31, 2009, we had 20 value-added representatives (VARs) selling in 45 countries outside the US and Canada. We believe that the global addressable market for a brain fitness approach to learning English is significant with over one billion English language learners worldwide.





Markets





Our products are available worldwide to educational institutions, speech and language clinics, learning centers and parents.





United States K-12 Market





Our sales are concentrated in K-12 schools in the United States, which in 2009 were estimated to total nearly 117,000 schools serving approximately 56 million students. In each of the last three fiscal years, the U.S. K-12 sector has represented approximately 90% of our sales. Almost 6,400 schools have purchased at least $10,000 of our product licenses and services, compared to 5,800 at the end of 2008.


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We market our products primarily as a reading intervention solution, to be used as an intervention or remedial supplement to existing curriculum materials for struggling, special education, and English language learners, at both the elementary and secondary school levels to improve reading and learning. Despite a national focus on reading and increased federal funding to improve reading proficiency and school district accountability, independent evaluations of student performance have demonstrated little improvement in reading results. According to the U.S. Department of Education (USDE), in 2007, 38% of fourth graders in the United States had below basic reading scores and 70% were not proficient in reading, and between 1992 and 2007, there was only a modest improvement in the proportion of fourth graders performing at the “below basic” level.





The Pre-K-12 education materials market includes approximately 14,000 public school districts, 90,000 public schools and 23,000 private schools. Purchasing decisions for our products are primarily made by district level administrators.





Sales of our products are included in the supplemental education materials segment of the overall education materials market. Simba Information’s Publishing for the PreK-12 Market 2009 – 2010 (April 2009) estimated or projectedthat:





Ø
The total market for K-12 instructional materials would be $8.27 billion in 2009.





Ø
The supplemental materials segment of that market was $4.1 billion in 2008.





Ø
The technology based electronic courseware segment of the supplemental materials market would be $887 million in 2009.





We do not compete in the separate basal materials market (a $3.3 billion market in 2008, according to Simba), which consists primarily of textbook programs that include student editions, teacher editions and companion materials to teach particular scope and sequence of a subject area for a span of grades. We also do not compete in the market for formative, summative or clinical assessments or in the market for school library and reference products.





The educational materials market is expected to continue to grow, driven by several factors:





Ø
Reauthorization of the Elementary and Secondary Education Act of 2001.Based on public announcements of its intentions,we expect the Obama administration to reform the Elementary and Secondary Education Act of 2001, commonly known as the No Child Left Behind Act (“NCLB”), with a new focus on increased accountability, Pre K and school reform.





Ø
Education Accountability Requirements. Performance and educator accountability requirements of federal legislation, including NCLB, and persistent achievement gaps based primarily on income and ethnicity which are driving the use and growth of programs addressing the needs of struggling readers.





Ø
Higher Federal Funding Levels.  In February, 2009, the federal government responded to the recession by passing the American Recovery and Reinvestment Act (ARRA) which increased federal expenditures on education by $100 billion over the next two years





Reauthorization of the Elementary and Secondary Education Act of 2001(ESEA)





Reauthorization of ESEA "can't wait," U.S. Secretary of Education Arne Duncan said on September 24, 2009 in his first speech devoted to the topic. Mr. Duncan has traveled to more than 30 states on a "Listening and Learning Tour" to hear views of educators and citizens on this topic and the federal role in education.  We expect the reauthorization to expand ESEA’s focus on accountability, including aligning teacher pay with improved student performance, national standards and expanding the focus on learner accountability to Pre K – college. If this expanded focus on accountability transpires, we believe our products will be very effective in meeting the needs of school districts who must improve student outcomes.





Education Accountability Requirements





We believe parents and policy makers are exerting greater pressure to hold teachers and administrators accountable for student learning. We expect financial incentives, extended day programs, enhanced intervention services, and supplementary educational services alternatives to continue to be methods of addressing this emphasis on local educator accountability and student performance. Our products help schools respond to these accountability pressures in a variety of ways, including:


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Ø
Our products can improve academic achievement in students for whom other approaches have failed.





Ø
Our products can be used to increase the scores of children who are “on the bubble” (just below a desired score on an achievement test).





Ø
Educators can use our online reporting tool, Progress Tracker, to track student progress by demographic group, responding to the Adequate Yearly Progress requirement for all learners.





Funding Sources





Funding for educational materials comes from a variety of federal, state and local sources.  The economic downturn has significantly reduced state and local tax revenue, putting severe pressure on state and local budgets.





In response to this reduction, the federal government passed the American Recovery and Reinvestment Act (ARRA) in February 2009, which allocated an additional $100 billion to public education.  Federal funds have historically been a critical resource to help school districts address the needs of the most challenged learners.  The ARRA both expands the funding for the programs that serve these challenged learners and provides fiscal stabilization funds to restore general school funding levels.





We believe that a significant proportion of our sales are funded by two key federal sources that support struggling readers, Title One and IDEA.  ARRA temporarily increased the funding for both these programs.  Title One, which supplements funding for schools with low income students, received an additional $10 billion in ARRA funds, while IDEA, which provides funding for special education students, received an additional $11.3 billion in ARRA funds.


In addition, two new funds will be released in 2010 that may be used to purchase our offerings – Race to the Top and Investing in Innovation.





Ø
The Race to the Top fund, appropriated at $4.35 billion, is a competitive grant program designed to encourage states in creating conditions for education innovation and reform. The grants can be used for offerings that make substantial gains in student achievement, thus closing the achievement gap.





Ø
The Investing in Innovation (i3) Fund, appropriated at $650 million, provides competitive grants to expand the implementation of, and investment in, innovative and evidence-based practices, programs and strategies that significantly improve K-12 achievement and close achievement gaps, decrease dropout rates, increase high school graduation rates; and improve teacher and school leader effectiveness.





Other Markets





In addition to selling to K-12 schools, we also sell to and through private practice professionals and learning centers. These speech and language and other professionals recommend the use of our products to appropriate clients and then supervise the use of the software, often in connection with their other services. In 2009, approximately 600 non-school professionals and entities in the United States and Canada (North America) re-sold our products.  While this market is a small proportion of our overall business, the private practice market nevertheless remains significant to us.  This segment was our first market, and many private practice professionals have extensive knowledge about our products.  As a result, their continued use and feedback plays a valuable role in our business. In addition, these professionals sometimes provide contract services to schools and, from time to time, recommend our products for students in those schools.





Sales to countries other than the United States and Canada are a small but growing part of our business. We are developing a network of value added representatives to serve these markets. During 2009, products were marketed to customers in 45 countries. As of December 31, 2009, we were represented by 20 value-added representatives.





Our strategy for international markets thus far has been conservative, so that we do not divert resources from our U.S. K-12 market. However, we believe the potential international opportunity is significant. Outside of North America, our products are used in three primary applications: (1) in tutoring and learning centers to strengthen academic skills, (2) by clinical professionals with impaired children, and (3) assisting in the acquisition of English as a second language. About one-fourth to one-third of the worldwide population now understands and speaks English to some degree, and English is the international language of business, travel, and diplomacy. While our products do not provide all the components necessary to teach English to non-native speakers, they have been demonstrated to be extremely effective in assisting in English language instruction, through building the necessary underlying cognitive, acoustic processing, phonological and other skills needed to learn and speak English fluently.


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In 2009, we began selling web based products and tutoring services directly to parents. These products are designed to meet the needs of learners who want to “stay ahead” or “catch up” and are delivered via a SaaS model.





Brain Fitness Approach to Learning





We believe there are two sides to learning efficiently and effectively,  (1) research-proven curriculum and (2) a well prepared brain able to capture, process and retain information. We believe that the challenge of accelerating learning for all learners is not solved just by better curriculum but also by improving the underlying cognitive skills that build brain capacity (Memory, Attention, Processing Rate & Sequencing).





Similar to how the download speed of an internet connection can have a dramatic impact on an internet user’s experience, two students using the same research-based curriculum can have very different learning experiences based upon the preparedness of the brain to capture, process and retain that information (their bandwidth).





Our products unify proven curriculum with brain fitness exercises to improve brain processing efficiency for learners, thereby accelerating the learning process that results in enduring gains. We build learning capacity by systematically and rigorously exercising the brain to develop the cognitive and reading skills required for lifelong learning success. The results from our products are fast, effective, enduring, and have been demonstrated through brain imaging studies, changes in achievement on standardized reading tests, high stakes state achievement tests, and more than 220 efficacy studies.





Cognitive Skills Development





Reading and learning require a variety of foundational cognitive skills, all functioning together.





Memory.  Working memory is the aspect of memory that allows one to keep information available while thinking about meanings and relationships, and is used in sentence and paragraph comprehension, remembering instructions and reasoning. The Fast ForWord exercises systematically vary the amount of information that must be retained to successfully complete the exercise task, using individually adaptive methods to gradually expand the working memory demands of the task. The Reading Assistantpassages build working and short-term memory through real-time comprehension tests.





Attention.  Attention is the ability to focus on tasks and ignore distractions. Every exercise in our product family requires selective and focused attention in order to advance. Specific vigilance tasks require sustained attention over progressively longer time frames, building the attention skills needed in all reading and learning.





Processing.  Processing means the ability to address information such as images and sounds quickly enough to discriminate their differences. Processing skills are an essential prerequisite for phonemic awareness (the ability to distinguish among and manipulate the smallest sounds in language that can change meaning) and reading. Our exercises build processing rate and accuracy in the skills addressed by the exercises. For example, exercises in our Fast ForWord Language to Reading and Literacy Advanced products focus on the accuracy and rate of processing for letter-sound correspondence, leading to the automaticity in those skills needed for reading. In addition, Reading Assistantbuilds brain processing and automaticity through the frequent reading of text out loud with our speech verification system.





Sequencing.  Sequencing refers to the ability to quickly and accurately determine the identity of specific stimuli and the order in which the stimuli occur. This ability is supported by both working and longer-term memory, attention, and processing. Sequencing of auditory, language and written information is critical for the accurate understanding of meaning. The Fast ForWord exercises systematically and individually adapt the complexity of the sequencing tasks needed to develop phonemic awareness, word fluency, oral and reading comprehension, and other critical cognitive operations.


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Neuroscience-Based Learning Principles





The Fast ForWord and Reading Assistantproducts apply learning principles that have been established through neuroscience and cognitive research as being critical to learning new tasks and establishing rapid change in brain function: frequency and intensity, adaptivity, simultaneous development, and timely motivation.





Frequency and Intensity:  The cortex of the human brain contains millions of neurons arranged in regions that represent our sensory systems, control our motor systems and provide for higher-order associative interactions. These regions contain networks of neurons that connect within and between regions. These functional networks develop and maintain their connections through a process that is driven by neural activity. The stronger the neural activity, the stronger the network becomes. As a result, completing a series of learning tasks in frequent, intense sessions is needed to make the changes in brain functioning that enhance learning. Our Fast ForWord products use protocols call for customers to use the products five days a week, between 30 and 90 minutes (depending on the product) per day, providing the frequency and intensity needed.





Adaptivity:  The mechanisms of brain plasticity are best engaged in learning a new task when new populations or new areas of neurons are engaged. Continually adjusting the learning tasks to become progressively more difficult provides better cortical activation for learning. The Fast ForWord products use sophisticated algorithms to analyze student learning data using a complex set of rules. These algorithms regulate the products’ speech modification rules and otherwise adjust content exposure to advance the individual student through the products at a rate specifically tailored to that student. The products adjust content exposure in a variety of ways. For example, many of the exercises automatically adjust the specific content presented to the student so that the student can make correct responses approximately 80% of the time for each discrete skill. This adjustment is designed to keep cortical activation up and to keep the exercises challenging and engaging, while allowing the student to experience a feeling of accomplishment and to avoid the frequent failure that can discourage a student’s learning.





Simultaneous Development:  Complex behaviors require the coincident and sequential engagement of multiple cortical systems. The Fast ForWord and Reading Assistantproducts simultaneously develop both major and supporting cognitive skills for enduring learning improvements. While each exercise is designed to develop underlying cognitive skills such as memory, attention, processing and sequencing, it also focuses on a specific set of reading or language tasks.





Timely Motivation:  A critical factor in strengthening neural connections, and therefore maximizing critical learning changes, is the input from the neuromodulatory reward systems that are activated by meaningful consequences of behavior. These reward systems need to be activated within tens of milliseconds of the neural synaptic activity to maximize the potential for synaptic strengthening. In the Fast ForWord exercises, learners are rewarded for a correct answer quickly, within this critical time frame, and on their first attempt only, in order to drive learning behavior. To keep students active and engaged, the products also feature a bonus point system and the delivery of special animations that signify milestones as students progress.


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Products





Fast ForWord products





Our flagship Fast ForWordfamily of products consists of three product series – the Language Series, the Literacy Series and the Reading Series.





Language and Literacy SeriesThe Fast ForWord Language series for elementary learners and the Literacy series for adolescent learners build foundational reading and language skills to help districts move below grade level learners to be successful learners in the general classroom.Product

DescriptionFast ForWord

Language v2

The Fast ForWordLanguage product builds learning capacity using exercises that specifically focus on oral language comprehension and listening, including phonological awareness (the understanding that words are composed of sounds and the ability to identify and manipulate the sounds of language), listening accuracy and comprehension, working memory, and familiarity with language structures. The Fast ForWordLanguage product uses acoustically modified speech, which stretches and emphasizes particular sounds in an adaptive manner, to help children learn to quickly isolate and recognize individual speech sounds, an underlying skill critical to reading.Fast ForWord

Language to

Reading v2

The Fast ForWordLanguage to Reading product builds learning capacity through improving cognitive skills while helping students make the link between spoken and written language, using exercises that focus on listening comprehension, sound-letter recognition, phonological awareness, beginning word recognition and English language conventions.Fast ForWord

Literacy

The Fast ForWordLiteracy product is specifically designed for adolescents and adults who lack reading proficiency. Its content and exercises are similar to those in the Fast ForWord Language product, but have been adapted to maximize impact for adolescents and English language learners based on actual learning results from those groups. Using graphics, characters and themes appealing to adolescents, the product progressively increases the demand on cognitive skills.Fast ForWord

Literacy Advanced

Fast ForWordLiteracy Advanced software includes content and exercises similar to those in the Fast ForWordLanguage to Reading software. Like the Literacy product, the content has been tuned to maximize impact using actual learning results, and the user interface is designed to appeal to adolescents. The product includes age-targeted exercises that emphasize phonemic awareness, decoding, word recognition, sequential and inferential comprehension and the ability to sequence multi-step instructions.


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Reading Series ProductsThe Fast ForWord Reading series of products builds learning capacity through developing cognitive skills using exercises focused on critical reading abilities. The Reading Series exercises focus on phonemic awareness, phonics and decoding, spelling, vocabulary, fluency and comprehension. The content of each product is correlated to the reading standards for the end of the grade level indicated by the product number. (Reading Readiness is correlated to kindergarten.) However, the increasingly demanding cognitive complexity of the products can take the learner well beyond that grade level.Product

DescriptionFast ForWord

ReadingReadiness

The Fast ForWordReading Readiness product builds learning capacity through exercises that prepare the student for reading, focusing on phonemic identification, categorization and blending, letter names, sound and letter correspondence, rapid letter/word recognition, and oral vocabulary.Fast ForWord

Reading 1

The Fast ForWord Reading 1 product builds learning capacity while introducing familiarity with print. The exercises emphasize sound-letter correspondence, rapid letter-word comprehension, high-frequency words and beginning print comprehension.Fast ForWord

Reading 2

Fast ForWordReading 2 software builds learning capacity through exercises that build a spectrum of reading skills, focusing on comprehension at the sentence and paragraph level, vocabulary, spelling, punctuation and capitalization. The product continues work in phonics and decoding and introduces morphological structures such as prefixes and suffixes. Morphology relates to the use of words, letters, and letter combinations that change the meaning of a word.Fast ForWord

Reading 3

The Fast ForWordReading 3 product builds learning capacity by continuing to improve cognitive skills through exercises that focus on increasing fluency. The exercises focus on semantic, syntactic, phonological and morphological categories, phonics, spelling and comprehension. Sentences in the exercise incorporate a high level of syntactic complexity. Syntax relates to how grammatical markers and words are combined to make meaningful sentences.Fast ForWord

Reading 4

Fast ForWordReading 4 software builds learning capacity by improving cognitive skills in the context of a focus on text interpretation. The exercises focus on comprehension and vocabulary, and build word skills relating to compound works, prefixes and homophones.Fast ForWord

Reading 5

The Fast ForWordReading 5 product builds learning capacity by improving cognitive skills while strengthening advanced comprehension strategies. The exercises carry a significant working memory load, as they build vocabulary, improve critical thinking and abstract reasoning, improve composition skills, and focus on accuracy, fluency and comprehension.


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Product

DescriptionInternet-Based ToolsProgress Tracker

Progress Tracker, our Internet-based data analysis and reporting tool, analyzes student learning results to provide diagnostic and prescriptive intervention information and allows educators to track and report their students’ learning progress. It also provides information about the Fast ForWordproducts’ correlation to state standards. Progress Tracker generates status flags using sophisticated algorithms to analyze student learning data with a complex set of rules partially based on past data patterns. These status flags alert the educator when intervention is necessary for a student, and suggest to the educator when to move the student to a lower or higher level product or to complete product use. Progress Tracker provides detailed reports at the student, classroom, school, and district level, and can be reported by subgroup, providing a tool for educators to analyze their progress towards the Annual Yearly Progress requirements mandated by No Child Left Behind. Customers can configure the system to send automatic emails to parents, teachers, administrators or others to provide easy periodic updates. Progress Tracker also provides the ability to collect behavioral survey data from teachers and parents prior to and after product use.In June 2007, we added Reading Progress Indicator to our Progress Tracker system. Reading Progress Indicator is a reliable and valid assessment of a student’s reading skills. It is designed to be quick and convenient to administer before and after Fast ForWord product use, to rapidly demonstrate the effectiveness of our products.





Reading Assistant products


Reading Assistant is a unique software tool that combines advanced speech verification technology with scientifically-based interventions to help elementary and secondary students strengthen their reading fluency, vocabulary and comprehension in order to become proficient, life-long readers. The National Reading Panel has identified five major components of reading and literacy: phonemic awareness, phonics, fluency, vocabulary and comprehension.  Our Fast ForWord family of products addresses all of these components, but is particularly strong in phonemic awareness and phonics.  The Reading Assistant product adds strength in fluency, vocabulary and comprehension, thereby allowing us to address a broader range of student needs.





Reading fluency is the ability of a student to read quickly enough to garner meaning from a text, and is reported to have a high correlation with overall reading proficiency.  However, to become a fluent reader, students must frequently read aloud and receive timely feedback and assistance with their reading.  Providing effective fluency training for all students is a challenge in the classroom because teachers do not have enough resources and/or time to give the consistent and rigorous one-on-one attention a child needs to improve his or her reading fluency.  Reading Assistantaddresses this problem by acting as a personal tutor.  The program listens as a student reads aloud, monitoring for signs of difficulty and providing immediate feedback and assistance when a child is challenged by a word.





In 2009 we released a new version of Reading Assistant – Reading Assistant Expanded Edition. The new offering has almost double the content and is designed to cover a broader range of reading levels in each grade.  This expanded reading content allows students to use the product over a longer time period, and provides engaging, appropriate content to readers at many levels. In addition, we enhanced support for English Language Learners including audio for quiz questions, Spanish translations of instructions and improved scaffolds for comprehension.




BrainSpark products and BrainPro services


The BrainSparkproducts and BrainPro services are based on our flagship Fast ForWordfamily of products.





TheBrainSparkproductsare targeted at learners ages five through thirteen who are at or above grade level and want to improve their overall learning potential. BrainSpark is cross-training for the brain, the products exercise two or more “learning muscles” within each game exercise. The BrainSpark products can be purchased directly online and accessed via a web-browser from a computer.


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BrainPro is targeted at learners who are below grade level and want to catch up. BrainPro learners access our Fast ForWord family of products from home and work with a certified tutor remotely. The BrainPro tutor is responsible for defining a customized program and goals and helping the learner achieve progress toward the learning goals with the help of the parents.




Product Effectiveness





Research by our school district customers, independent academics and our own scientists has demonstrated that Fast ForWord products improve language and reading skills across a broad spectrum of demographic groups, and we continue to accumulate outcomes data from students in classrooms across the country. As of December 31, 2009, more than 220 research studies, including the results from approximately 80,000 aggregate participants, demonstrated the academic gains achieved through our products. Published studies show outcomes from more than 850 learning organizations.





Highlights of this research include:





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More than fifty studies involving more than 8,500 children have demonstrated Fast ForWord efficacy using well-controlled experimental or quasi-experimental study conditions and reliable and valid performance measures, including studies that use randomized control groups.





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The What Works Clearinghouse, established by the U.S. Department of Education’s Institute of Education Sciences, has reviewed the research on the effect of the Fast ForWord products on English Language Learners and Beginning Readers.  Based upon studies that meet the What Works Clearinghouse’s high standards, the Clearinghouse has determined that the Fast ForWord products have positive effects.





Ø
The underlying neurological basis for these achievement gains was reported by a Stanford University study published in 2003 in the Proceedings of the National Academy of Sciences. This study confirmed that after using the Fast ForWord Language product, students on average experienced significant changes in brain activation patterns as shown by functional magnetic resonance imaging. On average, Fast ForWord participants also showed significant gains on measures of language and reading performance.





Ø
In an effort to better understand the nature of the rapid processing problems frequently seen in children with developmental reading problems (e.g., dyslexia), researchers from Harvard, MIT, Dartmouth, Rutgers, and Stanford investigated differences in the cortical activity of typical reading children and children with developmental dyslexia as they processed rapidly changing sounds. The results were published in Restorative Neurology and Neuroscience in 2007 and demonstrated that typical reading children process slowly and rapidly changing sounds in different cortical regions, while children with developmental dyslexia process them in the same region.  Children with developmental reading problems who underwent remediation with Fast ForWord products increased their language and reading skills, and the way they processed rapidly changing sounds changed, becoming more similar to that of typical readers.





Ø
A more recent study demonstrated that the neurological and behavioral changes following Fast ForWord intervention are not specific to children with learning problems.   Scientists at the University of Oregon published an article in Brain Research in April 2008 that demonstrated that behavioral and physiological changes are present in both language-impaired and normally developing children following the use of Fast ForWord software when compared to non-Fast ForWord comparison children.





Implementation





Neuroscience teaches us that to facilitate the brain changes that lead to enhanced learning, the student needs to complete a set of learning tasks in a frequent, intense timeframe. To provide that intensity and frequency, we have established product use protocols for our Fast ForWord products that call for customers to use the products five days a week, between 30 and 90 minutes per day, for a period of generally between four and twelve weeks (depending on the student and the product). In addition, we have established a three day a week, thirty minute protocol for our Reading Assistant products.


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In schools, our products are most frequently used in a computer lab setting, either a lab entirely devoted to our product use or a lab shared with other applications. A lab setting is likely to provide the appropriate kind of quiet focused atmosphere that is best for our product use. Some customers have effectively used the products, especially the Reading Assistant products, in regular classrooms.





We encourage our customers to use the products with as many students as their scheduling and computer resources permit.





License Terms





We license our products in a variety of configurations to meet the customer’s needs. Schools typically purchase site or workstation licenses, which are available either as a perpetual license or for a limited term.  Most customers also purchase implementation services, which we believe are important to encourage successful use of the products. Our approximate license package list prices range from approximately $10,000 to $85,000 per site, depending on the number of products, the number of workstations, the duration of the license and the volume purchased.





Products licensed for administration by private practice professionals are generally purchased on a per product per student basis. Our Language and Reading series products presently list for between $500 and $900 per product per student. The private practice professional charges separately for his or her services. Hospitals, clinics and learning centers purchase both per-product per-student licenses and site or workstation licenses, depending on their size and needs.


Services and Support





We believe that the training and implementation support provided by our service personnel is important to achieving appropriate product use in schools, where a limited school day and competing priorities makes it challenging for educators to devote the time and resources needed for a solid implementation. The Fast ForWord products employ neuroscience and research unfamiliar to many educators, and understanding these principles is critical to successful and sustained implementations. Our service professionals are highly trained and skilled at building the necessary knowledge and best practices to help schools and districts implement Scientific Learning products. In 2009 service, support and Progress Tracker accounted for 35% of revenue compared to 41% in 2008 and 33% in 2007. As of December 31, 2009, our service and support organization included 49 employees supplemented by 42 independent contractors who provide on-site customer training, consulting and technical services.





Services





To facilitate effective implementation, we offer on-site product training, technical installation, implementation management, consulting, and Web-based synchronous and asynchronous professional development services. To help our customers obtain the best possible student achievement results, our product training and professional development sessions provide an extensive hands-on introduction to our products, “best practices” implementation strategies, and an introduction to the science behind our products. On site trainings may be followed up by web based training providing timely consulting as customers implement our products. We also offer a Leadership and Accountability service, focused at the district level which provides administrators a detailed overview of the implementation at each of their schools, consulting on data analysis and interpretation, intervention and motivation strategies, connecting with classroom teachers and other topics of interest to the customer.





We host national or regional Circle of Learning user conferences, and a spectrum of both live and web-based forums, workshops, and seminars for customers and prospective customers. At these gatherings, speakers provide information on advances in neuroscience and learning, and current customers offer actual case studies on how ourproducts impact student achievement. These sessions also provide our customerswith opportunities to network and develop informal support relationships.





Support





For customers who purchase our support services, we provide progress monitoring, software technical update releases, and extensive telephone, email, chat and web-based support. Our progress monitoring services provide customers proactive on-going remote monitoring of their students’ progress by our staff, with periodic out-bound telephone contact tailored to the customer’s level of implementation success. Our Customer Connect Website provides extensive implementation and technical resources, together with Web-based seminars. In our annual independent customer surveys, customers using Fast ForWord products gave excellent ratings to the support they received and the professionalism of our support team.


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Warranty





We generally provide a warranty that our software products operate substantially as described in the manuals and guides that accompany the software for a period of ninety days. The warranty excludes damage from misuse, accident, and certain other circumstances. To date, we have not experienced any significant warranty expense.





Sales and Marketing





We sell to our principal market, K-12 school districts throughout the United States, primarily using a direct sales force. Our field sales personnel typically are experienced professionals with backgrounds in selling technology based curriculum products to the K-12 market. Most bring strong relationships with educators built over many years. We support our direct sales efforts with a field sales management team with extensive experience in this market, strong customer reference sites, and strategic consultants, who frequently are retired superintendents and other senior school district administrators who can attest to the positive impact of our programs based upon personal experience. To maximize our coverage of the K-12 market, we utilize an inside sales team to renew existing service contracts and to reach smaller, rural school districts and private schools. We also sell to K-12 schools in Canada using our inside sales team.





We believe that the mainstream education industry acceptance of our offerings is accelerating due to our focused “brain fitness” message, which emphasizes our ability to make existing instructional programs in the school district better by optimizing the brain for improved learning, particularly in reading. We have recently increased the frequency and sophistication of our web-based marketing efforts to reach many more educators quickly while targeting specific audiences with research results and success stories most relevant to their areas of responsibility and expertise.





Another critical component of our sales and marketing strategy is our series of “brain events”, including regional summits and national forums. These are company sponsored or co-sponsored events that provide us with a significant period of time in which to explain our unique approach and achievement results to top school administrators, helping them to establish a new vision for achieving student success in their districts and to build internal district consensus around their plan. Although our focus on improved sales force productivity also includes a balance of smaller sales with shorter cycles to get started in new accounts, the majority of our annual booked sales are from existing customers who have a year or more of positive experience with our programs, expanding to new sites and adding products and services to existing sites.





We sell to clinical professionals and learning centers principally through direct marketing (mail, web and telesales) and conferences (both industry conferences and an annual forum we conduct ourselves). In 2009, we began selling directly to parents online with our e-learning offering, BrainSparkTM, and our remote tutoring service, BrainProTM. We are also building a network of independent value-added representatives outside North America. As of December 31, 2009, we had relationships with twenty representatives. To date, booked sales outside North America have not been significant. We are building this channel in response to the growing demand for English fluency around the world. We believe that Fast ForWord and Reading Assistantproducts offer unique value in quickly “rewiring” the brain for English. We also believe the international market has significant potential growth opportunities, and we are positioning to take advantage of these in the future.





Competition





Districts and schools employ a wide variety of learning intervention programs and methods for their struggling students. The market for supplemental and interventional educational products is fragmented and competitive, with no single company or product with a dominant market share. We presently have a small share of the reading intervention supplemental market.





The critical factor for K-12 school districts is the perceived ability of the product to further the district’s instructional goals. Attributes that influence the district’s assessment of this factor include the ability to deliver measurable improvements in student achievement, cost, reputation, existing relationships with customers, completeness of the product offering, ability to provide effective and efficient product implementation, and ability to work with the other components of the school curriculum. We believe that generally we compete favorably on the basis of these factors.


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Our patented products are highly differentiated by their neuroscience basis and their focus on the development of learning capacity through improving cognitive skills. While we therefore have little direct competition, we do compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than us, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to language and reading are fundamentally different from the approach we take, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.





Product Development; New Products





The markets in which we compete are characterized by frequent product introductions and evolving educational standards and approaches. Our future success will depend in part on our ability to continue to enhance and update our existing products or to develop and successfully introduce new products.





Our research and development expenses were approximately $5.0 million for the year ended December 31, 2009, and $7.0 million and $4.5 million for the years ended December 31, 2008 and, 2007, respectively. Additionally in 2009, we capitalized approximately $1.0 million of development expenses attributable to Reading Assistant Expanded Edition. As of December 31, 2009, 29 of our employees were engaged in research and development activities, which include both product development and outcomes research.





Development Strategy





Over the past several years, our development efforts have focused on broadening our product solution and making our products more effective and easier to use in the school environment. In early January 2008 we completed the acquisition of the Reading Assistant product line along with associated patents and patent applications.





Major Product Introductions





Product

Launch yearFast ForWord Language

1997Fast ForWord Language to Reading

1998Away We Go! product family (predecessors to Fast ForWord Language Basics and Fast ForWord to Reading Prep)

1999Fast ForWord Middle and High School (predecessor to Fast ForWord to Literacy)

1999Fast ForWord Reading 3 (originally Fast ForWord Reading)

2000Progress Tracker

2001Fast ForWord Gateway Edition (new architecture of our major products that improved ease of use, added additional student content and provided additional Internet based capabilities)

2003Fast ForWord Reading 4

2003Fast ForWord Reading 1

2004Fast ForWord Reading 2

2004Fast ForWord Language Basics

2005Fast ForWord Reading Prep

2005Fast ForWord Reading 5

2005Fast ForWord Literacy

2006Fast ForWord Literacy Advanced

2006Reading Progress Indicator addition to Progress Tracker

2007Fast ForWord Language v2

2008Fast ForWord Language to Reading v2

2008Scientific Learning Reading Assistantv4.1.2

2008BrainSpark

2009BrainPro

2009Scientific Learning Reading Assistant Expanded Edition

2009


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Our products rely on market-tested technology and uniform platforms and are developed in a shared authoring environment, so that customers can easily broaden their Fast ForWordimplementations, as well as move students easily among the Fast ForWord products.





A critical component of our process for enhancing our products and developing new products is our analysis of the data uploaded to us through our Progress Tracker tool. This data is a unique and valuable resource. Analyzing the patterns among groups of participants allows us to understand, in detail, how students generally progress, where students have difficulty, where intervention might be appropriate, and how these patterns differ by demographic group. We can also identify trends in product use and efficacy that can help us develop product improvements for specific sub-groups of learners.





Intellectual Property





Our intellectual property strategy addresses both product technology and product concepts. Our policy is to protect our proprietary rights in our products and technology through a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures, and contractual provisions.





At December 31, 2009, we held the rights to 82 issued patents and 27 pending applications. These include 58 issued U.S. patents and 19 pending U.S. applications that we own or co-own. We also held seven issued patents from other countries and had seven applications pending abroad. We were the exclusive licensee under eleven issued U.S. patents, six issued foreign patents, and one pending foreign patent applications. These patent rights include those we acquired as part of our acquisition of the Soliloquy business.  At December 31, 2009, we held three issued U.S. patents and 2 pending U.S. applications relating to the Reading Assistant product.





Our U.S. patents relating to the Fast ForWord products expire between 2014 and 2021; the Reading Assistant patents expire in 2024.





The 18 patents and applications that we license are owned by the Regents of the University of California, (“the Regents”), and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2009, approximately 60% of our product booked sales was derived from selling products that use the licensed inventions. This license is exclusive and extends for the life of the University patents, which expire in 2014, subject to the right of the Regents to terminate in case of default and our right to terminate at any time upon 60 days written notice. If we were to lose our rights under this license, it would materially harm our business. This license requires payment of royalties based upon cumulative net booked sales of our products, subject to certain minimum royalty amounts. In 2006 and each year thereafter, the minimum royalty payment is $150,000. In 2009, 2008 and 2007, we had approximately $836,000, $757,000, and $1,028,000, respectively in royalty expense under the license.





We also have 10 U.S. trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark.





Posit Science Corporation





In September 2003, we transferred certain of our technology to Posit Science Corporation, or PSC, for use in the healthcare field. The initial focus of PSC has been on products to combat age-related cognitive decline and to enhance cognitive abilities as people age. The transaction included a license of the patents we own and certain software we developed, a sublicense of the patents we license from the universities, and the sale of some research-related assets. All of the rights licensed to PSC are limited to a specified healthcare field and most of the licenses are exclusive in that field. For these rights, PSC paid us a one-time initial fee, issued us shares in PSC and has an ongoing royalty obligation. PSC has also agreed to cross-license any patents issued to PSC. We retain all rights to our technology outside of the specified healthcare field.





Dr. Michael M. Merzenich, who is one of our founders and a former officer and director of ours, is also a founder, director and significant stockholder of PSC.


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Seasonality





Our quarterly booked sales and revenue fluctuate seasonally, reflecting a number of factors including school purchasing practices, budget cycles and instructional periods. Historically, our booked sales have been lowest in the first quarter of the year and highest in the second or third quarter of the year.





Backlog





Our deferred revenue was approximately $22.0 million as of December 31, 2009, and $20.0 million as of December 31, 2008. These deferred revenues are primarily composed of the portion of multi-year sales, term-based sales, support and Progress Tracker sales not yet recognized as revenue, and professional development and technical services that have not yet been performed. Approximately $15.9 million of our deferred revenue as of December 31, 2009 is expected to be recognized within the next 12 months.





Employees





As of December 31, 2009 we had 201 full-time equivalent employees, compared to 223 at December 31, 2008. None of our employees is represented by a union or subject to collective bargaining agreements. On January 7, 2009, we announced a series of changes intended to better align our costs and organization structure with the current economic environment and improve our profitability. These changes include a reduction in our work force of approximately 14% during the first quarter of 2009.





General





Scientific Learning is a Delaware corporation formed in 1997 and is a successor to Scientific Learning Principles Corporation, a California corporation. Our web address is www.scilearn.com.


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Item1A.   Risk Factors




RISK FACTORS





The following factors as well as other information contained in this report should be considered in making any investment decision related to our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.




Sales of our products depend on the availability and extent of government funding for public school reading intervention purchases, which is variable and outside the control of both us and our direct customers.  If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and net income.





United States public schools are funded primarily through state and local tax revenues, which are devoted primarily to school building costs, teacher salaries and general operating expenses.  Public schools also receive funding from the federal government through a variety of federal programs, many of which target children who are poor and/or are struggling academically.  Federal funds typically are restricted to specified uses.





The funding for a substantial portion of our K-12 sales typically comes from federal sources, in particular IDEA (special education) and Title One funding.  In 2009 our sales were significantly and favorably impacted by the substantial increases in IDEA and Title One funding under the American Recovery and Reinvestment Act (ARRA). The competition between vendors and programs for ARRA funding is intense, and these increases have been authorized for a limited duration.  The ARRA funding is expected to decrease after 2010, although some new programs – Race to the Top and Investing in Innovation is expected to continue.  Likewise, the current extraordinary levels of federal spending directed to economic recovery, the federal budget deficit and competing federal priorities could adversely impact the availability of federal education funding.  A cutback in federal education funding could have a materially adverse impact on our revenue.





State and local school funding continues to be significantly impacted by decreases in tax revenues due to the current economic downturn.  States face increasing pressure in 2010, primarily due to the significant adverse events in the job, credit, and housing markets. While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for homeowners, transportation spending and rising healthcare costs.  A continued reduction in state tax revenues could have a materially adverse impact on our revenue.




Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost sales, materially and adversely impacting our revenue and profitability.





Like other companies in the instructional market, our sales to K-12 schools are affected by school purchasing cycles and procedures, which can be quite bureaucratic.  The cost of some of our K-12 license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict.  When a district decides to finance its license purchase, the time required to obtain necessary approvals can be extended even further.  In addition, sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles.  As a result, our sales cycle generally takes months and, in some cases, can take a year or longer.  Therefore, we may devote significant time and energy to a particular customer sale over the course of many months, and then not make the sale when expected or at all.  This can result in lost opportunities that can materially and adversely impact our revenue and profit.





Sales in our non-school markets may continue to be affected by the current global recession.





Our non school sales consist principally of sales to private speech, language and other healthcare providers and sales to our international value-added resellers.  In addition, during 2009 we launched new products marketed directly to parents for at-home use by their children.





Historically, sales to private providers have been adversely impacted by economic downturns, as many parents postpone or forego these services when their financial resources are reduced.  During 2009, sales to both private providers and to our international channel declined substantially compared to the prior year.  We believe that this decline is mainly a result of current global economic difficulties.  The current weak economic conditions may likewise adversely affect our potential sales to parents of our new BrainSpark and BrainPro products.


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It is difficult to accurately forecast our future financial results.  This may cause us to fail to achieve the financial performance anticipated by investors and financial analysts, which could cause the price of our stock to decline.





Our revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year.  In 2009, we had net income of $4.8 million; in 2008, we had a net loss of approximately $3.3 million.  In 2007, we had net income of approximately $1.2 million.





Our sales strategy emphasizes district-level, multi-site transactions.  The receipt or implementation of a single large order, or conversely its loss or delay, can significantly impact the level of sales booked and revenue recognized in a given quarter.  This uncertainty is compounded by the fact that our various license and service packages have substantially differing revenue recognition periods.  Even when the amount and timing of a transaction can be accurately projected, it may be difficult to predict which license package a customer will purchase.





Our expense levels are based on our expectations of future revenue and are primarily fixed in the short term.  We may not be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, which could cause our net income to fluctuate unexpectedly.





Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.




To grow our K-12 business, we need to increase acceptance of our products among K-12 education purchasers.  Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.





We believe that to date most educators who have used Fast ForWord products are “early adopters.”  Early adopters make up a relatively small proportion of our K-12 market, so in order to grow our revenue and profit we need to increase our reach beyond early adopters to more conservative customers.  We believe that our ability to grow acceptance of our products in the conservative K-12 education market will depend largely on the critical factors discussed below.





Our Fast ForWord products use an approach that differs from the approaches that schools have traditionally used to address reading problems.  In particular, our products, which are designed to develop the brain to process more efficiently, are based on neuroscience research and focus on building cognitive skills.  These concepts may be unfamiliar to educators.  K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.





In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires at least 30 minutes per day out of a limited and already crowded school day.  Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us.  In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased revenue.





Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers.  To reach a broader group of customers, encourage additional sales from existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.





If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our revenue and growth prospects could be materially and adversely impacted.


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We rely on studies of student performance results to demonstrate the effectiveness of our products.  If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.





We rely heavily on statistical studies of student results on assessments to demonstrate that our products lead to improved student achievement.  Reliance on these studies to support our claims about the effectiveness of our products involves risks, including the following:




·
The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol.  If a school does not do so, the study may not show that our products produce substantial student improvements.




·
Some studies on which we rely may be challenged because the studies use a limited sample size, lack a randomly selected control group, include assistance or participation from us or our scientists, or have other design characteristics that are not optimal.  These challenges may assert that these studies are not sufficiently rigorous or free from bias, and may lead to criticism of the validity of the studies and the conclusions that we draw from them.




·
Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results.





Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient.





If our operations are disrupted due to weaknesses in our technology infrastructure, our business could be harmed.


Providing our services and conducting our general business operations both substantially rely on computer and network systems.  We have recently experienced disruptions in both our customer and internal network services due to hardware failures.  We are in the midst of a major project to upgrade many of our computer and network systems, which we believe have become outdated.  If our customer systems are disrupted, we may be required to issue credits, customers may elect not to renew their contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability.  If our internal systems are disrupted, we may lose productivity and incur delays in product development, sales operations or other functions.


If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims.
 
 Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released.  In the past, we have encountered unexpected bugs in our products shortly after release.  We expect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products could lead to:




·
delays in or loss of market acceptance of our products;




·
diversion of our resources;




·
a lower rate of expansion purchases from current customers;




·
injury to our reputation; and




·
increased service expenses or payment of damages.





Our Progress Tracker data tool, the Web-enabled version of the Reading Assistant product, our new Virtual Academy and other online services, and our new BrainSpark and BrainPro products all rely on the World Wide Web in order to function.  Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of that product.  The servers that support our Web-delivered products and services are located in third party facilities. While we believe that the services provided by these facilities are robust, interruptions in customer access could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems. We have experienced problems due to power loss in the past, and we will continue to be exposed to the risk of access failure in the future.


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If our products do not work properly, or if there are problems with customer access to our Web-delivered products and services, we may be required to issue credits, customers may elect not to renew their support or access contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability claims.  We cannot be certain that the limitations of liability set forth in our agreements would be enforceable or would otherwise protect us from liability for damages. A material liability claim against us, regardless of its merit or its outcome, could result in substantial costs, significantly harm our business reputation and divert management’s attention from our operations.





Our cash flow is highly variable and may not be sufficient to meet all of our objectives.





We believe that cash flow from operations, together with our current cash balances, will be our primary source of funding for our operations during 2010 and the next several years.  During 2009, we generated $14.5 million in cash from operations.  In 2008, we used $13.6 million of our cash and cash equivalent balances, with $10.1 million used for the acquisition of the Soliloquy business and $3.7 million used in operating activities





Historically, we have used cash in our operations during the first half of the year and built cash in the second half.  This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.  Reflecting this pattern as well as the significant sales increases in the second half, in the first six months of 2009, we used $4.2 million in operating activities and in the second half ended December 31, 2009, we generated $18.7 million of cash from operations.





In February 2010 we amended our credit line with Comerica Bank, which now has a limit of $7.5 million and will expire December 31, 2011.  In January 2009, we drew down and in August 2009 we repaid $2.5 million under that line.  At December 31, 2009, no borrowing was outstanding under our credit line with Comerica and we were in compliance with the covenants of the line.  Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth. If we do not comply with the covenants, we risk being unable to borrow under the credit line.




Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales, collections, and expenses.  We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.If we are unable to achieve sufficient levels of cash flow from operations, or are unable to obtain waivers or amendments from Comerica in the event we do not comply with our covenants, we would be required either to obtain debt or equity financing from other sources, or to reduce expenses.  Reducing our expenses could adversely affect our operations by reducing the resources available for sales, marketing, research or development efforts.  We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.


Our new BrainSpark and BrainPro products are marketed directly to parents.  We may be unable to successfully penetrate this market.


In the US, we presently market primarily to K-12 public schools.  Parents who purchase our products for use with their children do so through our much smaller channel, private providers, in which the marketing is done by the individual private provider.  For theBrainSpark and Brain Pro offerings launched in 2009, we are marketing and selling directly to parents, a new market for us.  We may find our marketing efforts in this market less effective or more expensive than we have planned.  The current recession may make our marketing and sales efforts in this market more difficult than we expect. If our marketing efforts are less effective than we expect, we may be unable to achieve our planned level of sales and revenue from this market. If our sales and revenue are substantially less than expected, this may cause us to incur impairment charges against the capitalized development costs for these products.





We will be required to comply with the auditors’ attestation requirement of Sarbanes-Oxley Section 404 no later than fiscal 2010.  If we or our auditors determine that our internal controls over financial reporting are not effective or if we are unable to comply with the auditors’ attestation requirement when we are required to do so, such ineffective controls or non-compliance could have a materially adverse effect on us.





Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we have been required to provide a management assessment on our internal control over financial reporting for fiscal 2007 through 2009, and we have complied with that requirement.


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We will be required to comply with the auditor’s attestation requirement in fiscal 2010.  We cannot assure you that, in the course of completing the work to satisfy the auditors’ attestation requirement, we or our auditors will not detect a material weakness in our internal control over financial reporting or that we can satisfactorily comply with the attestation requirement.




Claims relating to data collection from our user base may subject us to liabilities and additional expense.





Schools and clinicians that use our products frequently use students’ names to register them in our products and enter into our database academic, diagnostic and/or demographic information about the students.  In addition, the results of student use of our products are uploaded to our database.  We have designed our system to safeguard this personally-identifiable information, but the protection of such information is an area of increasing public concern and significant government regulation, including but not limited to the Children’s Online Privacy Protection Act.  If our privacy protection measures prove to be ineffective, we could be subject to liability claims for unauthorized access to or misuses of personally-identifiable information stored in our database.  We may also face additional expenses to analyze and comply with increasing regulation in this area.





We may not be able to compete effectively in the education market.





The market in which we operate is very competitive.  We compete vigorously for the funding available to schools, including against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading.  Many of the companies providing these competitive offerings are much larger than we are, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.





Our Fast ForWord products are differentiated in the market by their basis in neuroscience research and their focus on improving brain processing efficiency and cognitive skills.  Other neuroscientists have worked and are working with other companies to repackage and commercialize their research, resulting in the introduction of other products based on neuroscience research and focusing on improving brain processing.  We anticipate that the number of “brain fitness” products will continue to increase in the near future.  To the extent that these products are adopted in place of our product, this could materially and adversely impact our revenue.




If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.





We depend on the performance of our senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company.  The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price.  In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand.  We cannot assure you that we will be able to do so.




If we are unable to maintain our access to the intellectual property rights that we license from third parties, our sales and net income will be materially and adversely affected.





Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey.  In 2009, we generated approximately 60% of our booked sales from products that use this licensed technology.  We also have incorporated technology and content licensed from other third parties as part of our products and services.  If we were to lose our rights under these licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.


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If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.




Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others.  It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents.  Issued patents can prove to be invalid or unenforceable as a result of a variety of reasons, including deficiencies in prosecution.  As a result of potential deficiencies during the prosecution of certain patents to which we have rights, it is possible that these patents may be subject to a claim of unenforceability or invalidity.  If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our booked sales, revenue and net income.  The Company historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright.  The degree of future protection for our proprietary rights is also uncertain for products or product improvements in early-stage development, because it is difficult to predict from early-stage development efforts which product(s) will ultimately be marketed or what form the ultimately marketed product(s) will take.





In addition, we could become party to patent or trademark infringement claims, litigation or interference proceedings.  These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights.  Any such proceedings would result in substantial expense and significant diversion of management effort, and the outcome of any such proceedings cannot be accurately predicted.  An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.  In addition, competitors may design around our technology or develop competing technologies.  Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture or increase their market share with respect to related technologies.





We generally require the execution of a written licensing agreement, which restricts the use and copying of our software products.  However, if unauthorized copying or misuse were to occur to a substantial degree, our sales could be adversely affected.





Our common stock is thinly traded and its price is volatile.





Our common stock presently trades on the Nasdaq Capital Market, and our trading volume is generally low.  For example during the fourth quarter of 2009, our average daily trading volume was approximately 120,000 shares.  As a result, the ability of holders of our common stock to sell such common stock and thereby monetize their investment may be limited. In addition, the market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.





The ownership of our common stock is concentrated.





At December 31, 2009, Trigran Investments owned approximately 28% of our outstanding stock, and our officers and directors held approximately 11% of the outstanding stock.  As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders.  This concentration of ownership may also delay, prevent or deter a change in control of our company.





ITEM1B.  UNRESOLVED STAFF COMMENTS





Not applicable





ITEM2.     PROPERTIES





We currently have the following leased properties:





1.
A lease for approximately 30,500 square feet of office space in Oakland, California for our headquarters that expires in December 2013.  The lease includes two five-year options to extend the term of the lease.


2.
A lease for approximately 6,200 square feet of office space in Tucson, Arizona for our support center that expires in 2013.


3.
A lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet that expires in September 2011.  Following the closure of our operations in Waltham in the fourth quarter of 2009, we have subleased this property until October 2010.


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We believe our facilities are sufficient for our operations currently and should be adequate to meet our needs for at least the next two years.





ITEM3.     LEGAL PROCEEDINGS





None.





ITEM4      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





None.


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EXECUTIVE OFFICERS





The following table sets forth various information concerning our executive officers, as of February 20, 2010.





NAME

AGE

POSITIOND. Andrew Myers

38

President and Chief Executive OfficerLinda L. Carloni

56

Senior Vice President, General Counsel and Corporate SecretaryRobert E. Feller

41

Chief Financial Officer, Senior Vice President and TreasurerDr. William M. Jenkins

59

Senior Vice President and Chief Scientific OfficerJessica Lindl

35

Senior Vice President, MarketingDavid C. Myers

43

Senior Vice President, Sales and ServiceRonald Park

43

Vice President, Product Development





D. Andrew Myersjoined usas President and Chief Operating Officer in January 2008 and became our Chief Executive Officer in January 2009.  Prior to joining us, Mr. Myers worked at Pearson Education since 1996.  His last position was as Senior Vice President, Digital Product Development for Pearson Curriculum, where he was responsible for integrating the technology teams from six preceding business units into a digital development group of 275 employees.  From August 2004 to March 2007, Mr. Myers was the Chief Operations Officer for Pearson Digital Learning, where he was responsible for setting product, financial, technical and operational strategies for that 580-employee business unit.  From 2002 to 2004, Mr. Myers served as Vice President Sales for Pearson Digital Learning.  Mr. Myers started with Pearson as a sales representative in 1996.  Pearson Education is the education division of Pearson PLC, an international media company.  Mr. Myers holds an MBA from the Haas School of Business at the University of California Berkeley and a BS in finance from the University of Utah.





Linda L. Carloni joined the Company as General Counsel in October 1999, became our Secretary in March 2000 and was appointed Vice President in June 2000.  She was promoted to Senior Vice President in January 2009.  Before joining us, Ms. Carloni was a founder and Vice President of Alere Medical Incorporated, a healthcare services start-up. Earlier in her career, Ms. Carloni worked in technology transfer for the University of California, was the general counsel of Nellcor Incorporated, a medical device company, and was an associate and a partner at the Cooley Godward law firm.  She received her bachelor's degree in political science from Case Western Reserve University and her law degree from Boalt Hall School of Law at the University of California, Berkeley.





Robert E. Fellerjoined us in December 2008 as our Chief Financial Officer.  From 2006 until joining the Company, Mr. Feller served as Vice President, Finance and Administration at AdBrite, Inc., which operates an Internet-based advertising marketplace.  Prior to AdBrite, he served in financial leadership positions of increasing responsibility at salesforce.com, a leading provider of web-based customer relationship management services, from 2005 to 2006 as Vice President, Finance and from 2003 to 2005 as Corporate Controller and Senior Director Finance.  Mr. Feller began his career as an auditor with Arthur Andersen, LLP.  He holds an MBA from the Ross School of Business at the University of Michigan and a BA from the University of Michigan.





Dr. William M. Jenkins was appointed Chief Scientific Officer in June 2009.  Dr. Jenkins is a founder and served as Senior Vice President, Product Development from November 2000 through 2008 and Chief Technical Officer from January 2009 to June 2009.  From 1990 to 1996, Dr. Jenkins was an Adjunct Associate Professor at the University of California, San Francisco.  Dr. Jenkins is the principal developer of our current software products. Dr. Jenkins holds a B.S. in Psychology, an M.A. in Psychobiology and a Ph.D. in Psychobiology from Florida State University, with additional post-doctoral training from UCSF.





Jessica Lindl joined us as Vice President of Marketing in March 2007 and was promoted to Senior Vice President in January 2009. Prior to joining us, Ms. Lindl served as Vice President of Marketing and Product Management for Riverdeep, a leading developer of educational software. Ms. Lindl held marketing management positions of increasing responsibility at Riverdeep and The Learning Company, which was acquired by Riverdeep, from 2001 through 2006. Prior to her tenure at Riverdeep, Ms. Lindl served as the Director of Product Management for Simplexis, an e-procurement provider for the K-12 market, in 2000 and 2001 and as part of the sales management team for AT&T in San Francisco from 1995 to 1998. Ms. Lindl holds a bachelor’s degree in economics and international studies from Miami University in Oxford, Ohio and an MBA from the Haas School of Business at the University of California, Berkeley.


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David C. Myers joined us in December 2008 as Senior Vice President, Sales and Services.  Prior to joining us, during 2008 Mr. Myers was the East Region Vice President of Sales for the K-12 digital division of Pearson Education, where his team consisted of over 80 sales professionals and spanned 32 states.  Prior to this role, from July 2006 to December 2007 he led a smaller National team at Pearson that focused on Digital Secondary products.  From September 200 through June 2006, Mr. Myers served as a District Sales Manager at Pearson.  Mr. Myers started his career as a bilingual elementary education teacher and holds Master of Education and Bachelor of Arts degrees from Brigham Young University.
 
 Ron Park joined Scientific Learning in June 2009 as Vice President, Product Development, and has over 20 years of product development experience in the software industry.  Previously, Mr. Park served from 2008-2009 as founder and CTO of Arkapi Corporation, a provider of web and iPhone applications.  Prior to Arkapi, Mr. Park served from 2006-2007 as VP Engineering and Products for MuleSource Inc., an open source service-oriented architecture and enterprise service bus middleware software vendor.  Prior to MuleSource, from 2004 to 2007, Mr. Park was Group Director, Engineering at Siebel Systems, Inc. and Oracle Corporation after its acquisition of Siebel.  Earlier in his career Mr. Park held various management and engineering positions at both large and small software companies.
 
 Mr. Park holds a BS in Computer Science and Engineering from the University of California, Los Angeles, and an MBA from The Wharton School at the University of Pennsylvania.





There are no family relationships among our officers or directors.


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ITEM5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES





(a) Market Information. Our common stock currently is, and since November 26, 2008 has been, traded on the NASDAQ Capital Market under the symbol "SCIL”.  During all of 2007 and 2008 prior to November 26, our common stock traded on the NASDAQ Global Market under the symbol “SCIL”.





The following table sets forth, for the periods indicated, the closing high and low sales prices per share of our common stock as reported on the NASDAQ Global Market and NASDAQ Capital Market, as applicable.





2008

High


LowFirst Quarter

$
5.41


$
4.25Second Quarter

$
5.20


$
3.84Third Quarter

$
4.12


$
3.26Fourth Quarter

$
3.42


$
1.662009

High


LowFirst Quarter

$
2.35


$
1.50Second Quarter

$
2.35


$
1.85Third Quarter

$
3.60


$
2.03Fourth Quarter

$
5.88


$
3.40





Holders. As of January 31, 2010, the approximate number of stockholders of record of our common stock was 99.





Dividend Policy. We have never declared or paid cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. Our current Loan and Security Agreement with Comerica Bank provides that we may not pay any dividends other than stock dividends during the term of the Agreement.





Securities Authorized for Issuance under Equity Compensation Plans.  For information regarding securities authorized for issuance under equity compensation plans, see Item 12.





Performance Measurement Comparison.




The following chart compares the cumulative total stockholder return of Scientific Learning Common Stock for the five years ended December 31, 2009 with the cumulative total return during the same period of (i) the NASDAQ Composite Market Index and (ii) a Scientific Learning constructed peer group index. The companies in the peer group index were selected on the basis of similarity in the nature of their business.  At December 31, 2009, the peer group included Plato Learning, Inc., Princeton Review, Renaissance Learning Inc., Scholastic Corporation and K12 Inc. In 2008 we added K12 Inc. to our peer group.  K12 Inc is also a technology based education company whose primary market is the kindergarten through 12th grade market in the U.S.  K12 went public on December 13, 2007.  Over the last five years we have changed companies in the peer group because of acquisitions, changes in business, new companies entering the market and other changes affecting peer group companies.  This table shows these changes:







Members of Peer Group
Tenure in Peer GroupExcelligence
Removed from peer group after September 30, 2006 after it stopped trading.K12 Inc
Added to peer group in 2008 after going public in December 2007.





The comparison assumes $100 was invested on December 31, 2004 in Scientific Learning Common Stock and in each of the foregoing indices. It also assumes reinvestment of dividends. The stock price performance shown in the graph below should not be considered indicative of potential future stock price performance.


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Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities. Not applicable





(b) Not applicable





(c) Not applicable


29
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ITEM6.    SELECTED FINANCIAL DATA


In thousands, except per share amounts





Year Ended December 31,2009


2008


2007


2006


2005Statement of Operations Data:Revenues:Products

$
35,863


$
28,301


$
31,023


$
29,966


$
30,263Service and support


19,425



19,453



15,030



11,032



10,056Total revenues


55,288



47,754



46,053



40,998



40,319Cost of revenues:Products


2,679



2,178



1,680



1,638



2,018Service and support


8,895



9,721



8,539



7,897



5,637Total cost of revenues


11,574



11,899



10,219



9,535



7,655Gross profit


43,714



35,855



35,834



31,463



32,664Operating expenses:Sales and marketing


24,042



23,587



24,868



21,073



17,619Research and development


6,418



7,016



4,500



4,129



3,896General and administrative


8,135



7,883



7,660



6,643



5,841Total operating expenses


38,595



38,486



37,028



31,845



27,356Operating income (loss)


5,119



(2,631
)


(1,194
)


(382
)


5,308Interest and other income (expense), net


110



564



1,266



793



471Net income (loss) before income tax


5,229



(2,067
)


72



411



5,779Income tax provision (benefit)


429



1,248



(1,082
)


203



182Net income (loss)

$
4,800


$
(3,315
)

$
1,154


$
208


$
5,597Basic net income (loss) per share

$
0.27


$
(0.19
)

$
0.07


$
0.01


$
0.33Shares used in computing basic net income (loss) per share


18,039



17,488



17,161



16,846



16,715Diluted net income (loss) per share

$
0.26


$
(0.19
)

$
0.06


$
0.01


$
0.31Shares used in computing diluted net income (loss) per share


18,690



17,488



18,297



17,740



18,023Balance Sheet Data:Cash and cash equivalents

$
20,679


$
7,550


$
21,179


$
16,364


$
9,022Short-term investments


-



-



-



-



3,043Working capital


5,178



(3,551
)


7,862



3,951



2,842Total assets


43,128



30,260



33,803



26,283



18,734Stockholders’ equity (deficit) (1)


11,929



5,045



5,820



1,017



(1,835
)





(1)      We have paid no cash dividends since our inception.


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ITEM7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS





Overview





We develop, distribute and license technology that accelerates learning by improving the processing efficiency of the brain.  Based on more than thirty years of neuroscience and cognitive research, our family of products improves brain fitness with technology-based exercises that build the cognitive skills required to read and learn effectively. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the US, to whom we sell through a direct sales force.  To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support.  Since our inception, learners have used our products over two million times and approximately 6,400 schools have purchased at least $10,000 of our product licenses and services.  As of December 31, 2009 we had 201 full-time equivalent employees, compared to 223 at December 31, 2008.





Business Highlights





We market our Fast ForWord and Reading Assistant products primarily as a reading intervention solution for struggling and special education students and English Language Learners.  According to the U.S. Department of Education, in 2007, 33% of fourth graders in the United States had “below basic” reading scores and 67% were not proficient in reading, and between 1992 and 2007 there was only a modest improvement in the proportion of fourth graders performing at the “below basic” level.  While our installed base is growing, the approximately 6,400 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 117,000 K-12 schools in the US.





Federal education funds are a critical resource in helping school districts address the needs of the most challenged learners.  We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants.  With the passage of the American Recovery and Reinvestment Act (“ARRA” - the recent stimulus bill), these two federal sources are estimated to have increased from $24.9 billion in the 2008 – 2009 school year to $37 billion in the 2009 – 2010 school year. In most states the ARRA funds have been and are being disbursed to school districts, and we believe that the ARRA funding has had a substantial positive impact on our 2009 sales.





States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products.  States faced severe budget shortfalls in fiscal 2009 and forecast continuing funding difficulties in 2010.  The National Conference of State Legislatures estimates that the cumulative state budget gap was $113.2 billion in fiscal 2009, and in June 2009, forecast a cumulative budget gap for fiscal 2010 of $142.6 billion, involving 46 states.





In 2009, we launched our first products and services sold directly to parents. BrainSpark is for learners at or above grade level who want to improve their learning potential and BrainPro is for learners below grade level who want to catch up. Both offerings are delivered via SaaS (Software as a Service, a model of software deployment whereby we license our software on demand as a service to the end user). Neither offering contributed a significant amount of sales in 2009.





Company Highlights





For the year ended December 31, 2009, our total revenue increased by 16% and our total booked sales increased by 32% over 2008.  (Booked sales is a non-GAAP financial measure.  For more explanation on booked sales, see Revenue below). K-12 sales increased by 41% in the year ended December 31, 2009, compared to 2008, as the flow of federal stimulus funds to individual school districts and the spending requirements linked to these funds put school districts in a better position to execute new purchases. Booked sales and revenue also benefited from a large $6.9 million deal that closed in early July. For the year ended December 31, 2009, we closed 99 transactions in excess of $100,000, compared to 82 in 2008. Non-school sales, including private practice, international and OEM customers, decreased by 31% in 2009 compared to 2008. We believe that the decrease was primarily caused by adverse economic conditions affecting our customers in both the private practice and international markets. Operating expenses were flat in 2009 compared with 2008, as cost savings resulting from our restructuring initiative in January 2009 were partially offset by increased bonus and commission expense arising from our strong financial performance.


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Results of Operations





Revenues





Year Ended December 31,(dollars in thousands)

2009


Change


2008


Change


2007Products

$
35,863



27
%

$
28,301



-9
%

$
31,023Service and support


19,425



0
%


19,453



29
%


15,030Total revenues

$
55,288



16
%

$
47,754



4
%

$
46,053





2009 revenue compared to 2008: Product revenues increased by 27% in 2009 compared to 2008. The increase in 2009 was primarily due to higher US K-12 booked sales, which reflected the increased federal funding made available to schools by ARRA. Booked sales included one transaction for $6.9 million for which we recognized product revenue of $3.2 million.





Our service and support revenue was flat in 2009 compared to 2008. In 2008 we recognized OEM revenue relating to the Reading Assistant operations that we did not repeat in 2009. This was offset primarily by an increase in the number of implementation service days delivered.




2008 revenue compared to 2007: Product revenues decreased by 9% in 2008 compared to 2007. The decrease was mainly because one large transaction for approximately $7.4 million was booked in 2007 and no similarly-sized transaction was booked in 2008. This transaction included approximately $3.2 million of product revenue that was recognized during 2007.  Our largest transaction in 2008 was for approximately $2.2 million, including approximately $300,000 of product revenue that was recognized in 2008.




Our service and support revenue increased by 29% in 2008 compared to 2007 due to a higher number of schools on support, more services delivered,  higher revenue for the Reading Progress Indicator and OEM revenue from the operations we purchased in our acquisition of Soliloquy in January 2008. At December 31, 2008 we had approximately 15% more schools on support than at December 31, 2007.





Booked sales and selling activity:  Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity.  We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services.  Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. Revenue on a GAAP basis is recorded for booked sales when all four of the requirements for revenue recognition have been met; if any of the requirements to recognize revenue are not met, the sale is recorded as deferred revenue. We use booked sales information for resource allocation, planning, compensation and other management purposes.  We believe that revenue is the most comparable GAAP measure to booked sales.  However, booked sales should not be considered in isolation from revenue, and is not intended to represent a substitute measure of revenue or any other performance measure calculated under GAAP.





The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the twelve months ended December 31, 2009, 2008 and 2007:





Year Ended December 31,(dollars in thousands)

2009


Change


2008


Change


2007Booked sales

$
59,701



32
%

$
45,084



(10
%)

$
49,849Less: revenue recognized


(55,288
)


16
%


(47,754
)


4
%


(46,053
)Other adjustments


(2,135
)


541
%


(333
)






-Net increase/(decrease) in deferred revenue


2,278







(3,003
)






3,796Total deferred revenue end of period

$
22,230



11
%

$
19,952



(13
%)

$
22,955





Booked sales in the K-12 sector increased by 41% to $56.2 million for 2009 compared to $39.9 million in 2008.  Booked sales in the K-12 sector were $45.6 million in 2007.  The flow of federal stimulus funds to individual school districts and the spending requirements linked to these funds put school districts in a better position to execute new purchases during the year. As previously noted, one large transaction for approximately $6.9 million was booked in 2009, whereas the largest transaction booked in 2008 was for approximately $2.2 million.  Our total booked sales for 2008 decreased by 10% from 2007.  The decrease in booked sales was mainly because one large transaction for approximately $7.4 million was booked in 2007 and no similar-sized transaction was booked in 2008.  Booked sales to the K-12 sector in 2009 represented 94% of total booked sales, compared to 89% in 2008 and 91% in 2007.   “Other adjustments” consists primarily of sales with FOB destination delivery terms that had not been delivered by year end, and therefore no deferred revenue or receivable was recorded for these transactions.





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We believe large booked sales, which we define as transactions totaling more than $100,000, are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity.  In 2009 we continued to focus our sales force on multi-site sales, and we closed 99 transactions in excess of $100,000 compared to 82 in 2008 and 90 in 2007.  For the year ended December 31, 2009, 66% of our booked sales arose from transactions over $100,000.  For the comparable periods ending December 31, 2008 and 2007, large booked sales accounted for 59% and 69% of booked sales respectively.  Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate.  Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting.  We cannot predict the size and number of large transactions in the future.





Booked sales to non-school customers (primarily to private practice clinicians and international value-added resellers) decreased by 31% in 2009, as a result of adverse economic conditions. In addition, in 2008 we recorded OEM booked sales of approximately $1.0 million from the operations we purchased in our acquisition of Soliloquy in January 2008, compared with $110,000 in 2009. Booked sales outside the K-12 market increased by 21% in 2008 compared with 2007, mainly due to the incremental OEM sales as well as our continued expansion of the international and private practice channels.




Although the current economic and financial conditions, the temporary nature of federal stimulus funding, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 market.  However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.  Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding.  While federal funding for education has grown steadily over the last few decades, the current level of federal spending and the federal deficit are likely to put pressure on all areas in the federal budget.  In addition, school district spending based on federal education stimulus funding is expected to decline after 2010 or 2011. States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets; these conditions may continue to impact state education spending. In addition, the revenue recognized from our booked sales can be unpredictable.  Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected.  In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time. See “Risk Factors” for a further discussion of some of the factors that affect our sales and revenue.





Gross Profit and Cost of Revenues





Year Ended December 31,(dollars in thousands)

2009


2008


2007Gross profit on products

$
33,184


$
26,123


$
29,343Gross profit margin on products


93
%


92
%


95
%Gross profit on service and support


10,530



9,732



6,491Gross profit margin on services and support


54
%


50
%


43
%Total gross profit

$
43,714


$
35,855


$
35,834Total gross profit margin


79
%


75
%


78
%





The overall gross profit margin increased by 400 basis points in 2009 compared to the prior year, mainly due to a revenue mix shift and higher service and support margins.  Higher margin product revenues made up 65% of total revenues in 2009, compared to 59% in 2008.  Product margins in 2009 increased 100 basis points over 2008, as proportionately lower royalty costs were partially offset by increased amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant.  Service and support margins improved in 2009 compared to 2008 principally due to year over year price increases and cost savings resulting from more efficient delivery of services.


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 Table of Contents


The overall gross profit margin decreased in 2008 compared to the prior year due to a shift in revenue mix.  Higher margin product revenues made up 59% of total revenues in 2008 compared to 67% in 2007.  Product margins declined in 2008, mainly due to the impact of the amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant.  Service and support gross margins improved because a larger proportion of these revenues arose from support and Progress Tracker, which have higher margins than training and implementation services.




Operating Expenses





Year Ended December 31,(dollars in thousands)

2009


Change


2008


Change


2007Sales and marketing

$
24,042



2
%

$
23,587



-5
%

$
24,868Research and development


6,418



-9
%


7,016



56
%


4,500General and administrative


8,135



3
%


7,883



3
%


7,660Total operating expenses

$
38,595



0
%

$
38,486



4
%

$
37,028





In January 2009 we announced a 14% reduction in our workforce which was implemented during the first quarter of 2009.  The expected savings in salaries and benefit costs from this action are approximately $2.3 million annually.  In 2009 we paid severance costs of approximately $391,000.





On September 1, 2009, we announced a plan to consolidate our product development and product management leadership functions in our Oakland, California headquarters, mainly for strategic reasons. Under this plan, we closed our Waltham, Massachusetts office in December 2009 and eight Waltham research and development employees left the company.





In the fourth quarter of 2009 we determined that we needed to completely redesign our BrainSpark website and accordingly we recorded an impairment charge of $415,000. The amount of the impairment charge was determined by comparing the carrying amount of the website capitalized costs with the net present value of expected future cash flows to be generated by the website.





Sales and Marketing:  Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials.  The 2% increase in 2009 is mostly due to higher commission expense of approximately $1.4 million as a result of the strong sales performance, partially offset by lower salary and benefit costs as a result of the restructuring actions taken in January 2009.The decrease in sales and marketing expenses in 2008 compared to 2007 is primarily due to a reduction of approximately $1.6 million in incentive compensation and consulting costs, partially offset by an increase of approximately $213,000 in salary and benefit costs resulting mainly from severance payments.  At December 31, 2009, we had 49 quota-bearing sales personnel compared to 50 and 51 at December 31, 2008 and 2007, respectively.





Research and Development: Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs.  The decrease for 2009 is primarily due to the capitalization of approximately $986,000 of development costs relating to our Reading Assistant Expanded Edition product, partially offset by increased bonus expense of approximately $430,000. No development costs were capitalized in either 2008 or 2007. Research and development expenses increased by 56% in 2008 compared to 2007, mostly due to increased development personnel costs stemming from the Soliloquy acquisition.





General and Administrative: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees.  The 3% increase in 2009 compared to 2008 is primarily due to increases in bonus expenses of approximately $964,000, partially offset by a decrease in bad debt expense of $649,000. General and administrative expenses also increased by 3% in 2008 compared to 2007. The increase in 2008 is mostly caused by higher bad debt expense of $577,000 and severance costs of $266,000, partially offset by lower legal expenses, which decreased by $365,000.


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Interest and Other Income





Year Ended December 31,(dollars in thousands)

2009


Change


2008


Change


2007Interest on invested cash

$
52



-53
%

$
110



-84
%

$
680Interest expense on bank loan


(56
)

NA



-


NA



-Reclassification of service revenue


142



-51
%


288



-13
%


332Miscellaneous


(28
)


-275
%


16



129
%


7Interest and other income

$
110



-73
%

$
414



-59
%

$
1,019





Interest and other income decreased in 2009 compared to 2008 mainly because of lower reclassifications of service and support revenue relating to the amortization of deferred revenue for customers for whom we are no longer performing services, lower interest paid on our cash balances, and interest expense on our bank loan from January through August 2009. The main cause of the decrease from 2007 to 2008 was lower interest income as a result of lower average cash balances and declining interest rates.





Income Tax Provision





During 2009 we recorded an income tax expense of approximately $429,000. As of December 31, 2009, we have U.S. federal and state net operating loss carryforwards of approximately $54.1 million and $35.3 million, respectively.  The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2024 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2012 through 2017.





As of December 31, 2009, we have U.S. federal and state tax credit carryforwards of approximately $1.6 million and $1.3 million, respectively.  The federal credit will expire at various dates beginning in 2011 through 2028, if not utilized.  California state research and development credits can be carried forward indefinitely.





During 2008, we recorded an income tax expense of $1.2 million. This expense primarily consisted of a $1.2 million increase in the valuation allowance against our deferred tax assets. This valuation allowance increase was the result of recording a valuation allowance against our deferred tax assets. After considering all available positive and negative evidence, including our past operating results and our forecast of future taxable income, we concluded that we could no longer support a deferred tax asset balance. We intend to maintain the valuation allowance until sufficient positive evidence exists to support the realizability of the deferred tax assets.





During 2007 we recorded an income tax benefit of approximately $1.1 million. This benefit included a $1.2 million reduction in our deferred tax asset valuation allowance related to a portion of our deferred tax assets that in our opinion would more likely than not be realized, based on future projected taxable income for fiscal 2008. Prior to 2007, we recorded a full valuation allowance against our deferred tax assets. These projections were based on one year of projected future taxable income.





Net operating loss carryforwards and credit carryforwards reflected above are limited due to ownership changes as provided in the Internal Revenue Code and similar state provisions.





Liquidity and Capital Resources





Our cash and cash equivalents and short-term investments were $20.7 million at December 31, 2009, compared to $7.6 million at December 31, 2008 and $21.2 million at December 31, 2007.  At December 31, 2009 there were no borrowings outstanding under our credit line. During 2008 we expended $10.1 million of our cash for the acquisition of the assets of Soliloquy Learning.





We expect that during at least the next twelve months our cash flow from operations together with our current cash balances will be our primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures.  Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter. We expect that this pattern will continue, and that we will use cash in operations during the first half of 2010.  However, we expect that our current cash balances will be sufficient to fund our operating requirements during the first half of fiscal 2010. Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market.  We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.


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On February 28, 2010 we amended our existing revolving line of credit agreement with Comerica Bank.  The maximum that can be borrowed under the agreement is $7.5 million.  The line expires on December 31, 2011. Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate”.  Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth.  The agreement includes a letter of credit sublimit not to exceed $1.0 million. At December 31, 2009, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at December 31, 2009 and we were in compliance with all our covenants.  In February 2009 we borrowed $2.5 million from the line of credit which we repaid in August 2009.





If we are unable to achieve sufficient cash flow from operations, we may seek other sources of debt or equity financing, or may be required to reduce expenses. Reducing our expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development.  We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.





Cash provided by operations in 2009 was $14.5 million, compared to net cash used in operations in 2008 of $3.7 million and cash provided by operations of $6.1 million in 2007.  This improvement was mainly the result of higher net income and receivable collections resulting from our stronger sales performance. We collected $59.3 million of receivables in 2009, compared to $42.4 million in 2008, and $51.7 million in 2007.





Net cash used in investing activities for 2009 was $2.1 million, due to capital spending and additions to capitalized software. Net cash used in investing activities in 2008 was $10.4 million, of which $10.1 million relates to the acquisition of Soliloquy Learning assets. Net cash used in investing activities in 2007 was $2.4 million, consisting of net purchases of property and equipment of $1.1 million, a loan to JTT Holdings of $1.0 million in connection with the 2008 acquisition of Soliloquy, and deferred acquisition costs incurred of $319,000.


Net cash generated by financing activities in 2009, 2008 and 2007 was $0.7 million, $0.5 million, and $1.2 million, respectively.  Net cash generated by financing activities in all three years resulted from proceeds from the exercise of stock options and through purchases of stock through the employee stock purchase plan. In 2009 we borrowed and repaid $2.5 million from our credit facility. There was no borrowing on our credit line in 2008 or 2007.





Off-Balance Sheet Arrangements





We have no off-balance sheet arrangements.





Contractual Obligations and Commitments





We have a non-cancelable lease agreement for our corporate office facilities in Oakland, California.  The minimum lease payment was approximately $78,000 per month through 2008. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013.  We also have a lease agreement for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month.  In early 2008, we entered into a lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet at an average monthly rent of approximately $12,000 that expires in September 2011.  Following the closure of the Waltham office in December 2009, we have sublet this property until October 2010 at a monthly rent of approximately $5,000.





We also make royalty payments to the institutions who participated in the original research that produced our initial products. Our minimum royalty payments are $150,000 per year.


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The following table summarizes our obligations at December 31, 2009 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.





(dollars in thousands)

2010


2011


2012


2013


2014 and thereafter


TotalContractual Obligations:Operating lease obligations (net of sublease income)

$
1,259


$
1,323


$
1,274


$
1,242


$
-


$
5,098Minimum royalty obligations


150



150



150



150



150


$
750Total

$
1,409


$
1,473


$
1,424


$
1,392


$
150


$
5,848




Our purchase order commitments at December 31, 2009 are not material.





Application of Critical Accounting Policies





Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.





We believe that the estimates, assumptions and judgments pertaining to revenue recognition and allowance for doubtful accounts are the most critical assumptions to understand in order to evaluate our reported financial results.  A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below.  We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors.





Revenue Recognition





We derive revenue from the sale of licenses to our software and from service and support fees.  Software license revenue is recognized in accordance with the rules governing revenue recognition for software companies. These rules provide specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected.  The application of these rules requires us to exercise significant judgment related to our specific transactions and transaction types. In cases where we grant extended payment terms to school customers, we determine if the fixed or determinable fee criterion is met by reference to the customer’s specific funding sources, especially where the payment terms extend into the customer’s next fiscal year. If we determine that the fixed or determinable fee criterion is not met at the inception of the arrangement, we defer revenue recognition until the payments become due.





Sales to our school customers typically include multiple elements (e.g., Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services).  We recognize revenue using the residual method, whereby the difference between the total arrangement fee and the total “vendor specific objective evidence” (“VSOE”) of fair value of the undelivered elements is recognized as revenue relating to the delivered elements. VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price.  We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.





The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized.  All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products.  Deferred revenue is recognized as revenue as discussed below.





Multiple contracts with the same customer are generally accounted for as separate arrangements except in cases where contracts are so closely related that they are effectively part of a single arrangement.


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 Table of Contents


Product revenue





Product revenue is primarily derived from the licensing of software and is recognized as follows:





·
Perpetual licenses – software licensed on a perpetual basis.  Revenue is recognized at the later of product delivery date or contract start date using the residual method.  If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.





·
Term licenses – software licensed for a specific time period, generally three to twelve months.  Revenue is recognized ratably over the license term.





·
Individual participant licenses – software licensed for a single participant.  Revenue is recognized over the average period of use, typically six weeks.





Service and support revenue





Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis.  If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed.  If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement.  Revenue from services sold alone or with support is recognized as performed.





If an arrangement includes services that are essential to the functionality of the software, we recognize the fees for the software license and the services using the percentage of completion method in accordance with the rules relating to contract accounting.  We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. The percentage of completion method of accounting involves an estimation process and is subject to risks and uncertainties inherent in projecting future events. A number of internal and external factors can affect our estimates, including the nature of the services being performed, the complexity of the customer’s information technology environment and the utilization and efficiency of our professional services employees. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known.





Income Taxes





We account for income taxes using the liability method, which requires the recognition of deferred tax assets or liabilities for the tax-effected temporary differences between the financial reporting and tax bases of our assets and liabilities, and for net operating loss and tax credit carryforwards. We intend to maintain a valuation allowance until sufficient positive evidence exists to support the realizability of the deferred tax assets.





In evaluating our ability to realize our deferred tax assets we consider all available positive and negative evidence including our past operating results and our forecast of future taxable income. In determining future taxable income, we make assumptions to forecast federal and state operating income, the reversal of temporary differences, and the implementation of any feasible and prudent tax planning strategies. These assumptions require significant judgment regarding the forecasts of future taxable income, and are consistent with the forecasts used to manage our business.





Stock-Based Compensation





Under the fair value recognition provisions of ASC 718, we use the Black-Scholes option valuation model to estimate stock-based compensation expense at the grant date based on the fair value of the award and recognize the expense ratably over the requisite service period of the award. Determining the appropriate fair value model and assumptions used in calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected life.





The estimated expected stock price volatility increased from 49% in 2007 to 55% in 2008 and increased again to 58% in 2009. Our expected stock price volatility over the expected life of the options is based upon our historical experience over the expected life of the options.


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 Table of Contents


Our estimate of the forfeiture rate has also changed from 3.5% in 2007 to 6.2% in 2008 to 8.3% in 2009, based on our experience of actual forfeiture rates. Stock compensation expense may be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.





Capitalization of software development costs and website development costs.





As discussed in Note 1 to the Financial Statements, in 2009 we capitalized approximately $986,000 of costs relating to a new Reading Assistant product incurred after this product t had reached technological feasibility. The rules that govern how development costs are accounted for can have a major impact on our reported financial results. Significant judgment is required in assessing whether and when products have reached technological feasibility. We are also required to use judgment to estimate the net realizable value of the asset by projecting future revenues and cash flows expected to be generated by the products, in order to determine whether the unamortized cost exceed the net realizable value. Moreover, any future changes to our software product offerings could result in write-offs of previously capitalized costs and have a significant impact on our financial results.





We also capitalize web site application, infrastructure development and content development costs where a website is built for our internal needs and we do not plan to market the software externally,  For the years ended December 31, 2009 and 2008, respectively, we capitalized approximately $406,000 and $51,000 in web site development costs.  If indicators of impairment are present, estimates of future cash flows are used to test the recoverability of the web site asset If the carrying amount of the asset exceeds its fair value, an impairment charge is recognized. In late 2009 we determined that we needed to completely redesign our BrainSpark website and accordingly we recorded an impairment charge of $415,000. Significant judgment is required in evaluating which costs are eligible for capitalization and whether any impairment exists.





ITEM7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Interest Rate Risk





Our exposure to market risk for changes in interest rates relates primarily to the rate of interest that we earn on our cash and cash equivalents. We did not hold any marketable debt securities at December 31, 2009. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at December 31, 2009 would not have a material effect on our results of operations.


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 Table of Contents


ITEM8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





Report of Ernst & Young LLP, Independent Registered Public Accounting Firm





The Board of Directors and Stockholders


Scientific Learning Corporation





We have audited the accompanying balance sheets of Scientific Learning Corporation as of December 31, 2009 and 2008 and the related statements of operations, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedule listed in the index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.





We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.





In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Scientific Learning Corporation as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.





/s/    ERNST & YOUNG LLP


San Francisco, California


March 3, 2010


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 Table of Contents




Scientific Learning CorporationBalance Sheets(In thousands, except share and per share amounts)December 31,


December 31,2009


2008AssetsCurrent assets:Cash and cash equivalents

$
20,679


$
7,550Accounts receivable, net of allowance for doubtful accounts of $97 and $296 at December 31, 2009 and 2008, respectively


6,390



7,717Prepaid expenses and other current assets


2,142



1,341Total current assets


29,211



16,608Property and equipment, net


1,780



1,552Goodwill


4,568



4,568Other intangible assets, net


5,476



6,424Other assets


2,093



1,108Total assets

$
43,128


$
30,260Liabilities and stockholders' equityCurrent liabilities:Accounts payable

$
812


$
674Accrued liabilities


7,362



3,964Deferred revenue


15,859



15,521Total current liabilities


24,033



20,159Deferred revenue, long-term


6,371



4,431Other liabilities


795



625Total liabilities


31,199



25,215Commitments and contingenciesStockholders' equity:Preferred stock, $0.01 par value; 1,000,000 shares authorized, no shares issued or outstanding


-



-Common stock, $0.01 par value; 40,000,000 authorized, 18,294,808 and 17,675,560 shares issued and outstanding at December 31, 2009 and 2008, respectively, and additional paid-in capital


87,182



85,098Accumulated deficit


(75,253
)


(80,053
)Total stockholders' equity


11,929



5,045Total liabilities and stockholders' equity

$
43,128


$
30,260





See accompanying notes.


41
 Table of Contents




Scientific Learning CorporationStatements of Operations(In thousands, except per share amounts)Year Ended December 31,2009


2008


2007Revenues:Products

$
35,863


$
28,301


$
31,023Service and support


19,425



19,453



15,030Total revenues


55,288



47,754



46,053Cost of revenues:Cost of products


2,679



2,178



1,680Cost of service and support


8,895



9,721



8,539Total cost of revenues


11,574



11,899



10,219Gross profit


43,714



35,855



35,834Operating expenses:Sales and marketing


24,042



23,587



24,868Research and development


6,418



7,016



4,500General and administrative


8,135



7,883



7,660Total operating expenses


38,595



38,486



37,028Operating income (loss)


5,119



(2,631
)


(1,194
)Interest and other income (expense), net


110



564



1,266Income (loss) before income tax


5,229



(2,067
)


72Income tax provision (benefit)


429



1,248



(1,082
)Net income (loss)

$
4,800


$
(3,315
)

$
1,154Basic net income (loss) per share:

$
0.27


$
(0.19
)

$
0.07Shares used in computing basic net income (loss) per share


18,039



17,488



17,161Diluted net income (loss) per share:

$
0.26


$
(0.19
)

$
0.06Shares used in computing diluted net income (loss) per share


18,690



17,488



18,297





See accompanying notes.


42
 Table of Contents




Scientific Learning CorporationStatements of Cash Flows(In thousands)Year Ended December 31,2009


2008


2007Operating Activities:Net income (loss)

$
4,800


$
(3,315
)

$
1,154Amounts to reconcile net income to net cash provided by operating activities:Depreciation and amortization


1,895



1,266



313Stock-based compensation


1,389



1,997



2,463Increase (decrease) in deferred tax asset valuation allowance


-



1,191



(1,191
)Changes in operating assets and liabilities:Accounts receivable


1,327



(1,293
)


943Prepaid expenses and other current assets


(801
)


(29
)


(320
)Other assets


(90
)


(399
)


(17
)Accounts payable


138



(317
)


109Accrued liabilities


3,398



(5
)


(1,230
)Deferred revenue


2,278



(3,003
)


3,796Other liabilities


170



172



42Net cash provided by (used in) operating activities


14,504



(3,735
)


6,062Investing Activities:Purchases of property and equipment, net


(1,084
)


(304
)


(1,114
)Additions to capitalized software


(986
)


-



-Purchase of Soliloquy


-



(10,133
)


-Loan to JTT Holdings


-



-



(1,000
)Deferred acquisition costs


-



-



(319
)Net cash used in investing activities


(2,070
)


(10,437
)


(2,433
)Financing Activities:Borrowings under bank line of credit


2,500



-



-Repayment of borrowings


(2,500
)


-



-Proceeds from issuance of common stock, net


695



543



1,186Net cash provided by financing activities


695



543



1,186Increase  (decrease) in cash and cash equivalents


13,129



(13,629
)


4,815Cash and cash equivalents at beginning of period


7,550



21,179



16,364Cash and cash equivalents at end of period

$
20,679


$
7,550


$
21,179Supplemental disclosure of cash flow information:Cash paid during the year for income taxes

$
301


$
66


$
292Cash paid during the year for interest

$
56



-



-





See accompanying notes


43
 Table of Contents




Scientific Learning CorporationStatements of Stockholders’ Equity(In thousands, except share amounts)Common Stock andAdditional Paid-In





TotalCapital


Accumulated


Stockholders’Shares


Amount


Deficit


EquityBalance at December 31, 2006


16,972,333


$
78,909


$
(77,892
)

$
1,017Issuance of common stock under stock option plan


182,375



822



-



822Issuance of common stock under employee stock purchase plan


81,791



364



-



364Stock-based compensation


-



2,463



-



2,463Vesting of restricted stock units


79,387



-



-



-Net income and comprehensive income


-



-



1,154



1,154Balance at December 31, 2007


17,315,886


$
82,558


$
(76,738
)

$
5,820Issuance of common stock under stock option plan


124,765



395



-



395Issuance of common stock under employee stock purchase plan


79,406



148



-



148Stock-based compensation


-



1,997



-



1,997Vesting of restricted stock units


155,503



-



-



-Net loss and comprehensive loss


-



-



(3,315
)


(3,315
)Balance at December 31, 2008


17,675,560


$
85,098


$
(80,053
)

$
5,045Issuance of common stock under stock option plan


251,816



492



-



492Issuance of common stock under employee stock purchase plan


114,142



203



-



203Stock-based compensation


-



1,389



-



1,389Vesting of restricted stock units


253,290



-



-



-Net income and comprehensive income


-



-


$
4,800



4,800Balance at December 31, 2009


18,294,808


$
87,182


$
(75,253
)

$
11,929





See accompanying notes


44
 Table of Contents


Notes to Financial Statements





1. Summary of Significant Accounting Policies





Description of Business





Scientific Learning Corporation develops, distributes and licenses technology that accelerates learning by improving the processing efficiency of the brain.





Our patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support.  We sell primarily to K-12 schools in the United States through a direct sales force.





All of our activities are in one operating segment.





Our current operating assumptions and projections reflect management’s best estimate of future revenue, operating expenses, and capital commitments, and indicate that our current sources of liquidity, including the bank line of credit with Comerica, should be sufficient to fund operations through at least December 31, 2010.





We were incorporated in 1995 in the State of California and were reincorporated in 1997 in the State of Delaware.





Use of Estimates





The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. Actual results may differ from those estimated.





Revenue Recognition





We derive revenue from the sale of licenses to our software and from service and support fees.  Software license revenue is recognized in accordance with accounting standards for software companies.  There are four basic criteria which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected.  The application of the relevant accounting standards requires us to exercise significant judgment related to our specific transactions and transaction types. In cases where we grant extended payment terms to school customers, we determine if the fixed or determinable fee criterion is met by reference to the customer’s specific funding sources, especially where the payment terms extend into the customer’s next fiscal year. If we determine that the fixed or determinable fee criterion is not met at the inception of the arrangement, we defer revenue recognition until the payments become due.





Booked sales to our school customers typically include multiple elements (e.g., Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services).  We recognize revenue using the residual method, whereby the difference between the total arrangement fee and the total “vendor specific objective evidence” (“VSOE”) of fair value of the undelivered elements is recognized as revenue relating to the delivered elements. VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price.  We are required to exercise judgment in determining whether VSOE of fair value exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.





The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized.  All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products.  Deferred revenue is recognized as revenue as discussed below.  Direct costs related to deferred software license revenue are deferred until the related license revenue is recognized.





Multiple contracts with the same customer are generally accounted for as separate arrangements, except in cases where contracts are so closely related that they are effectively part of a single arrangement.


45
 Table of Contents


Notes to Financial Statements





1. Summary of Significant Accounting Policies (continued)





Product revenue





Product revenue is primarily derived from the licensing of software and is recognized as follows:


·
Perpetual licenses – software licensed on a perpetual basis.  Revenue is recognized at the later of product delivery date or contract start date using the residual method.  If VSOE of fair value does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.





·
Term licenses – software licensed for a specific time period, generally three to twelve months.  Revenue is recognized ratably over the license term.





·
Individual participant licenses – software licensed for a single participant.  Revenue is recognized over the average period of use, typically six weeks.





Service and support revenue





Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis.  If VSOE of fair value exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed.  If VSOE of fair value does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement.  Revenue from services sold alone or with support is recognized as performed.





If an arrangement includes services that are essential to the functionality of the software, we recognize the fees for the software license and the services using the percentage of completion method in accordance with the accounting standards for software and service companies.  We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known.





Cash and Cash Equivalents





We consider all highly liquid investments purchased with an original maturity of three months or less from the date of purchase to be cash equivalents. Cash and cash equivalents, which primarily consist of cash on deposit with banks and money market funds, are stated at cost, which approximates fair value. Our cash and cash equivalents consisted of the following (in thousands):





December 31,2009


2008Cash on deposit

$
502


$
6,753Money market funds


20,177



797$
20,679


$
7,550





We apply ASC 820, “Fair Value Measurements.” Level 1 financial assets measured at fair value on a recurring basis consist of money market funds (cash equivalents) of approximately $20.2 million as of December 31, 2009 and approximately $6.8 million at December 31, 2008.  We have no Level 2 or Level 3 financial assets measured at fair value on a recurring basis as of December 31, 2009 or at December 31, 2008.





Accounts Receivable





We conduct business primarily with public school districts and speech and language professionals in the United States.  We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments.  We adjust this allowance periodically based on our historical experience of bad debt write offs.


46
 Table of Contents


Notes to Financial Statements





1.   Summary of Significant Accounting Policies (continued)





Inventories





Product inventories, which are primarily finished goods, are stated at the lower of cost or market and are included in “Prepaid expenses and other current assets”.  Cost is determined using a weighted average approach, which approximates the first-in first-out method. If inventory costs exceed expected market value due to obsolescence or lack of demand adjustments are recorded for the difference between the cost and the market value.





Deferred charges





We defer royalty charges as incurred and recognize the expense over the term of the related license agreements or service periods. These deferred charges are included in “Prepaid expenses and other current assets” and in “Other assets” on our balance sheet.





Fair Value of Financial Instruments





The carrying amounts of our cash and cash equivalents, short-term investments, accounts receivable, and accounts payable approximate fair value.





Concentration of Risk





Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash equivalents, short-term investments and accounts receivable.





Cash and cash equivalents are invested in a major financial institution in the United States.  Such deposits may be in excess of insured limits and are not insured in other jurisdictions.  Management believes that the financial institutions that hold the Company’s investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments.





Our accounts receivable are primarily from booked sales to customers located primarily in the United States.  We perform ongoing credit evaluations of our customers.  We do not require collateral.





An allowance for doubtful accounts is determined with respect to those accounts that we have determined to be doubtful of collection.  At December 31, 2008 one customer accounted for more than 10% of our accounts receivable. No customers accounted for more than 10% of our accounts receivable at December 31, 2009. One customer accounted for more than 10% of our revenue in fiscal 2007. No customers accounted for more than 10% of our revenue in fiscal 2009 or 2008.





We have no off-balance sheet concentration of credit risk, such as foreign exchange contracts, option contracts or other hedging arrangements.





Our concentration of royalty arrangements potentially exposes us to risk. If we were to lose our rights under these arrangements, this could materially impact our booked sales, revenue and net income. The patents and applications that we license are owned by the Regents of the University of California, and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2009, approximately 60% of our product booked sales was derived from selling products that use the licensed inventions.





Property and Equipment





Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years.


47
 Table of Contents


Notes to Financial Statements





1.   Summary of Significant Accounting Policies (continued)





Software and web site development costs





We capitalize certain software development costs incurred subsequent to the establishment of technological feasibility and amortize the costs over the estimated lives of the related products. The annual amortization is the greater of the amount computed using (a) the ratio that current year to date gross revenues for the product bear to the aggregate of total anticipated revenues for the product or (b) the straight-line method over the remaining estimated economic life of the product. Technological feasibility is established upon completion of a working model.  In 2009 we capitalized approximately $986,000 of costs relating to a new Reading Assistant product that had reached technological feasibility. In 2008 and 2007 costs incurred subsequent to the establishment of technological feasibility for new projects were not significant, and were charged to research and development expense.  Software costs are amortized to cost of product revenues over the estimated useful life of the software, which is three years. Amortization was $91,000, zero and zero, for the years ended December 31, 2009, 2008 and 2007, respectively.





We also capitalize web site application, infrastructure development and content development costs where a website is built for our internal needs and we do not plan to market the software externally.  For the years ended December 31, 2009 and 2008, respectively, we capitalized approximately $406,000 and $51,000 in web site development costs.  If indicators of impairment are present, estimates of future cash flows are used to test the recoverability of the web site asset.  If the carrying amount of the asset exceeds its fair value, an impairment charge is recognized. In late 2009 we determined that we needed to completely redesign our BrainSpark website and accordingly we recorded an impairment charge of $415,000. We also capitalized development costs of $21,000 for the new website. We will amortize these costs over a period corresponding to the estimated life of the related products when the web site is ready for use.





Goodwill


We recorded goodwill and purchased intangible assets when we acquired the assets of Soliloquy. The cost of the acquisition was allocated to the assets and liabilities acquired, including purchased intangible assets, and the remaining amount was classified as goodwill. Goodwill arising from purchase transactions is not amortized to expense, but rather periodically assessed for impairment. The allocation of the acquisition cost to purchased intangible assets and goodwill, therefore, has a significant impact on our operating results. The allocation process involves an extensive use of estimates and assumptions, including estimates of future cash flows to be generated by the acquired assets.





We test goodwill annually for impairment or more frequently if events and circumstances warrant. This impairment testing involves a two-step process as follows:


Step 1 -- We have determined that we have one reporting unit and compare the fair value of the reporting unit to its carrying value, including goodwill. If the reporting unit’s carrying value, including goodwill, exceeds the unit’s fair value, we move on to Step 2. If the unit’s fair value exceeds the carrying value, no further work is performed and no impairment charge is necessary.
 
 Step 2 -- We perform an allocation of the fair value of the reporting unit to its identifiable tangible and non-goodwill intangible assets and liabilities. This allocation derives an implied fair value for the reporting unit’s goodwill. We then compare the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of its goodwill, an impairment charge shall be recognized for the excess.


Based on the annual impairment tests performed in the fourth quarter of 2009, we determined that the carrying value of our recorded goodwill had not been impaired and no impairment charge was recorded. We will continue to assess goodwill for impairment on an interim basis when indicators exist that goodwill may be impaired. Conditions that indicate that goodwill may be impaired include our market capitalization declining below net book value or a sustained decline in our stock price. A significant impairment could have a material adverse effect on the Company’s consolidated financial position and results of operations.


48
 Table of Contents


Notes to Financial Statements


1.
Summary of Significant Accounting Policies (continued)





Long-Lived Assets





We review long-lived assets, such as property and equipment and purchased intangible assets subject to amortization, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of an asset is measured by a comparison of the carrying amount of an asset to its estimated undiscounted future cash flows. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. As noted above, we incurred an impairment charge of $415,000 for the year ended December 31, 2009 in respect of capitalized BrainSpark web development costs. We recorded no impairment charges for the years ended December 31, 2008 or 2007.





Certain purchased intangible assets such as purchased technology and customer lists are amortized to cost of revenues and operating expense over time, while in-process research and development is recorded as a one-time charge on the acquisition date. The allocation of the acquisition cost to purchased intangible assets, therefore, has a significant impact on our operating results.





Accounting for Stock-Based Compensation





We record stock-based compensation expense over the service period in connection with shares issued under our employee stock purchase plan and stock options and restricted stock awards. The compensation expense for stock-based awards includes an estimate for forfeitures and is recognized over the service period of the award on a straight-line basis.




Advertising





Advertising costs are expensed as incurred.  Advertising expense was $172,000, $80,000 and $2,000 for the years ended December 31, 2009, 2008 and 2007, respectively.





Income Taxes





Deferred tax assets and liabilities are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the net amount expected to be realized.





Net Income Per Share





Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share reflects the potential dilution of securities by adding common stock equivalents (computed using the treasury stock method) to the weighted-average number of common shares outstanding during the period, if dilutive.


49
 Table of Contents


Notes to Financial Statements





1.
Summary of Significant Accounting Policies (continued)





The following table sets forth the computation of net income per share (in thousands, except per share data):





Year Ended December 31,2009


2008


2007Net income (loss)

$
4,800


$
(3,315
)

$
1,154Weighted average shares used in calculation of basic net income (loss) per share


18,039



17,488



17,161Effect of dilutive securities:Effect of dilutive securities:Employee stock options and awards


651



-



1,136Weighted-average diluted common shares


18,690



17,488



18,297Basic net income (loss) per share

$
0.27


$
(0.19
)

$
0.07Basic net income (loss) per share

$
0.27


$
(0.19
)

$
0.07Diluted net income (loss) per share

$
0.26


$
(0.19
)

$
0.06





For the years ended December 31, 2009, 2008, and 2007, respectively, 1,510,281, 3,150,180, and 923,621 options were excluded from the calculation of diluted net income per share because their effect is anti-dilutive.





Subsequent events





We have evaluated subsequent events through the issuance of our condensed financial statements.





Recent Accounting Pronouncements





In April 2008 the FASB issued ASC 350-30-50, “Determination of the Useful Life of Intangible Asset.”which amended the factors that should be considered in developing renewal or extension assumptions used to determine





the useful life of a recognized intangible asset under Statement of Financial Accounting Standards ASC 350,” Intangibles – Goodwill and Other” This new staff position was intended to improve the consistency between the useful life of a recognized intangible asset under ASC 350 and the period of expected cash flows used to measure the fair value of the asset under Statement of Financial Accounting Standards ASC 805, “Business Combinations” . ASC 350-30-50 became effective beginning with our first quarter of 2009 and did not have a material impact on our financial condition or results of operations.





2. Restructuring





On January 7, 2009, we announced a series of changes intended to better align our costs and organization structure with the current economic environment and improve our profitability. These changes included a reduction in our work force of approximately 14% during the first quarter of 2009. We notified employees affected by the workforce reduction in December 2008 and January 2009.  We accrued severance costs of approximately $104,000 in the year ended December 31, 2008 and $287,000 in the quarter ended March 31, 2009.  The costs were mainly recorded in the Research and Development and the Sales and Marketing line items in our Statement of Operations and were paid in full by June 30, 2009, as shown in the following table (dollars in thousands):





Accrued severance costs, January 1, 2009

$
104Restructuring charges


287Cash paid


(391
)Accrued severance costs, December 31, 2009

$
-


50
 Table of Contents


Notes to Financial Statements





2. Restructuring (continued)





On September 1, 2009, we announced a plan to consolidate our product development and product management functions in our Oakland, California headquarters. Under this plan, we closed our Waltham, Massachusetts office and most Waltham employees left the company by the end of 2009. We notified the employees affected by the workforce reduction on September 1, 2009. Our lease on the Waltham office expires on September 30, 2011. In January 2010, we signed an agreement to sublease the property until October 2010.





We acquired the Waltham office as part of our acquisition of the Reading Assistant product line in January 2008. We plan to continue to support and improve the Reading Assistant products, including the new Reading Assistant Expanded Edition that was launched in September 2009.





These restructuring costs were mainly recorded under Research and Development in our Statement of Operations and are shown in the following table (dollars in thousands):





Employee costs


Facility costs


TotalAccrued at January 1, 2009

$
-


$
-


$
-Accruals


149



226



375Cash Paid


(130
)


-



(130
)Accrued at December 31, 2009

$
19


$
226


$
245





We expect to pay the employee costs during the first quarter of fiscal 2010 and the facility costs over the remaining lease term.





3. Stock-Based Compensation





Stock-Based Compensation Plans





On December 31, 2009, we had four active share-based compensation plans, which are described below.





In May 1999, our stockholders approved our 1999 Equity Incentive Plan. The total number of shares authorized for issuance under the plan is 6,492,666.  Restricted stock units awarded under this plan generally vest over four years of continuous service in annual or semi-annual installments. Option awards have generally been granted with an exercise price equal to the market price of our common stock at the date of grant, and generally vest based on four years of continuous service with a ten-year contractual term.





In May 1999, our stockholders approved the 1999 Non-Employee Directors’ Stock Option Plan. The total number of shares authorized for issuance under this plan is 250,000.





In May 2002, the Board of Directors approved the 2002 CEO Stock Option Plan, which was subsequently approved by the shareholders in May 2003.  The total number of shares authorized for issuance under this plan is 470,588.





In May 1999 the stockholders approved the 1999 Employee Stock Purchase Plan (ESPP), which became effective upon the completion of the initial public offering of our common stock.  The total number of shares originally authorized for issuance under the plan was 700,000.  In June 2007 an additional 500,000 shares were authorized.





Eligible employees may purchase common stock at 85% of the lesser of the fair market value of our common stock on the first day of the applicable one-year offering period or the last day of the applicable six-month purchase period.  At December 31, 2009, 306,985 shares were available for issuance under this plan.


51
 Table of Contents


Notes to Financial Statements





3. Stock-Based Compensation (continued)





Stock Based Compensation Expense





We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates.  We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.





Compensation Cost





The following table summarizes the impact of share-based compensation in the years ended December 31, 2009, 2008 and 2007 (in thousands, except per share amounts):





Year Ended December 31,2009


2008


2007Cost of service and support revenues

$
151


$
200


$
216Sales and marketing


490



685



892Research and development


285



434



390General and administrative


463



678



965Total stock-based compensation expense

$
1,389


$
1,997


$
2,463





Valuation of Stock Option Awards





The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures. The fair value of these stock options was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant. Estimated volatility is based on the historical prices of our common stock over the expected life of each option. Expected life of the options is based on our history of option exercise and cancellation activity. The risk free interest rates used are based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options. We use historical data to estimate pre-vesting option forfeitures.  We recognize compensation expense for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.





The fair value of stock options granted was estimated using the following weighted-average assumptions:





Year Ended December 31,2009


2008


2007Expected life (in years)


5.5



5.1



4.0Risk-free interest rate


1.9
%


2.0
%


4.9
%Dividend yield


0.0
%


0.0
%


0.0
%Expected volatility


58
%


55
%


49
%


52
 Table of Contents


Notes to Financial Statements





3. Stock-Based Compensation (continued)





Summary of Stock Options





The following table summarizes all stock option activity under our share-based compensation plans for the year ended December 31, 2009:





Outstanding OptionsNumber of Shares


Weighted-Average Exercise Price Per Share


Weighted-Average Remaining Contractual Term (Years)


Aggregate Intrinsic ValueOutstanding at December 31, 2008


3,152,680


$
4.25Granted


499,900


$
2.03Exercised


(251,816
)

$
1.97Cancelled (includes forfeited and expired)


(511,417
)

$
7.59Outstanding at December 31, 2009


2,889,347


$
3.48



4.02


$
6,264,503Vested and expected to vest at December 31, 2009


2,838,204


$
3.50



3.93


$
6,123,326Exercisable at December 31, 2009


2,318,491


$
3.58



3.05


$
4,888,200





The aggregate intrinsic value of options outstanding at December 31, 2009 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 2,057,500 shares that had exercise prices that were lower than the $5.06 market price of our common stock at December 31, 2009 (“in the money options”). The total intrinsic value of options exercised during the years ended December 31, 2009, 2008 and 2007 was $238,000, $149,000 and $416,000, respectively.  The fair value of options vested during the years ended December 31, 2009, 2008 and 2007 was $375,000, $783,000, and $1.5 million, respectively. The weighted average grant date fair value of options granted during the years ended December 31, 2009, 2008 and 2007 was $1.09, $1.13, and $2.96, respectively.





The following table summarizes information concerning outstanding and exercisable stock options at December 31, 2009:





Outstanding


ExercisablePrice Range


Number of Shares


Weighted-Average Exercise Price Per Share


Weighted-Average Remaining Contractual Life (Years)


Number of Shares


Weighted Average Exercise Price Per Share$
1.17 - $1.37



62,382


$
1.22



2.42



62,382


$
1.22$
1.39 - $1.39



1,000,000


$
1.39



2.42



1,000,000


$
1.39$
1.40 - $5.06



995,118


$
2.69



6.30



530,929


$
3.22$
5.06 - $5.95



379,138


$
5.85



4.58



379,138


$
5.85$
5.96 - $30.50



452,709


$
8.14



2.27



346,042


$
8.422,889,347


$
3.48



4.02



2,318,491


$
3.58





As of December 31, 2009, total unrecognized compensation cost related to stock options granted under our various plans was $0.5 million. We expect that cost to be recognized over a weighted-average period of 2.7 years.


53
 Table of Contents


Notes to Financial Statements





3. Stock-Based Compensation (continued)





Summary of Restricted Stock Units and Restricted Stock Awards





The following table summarizes all restricted stock unit activity under our share-based compensation plans for the year ending December 31, 2009:





Outstanding Restricted Stock UnitsNumber of Shares


Weighted-Average Remaining Contractual Term (Years)


Aggregate Intrinsic ValueOutstanding at December 31, 2008


544,823Awarded


61,721Released (Vested)


(253,290
)Forfeited or expired


(104,318
)Outstanding at December 31, 2009


248,936Vested and expected to vest at December 31, 2009


236,059



1.06


$
1,194,461





Restricted stock units were granted for the first time in 2006 under our 1999 Equity Incentive Plan. The fair value of these grants was calculated based upon the fair market value of our stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during fiscal years 2009, 2008 and 2007 was $1.96, $4.64 and $6.83, respectively, and the fair value of stock units that vested during fiscal years 2009, 2008 and 2007 was $887,000, $1.1 million and $771,000, respectively.  As of December 31, 2009, total unrecognized compensation cost related to restricted stock units was $1.0 million. We expect that cost to be recognized over a weighted-average period of 1.9 years.





Employee Stock Purchase Plan (“ESPP”)





ESPP awards for offering periods prior to and after the adoption of SFAS No. 123R were valued using the Black-Scholes model using the following assumptions:





Year Ended December 31,2009


2008


2007Expected life (in years)


0.5 - 1.0



0.5 - 1.0



0.5 - 1.0Risk-free interest rate


1.1
%


3.3
%


5.0
%Dividend yield


0.0
%


0.0
%


0.0
%Expected volatility


85
%


58
%


44
%





Disclosures Pertaining to All Share-Based Compensation Plans





Cash received under all share-based payment arrangements for the years ended December 31, 2009, 2008 and 2007 was $695,000, $543,00 and $1.2 million, respectively, related to the exercise of stock options and the purchase of ESPP shares. The weighted-average grant-date fair value of options, restricted stock units and restricted stock awards granted in the years ended December 31, 2009, 2008 and 2007 was $1.18,  $3.89, and $5.32 per share, respectively.


54
 Table of Contents


Notes to Financial Statements





4.  Prepaid Expenses and Other Current Assets





Prepaid expenses and other current assets consist of the following (in thousands):





December 31,2009


2008Prepaid expenses

$
1,557


$
999Product inventory


495



236Other receivables


90



106$
2,142


$
1,341





5.  Property and Equipment





Property and equipment consists of the following (in thousands):





December 31,2009


2008Computer equipment and software

$
3,327


$
5,775Office furniture and equipment


1,043



1,500Leasehold improvements


598



6194,968



7,894Less accumulated depreciation


(3,188
)


(6,342
)$
1,780


$
1,552





Depreciation expense for the years ended December 31, 2009, 2008, and 2007 was $856,000, $495,000 and $313,000, respectively.





6. Intangible assets





Details of our intangible assets at December 31, 2009 and 2008 are as follows (in thousands):





Gross carrying amount


2009 amortization expense


Net carrying amount at December 31, 2009


Amortization period (years)Core technology

$
5,800


$
629


$
4,687



10OEM contracts


560



131



293



5Customer list


220



75



87



3Non compete agreement


610



113



409



5$
7,190


$
948


$
5,476


55
 Table of Contents


Notes to Financial Statements





6. Intangible assets (continued)





Gross carrying amount


2008 amortization expense


Net carrying amount at December 31, 2008Core technology

$
5,800


$
484


$
5,316OEM contracts


560



136



424Customer list


220



58



162Non compete agreement


610



88



522$
7,190


$
766


$
6,424





The aggregate estimated annual intangible amortization expense is as follows (in thousands):





Fiscal year

Amortization2010


1,0572011


1,0092012


9792013


7412014


6482015 and thereafter


1,042$
5,476





Goodwill is not subject to amortization.  There have been no changes to the carrying amount of goodwill during 2009.





7.  Other Assets





Other assets consist of the following (in thousands):





December 31,2009


2008Long-term lease deposits

$
953


$
878Capitalized software, net


895



-Other non current assets


245



230$
2,093


$
1,108





Capitalized software amortization of $91,000 was charged to expense in 2009.





8.  Accrued Liabilities





Accrued liabilities consist of the following (in thousands):





December 31,2009


2008Accrued vacation

$
953


$
1,037Accrued commissions and bonus


4,192



1,177Accounts payable accruals


185



293Other accrued liabilities


2,032



1,457$
7,362


$
3,964


56
 Table of Contents


Notes to Financial Statements





9. Deferred Revenue





Deferred revenue consists of the following (in thousands):





December 31,2009


2008Current:Products

$
2,322


$
3,124Service and support


13,537



12,397$
15,859


$
15,521Long term:Products

$
232


$
148Service and support


6,139



4,823$
6,371


$
4,971





10.  Bank Line of Credit





On February 28, 2010 we amended our existing revolving line of credit agreement with Comerica Bank.  The maximum that can be borrowed under the agreement is $7.5 million.  The line expires on December 31, 2011. Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate”.  Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth.  The agreement includes a letter of credit sublimit not to exceed $1.0 million. At December 31, 2009, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at December 31, 2009 and we were in compliance with all our covenants.  In February 2009 we borrowed $2.5 million from the line of credit which we repaid in August 2009.





11. Income Taxes





Substantially all income before income taxes is derived from the United States.





The components of the provision (benefit) for income taxes are as follows (in thousands):





Year ended December 31,2009


2008


2007Current:Federal

$
50


$
(101
)

$
28State


265



41



81Foreign


-



1



-Total current


315



(59
)


109Deferred:Federal


104



1,157



(1,055
)State


10



150



(136
)Total deferred


114



1,307



(1,191
)Total provision (benefit) for income taxes

$
429


$
1,248


$
(1,082
)


57
 Table of Contents


Notes to Financial Statements





11. Income Taxes (continued)





Differences between income taxes calculated using the federal statutory income tax rate and the provision (benefit) for income taxes were as follows (in thousands):





Year ended December 31,2009


2008


2007Computed tax at statutory rate of 34%

$
1,777


$
(703
)

$
24State taxes, net of federal benefit


299



(64
)


80Federal Alternative Minimum Tax


102



5



41Losses benefited


(1,787
)


(229
)


(783
)Non deductible stock-based compensation


105



147



435Other non deductible expenses


259



108



312Change in valuation allowance


(326
)


1,984



(1,191
)Total provision (benefit) for income taxes

$
429


$
1,248


$
(1,082
)





Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of our deferred tax assets (liabilities) are as follows, (in thousands):





December 31,2009


2008Deferred tax assetsNet operating loss carryforwards

$
20,742


$
22,794Capitalized software development costs


22



45Deferred revenue


1,723



2,170Research credit carryforward


2,635



2,451Other


1,922



1,993Total gross deferred tax assets


27,044



29,453Deferred tax liabilitiesGoodwill


(237
)


(116
)Gross deferred tax assets / liabilities


26,807



29,337Valuation allowance


(27,044
)


(29,453
)Total net deferred tax liabilities

$
(237
)

$
(116
)





During 2009 we recorded an income tax expense of approximately $429,000. The valuation allowance decreased during 2009 by approximately $2.4 million.





As of December 31, 2009, we have U.S. federal and state net operating loss carryforwards of approximately $54.1 million and $35.3 million, respectively.  The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2024 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2012 through 2017.





As of December 31, 2009, we have U.S. federal and state tax credit carryforwards of approximately $1.6 million and $1.3 million, respectively.  The federal credit will expire at various dates beginning in 2011 through 2028, if not utilized.  California state research and development credits can be carried forward indefinitely.


58
 Table of Contents


Notes to Financial Statements





11. Income Taxes (continued)





During 2008, we recorded an income tax expense of $1.2 million. This expense primarily consisted of a $1.2 million increase in the valuation allowance against our deferred tax assets. This valuation allowance increase was the result of recording a valuation allowance against our deferred tax assets. After considering all available positive and negative evidence, including our past operating results and our forecast of future taxable income, we concluded that we could no longer support a deferred tax asset balance. We intend to maintain the valuation allowance until sufficient positive evidence exists to support the realizability of the deferred tax assets.





In connection with our adoption of ASC 718, we use the "with-and-without" approach described in ASC 740-20-05 "Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations" to determine the recognition and measurement of excess tax benefits.  In addition, we have elected to account for indirect effects of stock option based awards on other tax attributes, such as research and alternative minimum tax credits, through the income statement.  Accordingly, we have elected to recognize excess tax benefits from stock option exercises in additional paid in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to us.





Therefore, included in the net operating loss carryforwards are losses created by the exercise of stock options.  Although these net operating loss carryforwards are reflected in total U.S. net operating tax loss carryforwards, pursuant to ASC 718, deferred tax assets associated with these deductions are only recognized to the extent that they reduce taxes payable.  Further, these recognized deductions are treated as direct increases to stockholders' equity and as a result do not impact the Statement of Operations.  To the extent stock-option related deductions are not recognized pursuant to ASC 718, the unrecognized benefit is not reflected on the Balance Sheet.





Net operating loss carryforwards and credit carryforwards reflected above are limited due to ownership changes as provided in the Internal Revenue Code and similar state provisions.





We apply the provisions of FASB Interpretation ASC 740-10, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB ASC 740-10. ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. There was not a material impact on our financial position and results of operations as a result of the adoption of the provisions of ASC 740-10. At December 31, 2009, we had a liability for unrecognized tax benefits of $2.0 million (of which $18,000, if recognized, would affect the Company’s effective tax rate).  We believe there may be changes in our unrecognized tax positions over the next twelve months, but that this will not result in a material adjustment.





Interest and penalty costs related to unrecognized tax benefits are classified as a component of “ Income Tax Expense” in the accompanying statement of operations and the corresponding liability in "Accrued Liabilities" in the accompanying balance sheet. We recognized an immaterial amount of interest expense related to unrecognized tax benefits for the year ended December 31, 2009.





We file U.S. federal and state income tax returns. Tax returns remain open to examination by the appropriate governmental agencies for tax years 2004 to 2008. The federal, and state, taxing authorities may choose to audit tax returns for tax years beyond the statue of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. We are not currently under audit in any major tax jurisdiction.


59
 Table of Contents


Notes to Financial Statements





11. Income Taxes (continued)





A reconciliation of our unrecognized tax benefits is as follows (in thousands):





Year ended December 31,2009


2008Balance at January 1

$
1,883


$
1,876Additions for tax positions of prior years


430



-Additions for tax positions related to current year


130



106Reductions for tax positions of prior years


(50
)


(99
)Settlements during the current year


-



-Balance at December 31

$
2,393


$
1,883





12. Stockholders’ Equity (Deficit)





Common Stock





At December 31, 2009, we had reserved shares of common stock for future issuance as follows:





Stock options outstanding


2,889,347Stock awards outstanding


248,936Stock options available for future grants


1,660,590Employee stock purchase plan


306,9855,105,858





13. Inventories





Inventories of $495,000 and $236,000 at December 31, 2009 and December 31, 2008, respectively, are included in “Prepaid expenses and other current assets” and consist entirely of finished goods.





14.  Commitments and Contingencies





Leases





We have a non-cancelable lease agreement for our corporate office facilities in Oakland.  The minimum lease payment was approximately $78,000 per month through 2008. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013.  We also have a lease agreement for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month.  In early 2008, we entered into a lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet at an average monthly rent of approximately $12,000 that expires in September 2011.  Following the closure of the Waltham office in December 2009, we signed an agreement to sublease this property until October 2010 at a monthly rent of approximately $5,000.





The Oakland lease contains two options to extend the term of the lease, the first for a period of five years from the end of the initial lease term, and the second for a period of five years from the expiration of the first extension period.  The Tucson lease contains an option to extend the lease for a period of two years from the expiration of the initial term.  The Waltham lease contains escalation clauses in respect of real estate taxes and operating costs. We account for rent expense on a straight line basis.


60
 Table of Contents


Notes to Financial Statements





14. Commitments and Contingencies (continued)





Future minimum payments under these leases as of December 31, 2009 are as follows (in thousands):





2010


1,2592011


1,3232012


1,2742013


1,242$
5,098





Rent expense under all operating leases was $1.3 million, $1.2 million and $1.0 million for the years ended December 31, 2009, 2008 and 2007, respectively.





License Agreement





In September 1996, we entered into a license agreement with a university for the use of the intellectual property underlying its most significant current products.  In exchange for the license, which expires in 2014, we issued stock and paid a license-issue fee.  The agreement also provided for milestone payments, all of which have been made, and for royalties based on booked sales of products using the licensed technology.  Royalty expenses were $836,000, $757,000 and $1.0 million for the years ended December 31, 2009, 2008 and 2007, respectively, and are included in cost of product revenues.  Annual minimum guaranteed royalty payments are $150,000.





If we lose or are unable to maintain the license agreement during the term of the underlying patents, it would adversely affect our business. The university may terminate the license agreement if we fail to perform or violate its terms without curing the violation within 60 days of receiving written notice of the violation.





15. Warranties; Indemnification





We generally provide a warranty that our software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days.  The warranty does not apply in the event of misuse, accident, and certain other circumstances.  To date, we have not incurred any material costs associated with these warranties and have no accrual for such items at December 31, 2009.





From time to time, we enter into contracts that require us, upon the occurrence of certain contingencies, to indemnify parties against third party claims.  These contingent obligations primarily relate to (i) claims against our customers for violation of third party intellectual property rights caused by our products; (ii) claims resulting from personal injury or property damage resulting from our activities or products; (iii) claims by our office lessors arising out of our use of the premises; and (iv) agreements with our officers and directors under which we may be required to indemnify such persons for liabilities arising out of their activities on our behalf.  Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of theseobligations cannot be reasonably estimated.  No liabilities have been recorded for these obligations on our balance sheet as of December 31, 2009 or 2008.





16. Employee Retirement and Benefit Plan





We have a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code, which covers substantially all employees. Eligible employees may contribute amounts to the plan, via payroll withholding, subject to certain limitations. In 2007 we started to match contributions by plan participants at a rate of 3% of salary, with an annual maximum of $2,000 per participant.  For the years ended December 31, 2008 and 2007 our matching contributions were $393,000 and $280,000, respectively.  We decided to discontinue the matching contributions in 2009.


61
 Table of Contents


Notes to Financial Statements





17. Related Party Transactions





On September 30, 2003, we entered into an agreement with Posit Science Corporation (“Posit Science”), formerly Neuroscience Solutions Corporation, to provide Posit Science with exclusive rights in the healthcare field to certain intellectual property, patents and software we own or license, along with transfer of certain healthcare research projects.  A co-founder, substantial shareholder, and former member of our Board of Directors is a co-founder, officer, director and substantial shareholder of Posit Science. Under the agreement, we will receive net royalties between 2% to 4% on products sold by Posit Science that use our patents or software.





We have a 3.5% equity interest in Posit Science. We recorded royalty income from Posit Science of $154,000, $150,000 and $246,000 in fiscal years 2009, 2008 and 2007, respectively.





In July 2007 Michael A. Moses joined our Board of Directors as Vice Chair and also entered into a consulting agreement with us.  The consulting agreement provides for a consulting fee of $40,000 per year and two stock option grants, both with a five year term and at a per share exercise price of $7.15, the closing price of the Company’s Common Stock on July 25, 2007. The first option grant for 80,000 shares vests over four years, with a one year cliff with ratable monthly vesting thereafter. The second option for 100,000 shares vests only in the event the per share price of the Company’s common stock reaches and maintains for 20 consecutive business days a specified target closing price as follows: 25,000 shares vesting at each target stock price of $15, $20, $25, and $30.





We also have in place consulting agreements with two of our founders, who are or were also members of our Board of Directors.  Dr. Paula Tallal, who is a current Board member, provides ongoing consulting in the areas of customer relationships and research planning and in fiscal 2009, 2008 and 2007 received total compensation of approximately $69,000, $111,000, and $107,000, respectively.  Dr. Michael Merzenich, who retired as a Board member in October 2008, provides consulting services including public speaking, meetings with third parties and other projects as agreed from time to time, and in fiscal 2009, 2008 and 2007 received total compensation of approximately $45,000, $28,000, and $21,000, respectively.


62
 Table of Contents


Notes to Financial Statements





18. Interim Financial Information (unaudited)





Quarterly financial data (in thousands, except per share amounts):





2009Quarter EndedMarch 31


June 30


September 30


December 31


TotalTotal revenues

$
8,624


$
10,616


$
20,293


$
15,755


$
55,288Gross profit


6,027



8,061



17,042


$
12,584



43,714Net income (loss)


(2,861
)


(314
)


6,455


$
1,520



4,800Net income (loss) per share:Basic

$
(0.16
)

$
(0.02
)

$
0.36


$
0.08


$
0.27Diluted

$
(0.16
)

$
(0.02
)

$
0.35


$
0.08


$
0.26  2008Quarter EndedMarch 31


June 30


September 30


December 31


TotalTotal revenues

$
9,085


$
13,481


$
12,695


$
12,493


$
47,754Gross profit


6,170



10,441



9,685



9,559



35,855Net income (loss)


(4,664
)


(438
)


590



1,197



(3,315
)Net income (loss) per share:Basic

$
(0.27
)

$
(0.03
)

$
0.03


$
0.07


$
(0.19
)Diluted

$
(0.27
)

$
(0.03
)

$
0.03


$
0.07


$
(0.19
)


63
 Table of Contents


ITEM9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE





None.





ITEM9A(T).   CONTROLS AND PROCEDURES





Evaluation of Disclosure Controls and Procedures





Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.





As required under Rule 13a-15(b) of the Exchange Act, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K, and concluded that our disclosure controls and procedures were effective as of December 31, 2009.





It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud.  Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.





Changes in Internal Controls over Financial Reporting





There were no changes in our internal control over financial reporting that occurred during the year ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.





Management's Report on Internal Control over Financial Reporting





Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes, in accordance with generally accepted accounting principles. Because of inherent limitations, a system of internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to change in conditions, or that the degree of compliance with the policies or procedures may deteriorate.





Our management, including our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on its evaluation, our management concluded that our internal control over financial reporting was effective as of the end of the period covered by this report.





This annual report does not include an audit report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to audit by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.





ITEM9B. OTHER INFORMATION





None.


64
 Table of Contents


PARTIII





ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





The information required by this item with respect to our executive officers is contained in Part I “Executive Officers” and such information is also incorporated by reference in this section.





Information required by this item respecting our directors, audit committee and code of ethics is set forth under the caption “Proposal 1: Election of Directors” in our Proxy Statement relating to our 2010 Annual Meeting of Stockholders (the “Proxy Statement”) and is incorporated by reference into this Form 10-K Report.  The Proxy Statement will be filed with the Securities and Exchange Commission in accordance with Rule 14a-6(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  With the exception of the foregoing information and other information specifically incorporated by reference into this Form 10-K Report, the Proxy Statement is not being filed as a part hereof.





Information with respect to compliance with Section 16(a) of the Exchange Act is set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.





ITEM11.   EXECUTIVE COMPENSATION





Information required by this item concerning compensation of executive officers and directors is set forth under the caption “Executive Compensation” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.





ITEM12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS





Information required by this item concerning security ownership of certain beneficial owners and management is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.





Information required by this item concerning shares authorized for issuance under equity compensation plans approved by stockholders and not approved by stockholders is set forth under the caption “Equity Compensation Plan Information” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.





ITEM13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





Information required by this item concerning director independence is set forth under the caption “Proposal 1: Election of Directors” in the Proxy Statement.  Information concerning certain relationships and related transactions is set forth under the captions “Employment Agreement” and “Certain Transactions” in the Proxy Statement.  Both are incorporated by reference into this Form 10-K Report.





ITEM14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES





Information required by this item concerning the independent auditor’s fees and services is set forth under the caption “Ratification of Selection of Independent Registered Public Accounting Firm” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.


65
 Table of Contents


PARTIV





ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES





(a)
Documents filed as part of this report:





(1)
Financial Statements





Report of Ernst & Young LLP, Independent Registered Public Accounting Firm


Balance Sheet – December 31, 2009 and 2008


Statements of Operations – Years Ended December 31, 2009, 2008 and 2007


Statements of Stockholders’ Equity – Years Ended December 31, 2009, 2008 and 2007


Statements of Cash Flows – Years Ended December 31, 2009, 2008 and 2007


Notes to Financial Statements





(2)
Financial Statement Schedules





As required under Item 8, Financial Statements and Supplementary Data, the financial statement schedule of the Company is provided in this separate section.  The financial statement schedule included in this section is as follows:





Schedule II – Valuation and Qualifying Accounts (in thousands):





Opening Balance


Charges (credits) to Operating Expenses


Additions (deductions) to Allowance


Closing Balance2009

$
296


$
(75
)

$
(124
)

$
972008

$
96


$
574


$
(374
)

$
2962007

$
99


$
(3
)





$
96





Other schedules are either not applicable or the required information is shown in the consolidated financial statements or notes thereto.





(b)
Exhibits





A list of exhibits filed herewith is contained in the exhibit index that immediately precedes such exhibits and is incorporated herein by reference.


66
 Table of Contents




SIGNATURES





Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





SCIENTIFIC LEARNING CORPORATIONBy   /s/ D. Andrew Myers

March 3, 2010D. Andrew MyersPresident, Chief Executive Officer





Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.





SIGNATURES

TITLE

DATE/s/D. Andrew MyersD. Andrew Myers

President, Chief Executive Officer, Director

March 3, 2010(Principal Executive Officer)/s/Robert E. FellerRobert E. Feller

Chief Financial Officer, Treasurer

March 3, 2010(Principal Financial and Accounting Officer)/s/ Edward Vermont Blanchard, Jr.Edward Vermont Blanchard, Jr.

Director

March 3, 2010/s/ Robert C. BowenRobert C. Bowen

Executive Chairman, Director

March 3, 2010/s/ Rodman W. Moorhead, IIIRodman W. Moorhead, III

Director

March 3, 2010/s/ Dr. Michael A. MosesDr. Michael A. Moses

Director

March 3, 2010/s/ Lance R. OddenLance R. Odden

Director

March 3, 2010/s/ Dr. Paula A. TallalDr. Paula A. Tallal

Director

March 3, 2010/s/ Jeffrey D. ThomasJeffrey D. Thomas

Director

March 3, 2010


Table of Contents


EXHIBIT INDEX





Exhibits to be filed with this 10-K


Exhibit

Number

Description3.1(14)

Amended and Restated Certificate of Incorporation3.2(15)

Amended and Restated Bylaws3.3(15)

Certificate of Amendment to the Amended and Restated Certificate of Incorporation4.1

Reference is made to Exhibits 3.1 and 3.24.2(1)

Specimen Stock Certificate10.1(1)*

Form of Indemnity Agreement with each of our directors and executive officers10.2(19)*

1999 Equity Incentive Plan, as amended10.3(10)*

Forms of Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement under the Incentive Plan10.4(3)*

Forms of Stock Option Grant Notice, Stock Option Agreement and Stock Bonus Agreement under the Incentive Plan10.5(9)*

1999 Non-Employee Directors’ Stock Option Plan, as amended10.6(19)*

1999 Employee Stock Purchase Plan, as amended10.7*

Form of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan10.8(7)*

Milestone Equity Incentive Plan10.9(2)*

2002 CEO Option Plan10.10(2)*

Employment Agreement dated as of May 31, 2002 by and between Scientific Learning Corporation and Robert C. Bowen10.11(7)*

Letter Agreement dated January 2004 by and between the Registrant and Robert C. Bowen amending the Employment Agreement10.12(16)*

Amendment to Employment Agreement with Robert C. Bowen made as of January 1, 2009.10.13(20)*

Amendment No. 2 to Employment Agreement with Robert C. Bowen10.14*

Retirement Agreement by and between Scientific Learning Corporation and Robert C. Bowen, effective as of January 1, 201010.15*

Independent Contractor Agreement by and between Scientific Learning Corporation and Robert C. Bowen, effective as of January 1, 201010.16(16)*

Offer of Employment Letter Agreement with D. Andrew Myers10.17(20)*

Letter Agreement with D. Andrew Myers amending the terms of his employment, dated December 15, 2008.10.18(8)*

Independent Contractor Agreement dated April l7, 2003 between the Registrant and Paula A. Tallal and Project Assignment thereunder dated December 17, 200410.19*

Independent Contractor Project Assignment between the Registrant and Paula A. Tallal effective January 1, 201010.20(17)*

Independent Contractor Agreement dated July 25, 2007 between the Registrant and Michael A. Moses10.21*

Independent Contractor Project Assignment between the Registrant and Michael A. Moses effective January 1, 201010.22(13)*

2009 Management Incentive Plan10.23(21)*

2008 Management Incentive Plan10.24(26)*

2010 Management Incentive Plan10.25(22)*

Letter Agreement related to Salary Deferral Plan.10.26(6)

Loan and Security Agreement dated as of January 15, 2004 by and between the Registrant and Comerica Bank10.27(9)

First Amendment to Loan and Security Agreement, dated as of September 29, 2004, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement10.28(10)

Second Amendment to Loan and Security Agreement, dated as of December 2, 2005, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement10.29(12)

Third Amendment to Loan and Security Agreement, dated as of September 5, 2006, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement10.30(15)

Fourth Amendment to Loan and Security Agreement, dated as of June 5, 2007, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement10.31(23)

Fifth Amendment to Loan and Security Agreement, dated as of June 30, 2008, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement10.32(11)

Sixth Amendment to Loan and Security Agreement, dated as of January 30, 2009, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement  Table of Contents
  Exhibit

Number

Description
 10.33

Bilateral Extension Letter relating to Loan and Security Agreement, dated as of December 31, 2009, by and between Comerica Bank and the Registrant.10.34

Seventh Amendment to Loan and Security Agreement, dated as of February June 30, 2008, by and between Comerica Bank and the Registrant, including Prime Referenced Rate Addendum to Loan and Security Agreement, amending the Loan and Security Agreement10.35(1)†

Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California10.36(5)

Amendment No. 3 to Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California, amending the agreement10.37(12)

Amendment No. 4 to Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California, amending the agreement10.38(5)

Lease, dated as of October 1, 2003, with Rotunda Partners II10.39(24)

First Amendment to Lease dated February 2008, between TriPointe Tucson, LLC and the Company.10.40(24)

Commercial Lease, dated February 26, 2008, between Clematis, LLC and the Company.10.41(4)

Technology Transfer Agreement dated as of September 30, 2003 by and between the Registrant and Neuroscience Solutions Corporation (now renamed Posit Science Corporation) or “NSC”10.42(4)

SLC License Agreement dated as of September 30, 2003 by and between the Registrant and NSC10.43(4)

NSC License Agreement dated as of September 30, 2003 by and between NSC and the Registrant10.44(25)

Major Reseller Agreement dated as of October 15, 2007, between Posit Science Corporation and Registrant10.45(18)

Asset Purchase Agreement between Registrant and JTT Holdings, Inc., d/b/a/ Soliloquy Learning dated December 18, 200723.1

Consent of Independent Registered Public Accounting Firm31.1

Certification of Chief Executive Officer (Section 302).31.2

Certification of Chief Financial Officer (Section 302).32.1

Certification of Chief Executive Officer (Section 906).32.2

Certification of Chief Financial Officer (Section 906).





1)

Incorporated by reference to the exhibits previously filed on July 17, 1998 with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (File No. 333-56545).2)

Incorporated by reference to the exhibits previously filed with the Registrant’s Form 8-K on June 7, 2002 (File No. 000-24547).3)

Incorporated by reference to the exhibits previously filed with the Registrant’s Form 10-Q for the quarter ended June 30, 2003 (File No. 000-24547).4)

Incorporated by reference to the exhibits previously filed with the Registrant’s Form 8-K on October 1, 2003 (File No. 000-24547).5)

Incorporated by reference to the exhibits filed with the Registrant’s Form 10-Q for the quarter ended September 30, 2003 (File No. 000-24547).6)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K on February 5, 2004 (File No. 000-24547).7)

Incorporated by reference to the exhibits previously filed with the Registrant’s Form 10-Q for the quarter ended March 31, 2004 (File No. 000-24547).8)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on December 20, 2004 (File No. 000-24547).9)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 10-K for the year ended December 31, 2004 (File No. 000-24547).




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10)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 10-K for the year ended December 31, 2005 (File No. 000-24547).11)

Incorporated by reference to the exhibit previously filed with the Registrant’s Form 8-K filed April 30, 2009 (File No. 000-24547).12)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 10-K for the year ended December 31, 2006 (File No. 000-24547).13)

Incorporated by reference to exhibit previously filed with the Registrant’s Form 8-K filed on February 23, 2009 (File No. 000-24547).14)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 10-Q for the quarter ended March 31, 2007 (File No. 000-24547).15)

Incorporated by reference to the exhibits previously filed on July 16, 2007 with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (File No. 333-143093).16)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on December 7, 2007 (File No. 000-24547).17)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on July 26, 2007 (File No. 000-24547).18)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on December 21, 2007 (File No. 000-24547).19)

Filed as an Appendix to the Company’s definitive proxy statement filed with the SEC on April 10, 2007 (SEC File No. 000-24547), and incorporated herein by reference.20)

Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on January 2, 200921)

Incorporated by reference to exhibit previously filed with the Registrant’s Form 8-K filed on March 12, 200822)

Incorporated by reference to exhibit previously filed with the Company’s Form 8-K filed on August 1, 2008.23)

Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended June 30, 200824)

Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended March 31, 200825)

Incorporated by reference to exhibit previously filed with the Company’s Form 10-K for the year ended December 31, 200726)

Incorporated by reference to exhibit previously filed with the Company’s Form 8-K/A filed on February 11, 2010†

Certain portions of this exhibit have been omitted based upon confidential treatment granted by the Securities and Exchange Commission for portions of the referenced exhibit.*

Management contract or compensatory plan or arrangement.