|UNITED STATESSECURITIES 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, 2001; or


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

|300 FRANK OGAWA PLAZA, SUITE 500           
          OAKLAND, CA                      
(Address of principal executive offices) | 94612-2040
                                                     (Zip Code)
|-------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------

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


Securities registered pursuant to Section 12 (g) of the Act: COMMON STOCK,
PAR VALUE
$0.001 PER SHARE
(Title of Class)


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: / /


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. / /


The aggregate market value
of the voting stock held by non-affiliates of the Registrant, based upon the
closing sale price of the Common Stock on March 8, 2002 as reported on the
Nasdaq National Market, was approximately $9,696,700. Shares of Common Stock
held by each executive officer and director and by certain 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 Friday, March 8, 2002
the Registrant had outstanding 15,577,292 shares of Common Stock.


DOCUMENTS
INCORPORATED BY REFERENCE


Portions of the Proxy
Statement for the Registrants 2002 Annual Meeting of Stockholders to be
held on May 21, 2002, at 300 Frank H. Ogawa Plaza, Suite 500, Oakland, CA
94612-2040 are incorporated by reference in Part III.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|TABLE OF
CONTENTS
|-----------------

|PART I |  |  |  | PAGE NO
|------ |  |  |  | -------

|Item 1. |  | Business |  | 3
|------- |  | -------- |  | -

|Item 2. |  | Properties |  | 18
|------- |  | ---------- |  | --

|Item 3. |  | Legal Proceedings |  | 19
|------- |  | ----------------- |  | --

|Item 4. |  | Submission of Matters to a Vote of Security Holders |  | 19
|------- |  | --------------------------------------------------- |  | --

|PART II |  |  |  | 
|------- |  |  |  | 

|Item 5. |  | Market for Registrants Common Equity and Related Stockholder Matters |  | 22
|------- |  | --------------------------------------------------------------------- |  | --

|Item 6. |  | Selected Financial Data |  | 23
|------- |  | ----------------------- |  | --

|Item 7. |  | Managements Discussion and Analysis of Financial Condition and Results of       Operations |  | 24
|------- |  | ------------------------------------------------------------------------------------------- |  | --

|Item 7A. |  | Quantitative and Qualitative Disclosures about Market Risk |  | 31
|-------- |  | ---------------------------------------------------------- |  | --

|Item 8. |  | Financial Statements and Supplementary Data |  | 32
|------- |  | ------------------------------------------- |  | --

|Item 9. |  | Changes in and Disagreements with Accountants on Accounting and Financial       Disclosure |  | 47
|------- |  | ------------------------------------------------------------------------------------------ |  | --

|PART III |  |  |  | 
|-------- |  |  |  | 

|Item 10. |  | Directors and Executive Officers of the Registrant |  | 48
|-------- |  | -------------------------------------------------- |  | --

|Item 11. |  | Executive Compensation |  | 48
|-------- |  | ---------------------- |  | --

|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management |  | 48
|-------- |  | -------------------------------------------------------------- |  | --

|Item 13. |  | Certain Relationships and Related Transactions |  | 48
|-------- |  | ---------------------------------------------- |  | --

|PART IV |  |  |  | 
|------- |  |  |  | 

|Item 14. |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K |  | 49
|-------- |  | ---------------------------------------------------------------- |  | --

|SIGNATURES |  |  |  | 52
|---------- |  |  |  | --

|2
|-

|PART I


ITEM 1.
BUSINESS


We develop, market and sell
products and services that are based on more than 25 years of brain, language
and reading research. Our goal is to become the leading provider of software and
other educational products and services based on the study of how the brain
learns. To date, our primary focus has been on training programs that build the
language and reading skills that are the foundation for learning. We have
developed and introduced a suite of software programs, the Fast
ForWord®Family, designed to help children, adolescents and
adults with language comprehension, learning how to read and becoming better
readers. BrainConnection.com is a comprehensive Web-based information source
about the brain and learning, which provides a wide range of written, graphical,
audio and interactive content, skill assessments and targeted e-commerce
resources for educators, parents, and others interested in the learning process.


In 2001, over 70,000
students enrolled in one of our Fast ForWord training programs, bringing the
total number of individuals who have enrolled to over 120,000.


We assist educators,
parents and speech and language and other professionals with integrating our
programs into existing educational programs. We provide professional training,
installation and implementation services and technical and other support. We
also provide ongoing performance analysis to those supervising training program
participants.


We are a Delaware
corporation. We incorporated in 1995 in California under the name Scientific
Learning Principles Corporation and reincorporated in 1997 in Delaware under our
present name, Scientific Learning Corporation.


MARKETS


PUBLIC SCHOOLS  Our
primary market is K-12 public schools in the United States. In 2001, sales to
K-12 public schools represented approximately 76% of revenue.


Many studies have indicated
that improvements in student achievement have been limited over the past twenty
years. Parents, educators and government officials at the local, state and
federal levels are increasingly focused on demonstrating the results of
educational instruction. A key element of the No Child Left Behind Act of 2002,
which reauthorized, increased and imposed new rules on federal funding for
public schools, is its focus on funding products and approaches that have been
proven to work and are based on scientific research.


Spending on U.S. K-12
education technology was estimated to be $7.5 billion in 2001 according to
Education Market Research. Spending on educational software was estimated to be
$1.4 billion in 2001 and is expected to grow more rapidly than overall education
spending according to Simba Information, Inc.


There are over 110,000
public elementary and secondary schools in the United States according to Market
Data Retrieval. To date, our programs have been used in approximately 1,400
schools, less than 2% of the total. In 2001, over 60% of our sales to public
schools were to districts who had previously purchased our software and
services.


PRIVATE PRACTICE CHANNEL
 We also sell to the private practice channel, which accounted for
approximately 24% of 2001 revenue. Private practice professionals, primarily
speech and language professionals, recommend the use of our products in
appropriate cases and then administer the program in connection with providing
traditional services. We also sell to private schools. In 2001, over 90% of our
private practice channel sales were made at the recommendation of private
practice professionals or schools who have previously recommended or used our
software.


SOFTWARE
PROGRAMS


We combine more than 25
years of brain and language research with technological advancements to create
innovative learning products and information services. Our current suite of
products assess language comprehension and reading skills, prepare individuals
for reading, assist in learning to read and aid in becoming better readers. The
Fast ForWord family of programs helps students rapidly improve language and
reading skills. They provide a valuable supplement to schools reading
curricula, preparing and enabling students to take advantage of good curricula
and good instruction in the classroom. The programs are sold both on an
individual basis and bundled with service packages to suit schools needs.


3
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|Most of our family of
language and reading training programs use intensive, computer-controlled
training exercises that automatically adapt to each users performance to
modify the manner in which the brain processes language. In addition, they
provide cross-training in key executive function skills, which are the
organizational skills necessary for thinking, such as short-term memory and
determining the sequence of events.


FAST FORWORD LANGUAGE


Fast ForWord Language,
launched in 1997, is an intensive, computer-based training program, which has the
look and feel of a computer game. Fast ForWord Language is designed to keep
students engaged and entertained during the thousands of repetitions necessary
to improve a students language skills. The words and sentences used in the
Fast ForWord Language exercises have been electronically modified to expand and
enhance the rapidly changing phonetic elements within natural speech. As a
students skill level advances, the exercises become increasingly
difficult, driving the student to continually improve his or her oral language
skills. At the most difficult level of each exercise, the student is presented
with natural, unmodified speech. The exercises also cross-train the student in
executive function skills, which are necessary for a solid foundation for
learning to read or becoming a better reader. The program adjusts to the
students skill level and ongoing performance so that the student is making
correct responses approximately 80% of the time. This adjustment is designed to
keep the program challenging and engaging, while allowing the student to
generate a feeling of accomplishment and to avoid failure, which can be
discouraging and detrimental to learning.


The Fast ForWord Language
program is designed to be used for 100 minutes per day, five days a week for
four to eight weeks. The professional supervising the individuals use of
the program can follow and analyze the participants data through the
ProgressTracker and SLc Lesson monitoring tools, which use our patented
Internet and database technology.


Field studies we conducted
of Fast ForWord Language with an aggregate of approximately 900 participants
show that 90% of participants identified as having language and reading problems
showed statistically significant gains in language comprehension skills,
achieving, on average, one to two years of improvement in language and related
reading skills after four to eight weeks of Fast ForWord Language training.
Recent independent and third party studies have confirmed the positive impact of
Fast ForWord Language. Based on extensive interviews with parents and educators,
students who have completed the Fast ForWord Language program are generally
reported to have shown substantial improvements in both self-esteem and
confidence as their communication skills improved. We believe our training
programs can help improve the language and related reading skills of most users.


FAST FORWORD LANGUAGE TO READING


Fast ForWord Language to
Reading was launched in 1998 and is a computer-based training program that
trains reading and oral language skills. Fast ForWord Language to Reading
provides focused practice in language comprehension skills for students who have
basic oral language proficiency. Building on that foundation, Fast ForWord
Language to Reading also trains reading skills such as word decoding,
sound-letter recognition and visual tracking. Word decoding enables a student to
build associations between word sounds, written representations of words and
meaning. Sound-letter recognition is the ability to translate letters into
spoken words. We believe that being able to process rapid sound-letter
associations is critical to being able to read. Fast ForWord Language to Reading
also provides training exercises that reinforce left-to-right reading patterns
for students who may need to improve their visual tracking.


The Fast ForWord Language
to Reading program is designed to be used for 90 minutes per day, five days a
week for four to eight weeks. As with Fast ForWord, Fast ForWord Language to
Reading results can be monitored through SLc Lesson.


FAST FORWORD MIDDLE AND HIGH SCHOOL


Fast ForWord Middle and
High School was launched in 1999 and is a computer-based training program that
is designed specifically for middle and high school students and adults. Fast
ForWord Middle and High School offers the same benefits of Fast ForWord Language
but with graphics, story lines and content tailored for an older population.
Fast ForWord Middle and High School combines electronically modified speech with
cross-training in critical language and reading skills in a manner that
automatically adjusts to each users performance. This program enables
participants to track their own cumulative progress without connecting to the
Internet as well as permitting results to be monitored through SLc Lesson.


4
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|FAST FOR WORD READING


Fast ForWord Reading,
introduced in 2000, is a computer-based training program that is designed to
systematically and rapidly build reading skills, focusing on the skills that
correlate directly to school curriculum standards, including: word recognition
and fluency, advanced decoding, spelling and vocabulary, and passage
comprehension. The Fast ForWord Reading training schedule is flexible, allowing
educators to choose exercises and training times that match the needs of each
student. The exercises adjust automatically to a students skill level, and
the programs Progress Viewer enables participants to track their own
cumulative progress without connecting to the Internet. Fast ForWord Reading
data can also be reviewed by the supervising professional through the
ProgressTracker monitoring tool.


FAST FORWORD BASICS


Fast ForWord Basics was
introduced in 1999 and is comprised of seven interactive modules that each focus
on key skills needed for success in grades pre-K through 2, such as recognition
of colors and shapes, and provides practice in memory, using and manipulating
phonemes, letter-name association, word recognition, fine motor control, and
hand-eye coordination. Its modular format allows professionals to choose which
modules a child will play, providing customized game sessions tailored to a
childs interests or needs.


FAST FORWORD BOOKSHELF


Fast ForWord Bookshelf,
introduced in 1999, is comprised of proprietary stories presented in both an
interactive CD ROM format and a four-color printed format. These stories are
designed as a companion to the Fast ForWord Basics skill-building software and
provide exposure to appropriate spoken and written language content thereby
supporting the training related to phonemes, the basic building blocks of
language, in Fast ForWord Basics skill-building software games. Some versions
contain four different levels of acoustically modified speech as well as natural
speech.


PROGRESSTRACKER


ProgressTracker, a Web
browser based, java application, was introduced in 2001 to meet the needs of
educators for monitoring student progress. Educators, using our patented
Internet and database technology, can view student progress and compliance on
our training programs over the Internet in a variety of ways, at the individual,
class, school and district level. Teachers can see how students are progressing
on specific skills. Reports showing student progress on the skills trained with
our programs can be shared with students, parents, fellow teachers and school
and district administrators


SLc LESSON


SLc Lesson employs our
patented Internet and database technology to permit the results from each
participants training program exercises to be conveniently viewed and
analyzed by the person overseeing the participants training. Training
results are uploaded periodically via the Internet to our proprietary database
for analysis of the students progress to date. SLc Lesson then provides
performance charts and templates in various discrete learning areas, which can
be downloaded through the Internet, enabling the training administrators to
monitor compliance, track performance and provide students and parents with
measurable performance results.


AWAY WE GO! AND AWAY WE GO! BOOKSHELF


Home versions of Fast
ForWord Basics and Fast ForWord Bookshelf are marketed to consumers under the
brand name Away We Go!. Away We Go! Bookshelf does not use acoustically modified
speech.


READING EDGE


Reading Edge is a
computer-based screening and assessment product designed to evaluate early
reading skills. Reading Edge helps identify students who may be at risk for
reading problems in grades K-2 and provides later screening of older students
who may be experiencing reading difficulties. Reading Edges animated games
provide fast and reliable measurements for evaluating proficiency in essential
skill areas that are strong predictors of future reading success, including
phonological memory, phonological awareness, phonemic decoding and letter
identification. The educator version of Reading Edge provides a rapid forward
assessment tool. The home version incorporates the assessment functionality with
engaging games that encourage practice of important reading skills. Reading Edge
has been tested with children in grades K-2. We acquired Reading Edge in 1999
from the successor to its developer.


5
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|CROSSTRAIN


CrossTrain, launched in
November 1999, is a professional development package for educators and speech
and language and other professionals that contains all the tools and information
necessary to offer our family of language and reading training programs. The
package includes videos, CD ROMs, printed materials, and other training materials on
the Web. CrossTrain offers the same comprehensive content as our professional
development seminars but in a self-paced tutorial that is more convenient.


SERVICES


BRAINCONNECTION.COM


In 1999 we launched
BrainConnection, offering an interactive Web site, conferences for educators,
and online professional development. BrainConnection provides practical and
easily understandable information about how the brain works and how students
learn. The BrainConnection.com Web site targets decision-makers in education,
policy-makers, front-line educators, clinical professionals and parents with:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | articles
by leading authors in the area of education and brain research, as well as
interviews with well-recognized experts in reading, education, psychology and
neuroscience;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Web-based
games and tools that offer fun online activities as they screen for language and reading
skills;
|- |  | ----------------------------------------------------------------------------------------------------------

| |  | audio
programming related to a variety of learning and behavioral issues;
|- |  | -------------------------------------------------------------------------

| |  | a
gallery of illustrations and interactives for classroom or clinical
use;
|- |  | --------------------------------------------------------------------------

| |  | quizzes
and classroom instructional tools to illustrate how the brain works;
|- |  | ----------------------------------------------------------------------------

| |  | current
news articles covering relevant topics and events related to the brain, learning and
education; and
|- |  | -----------------------------------------------------------------------------------------------------------

| |  | an
online store for purchasing learning-related products.
|- |  | ---------------------------------------------------------

|Links to information about
our products that relate to the topics discussed are present throughout the
site.


The BrainConnection to
Education forums for educators target educational decision-makers who can
influence the policies, curriculum decisions, and funding that impact students.
These gatherings feature presentations by well-known scientists and practicing
educators and administrators with expertise in the fields of education and
learning. In addition, presentations made by our customers offer attendees
concrete case studies on how technology and advances in neuroscience can impact
student achievement.


In 2000, we introduced
BrainConnection Professional Development courses to the Web site. These on-line
courses offer practicing educators foundational information with courses such as
The Developing Brain, Language and the Brain, and
The Reading Brain.


PROFESSIONAL DEVELOPMENT SEMINARS


To assist educators,
parents and speech and language and other professionals, we provide educational
seminars on brain research, the connection between oral language comprehension
and learning to read, and the practical application of the Fast ForWord family
of programs. Typically, workshops are one-day intensive training seminars for
educators and speech and language professionals. Participants in our
professional development seminars are eligible to receive continuing education
credit to support the ongoing educational certification requirements of teachers
and educators.


SUPPORT SERVICES


SUPPORT FOR EDUCATORS,
PARENTS AND PROFESSIONALS. We provide a number of support services for
educators, parents and speech and language and other professionals involved in
improving reading and language skills. A trained staff is available over a
toll-free telephone line and over the Internet to answer questions from and
provide support to educators, professional providers and parents.


TECHNICAL SUPPORT. We
provide a variety of technical support services to our customer base. An
experienced staff of technical service representatives is available to answer
technical questions regarding our programs, computer hardware and networks. In
addition, for schools that require it, we provide on-site software installation,
technical training and technical support.


SCIENTIFICLEARNING.COM. We
also maintain our company Web site at ScientificLearning.com. This site provides
information about our company and our products and services as well as extensive
technical and customer support resources.


6
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|SALES AND
MARKETING


We market and sell our
products through two primary channels of distribution: public schools and the
private practice channel. We also make some of our programs and products
available directly to consumers, through our Web site, but direct-to-consumer
sales to date have been minimal.


PUBLIC SCHOOLS. At December
31, 2001, we had 25 sales representatives focused on the public school market.
The majority of our public school sales have occurred since the formation in the
fall of 1998 of a dedicated sales force focused on that market. Our hiring
process has targeted experienced professionals who have established
relationships with prospective customers. Our sales force typically targets
sales at the school or school district level. We contact school and district
officials through direct marketing efforts to encourage them to attend our
seminars and learn about how our training programs can improve student results.
We also participate in industry conferences and trade shows.


We sell our programs,
products and services individually and in various combinations with training and
installation on a bundled basis. Depending on the program, our software may be
offered for a single student, workstation license, or on a site license basis.
Program licenses range from single use, limited term licenses, typically three
to twelve months, or on a perpetual basis. Our language and reading training
programs generally list for $850 per program per student, while workstation and
site license bundles list for $9,995 through $59,900, depending on what is
included. Both are typically discounted for volume sales.


PRIVATE PRACTICE CHANNEL.
We have two sales representatives focused on the private channel market
including speech and language professionals and private schools. Speech and
language professionals as well as other professionals in private practice
recommend the use of our products in appropriate cases and then administer the
program in connection with providing traditional services. In such instances,
Fast ForWord Language, Fast ForWord Language to Reading, Fast ForWord Middle and
High School, and Fast ForWord Reading are typically sold directly to the student
or family for a list price of $850 per student, minimizing the administrative
burden on the private practice professional, who charges separately for time
spent supervising the student. The fees charged by the speech and language
professional generally range from $1,000 to $2,000 per student.


TECHNOLOGY


Our programs are
cross-platform, software-based programs available for a variety of hardware and
software configurations. They are designed to work with the computer technology
widely available in schools and homes, minimizing the need for users to purchase
new equipment. The programs can be used in a variety of ways, including an
on-site model where educators and speech and language and other professionals
supervise students in school or office, an off-site model where students can
train from their homes and a client/server-based model for larger scale
deployments. Some of our programs link to Scientific Learning via standard
Internet connections for data transfer and updates. Using our patented Internet
and database technology, program administrators can use any Web browser to
upload program results to our database and monitor individuals under their
supervision.


Products are typically
delivered via a CD ROM. Our training programs can be activated only by receiving
a user access code. Some of our programs require periodic uploads of performance
data over the Internet. If users of these products do not upload data within a
required time period, access to the program is denied.


We use an object-oriented
authoring environment for all our software products. New products and product
extensions can be built off our core object model, allowing all products to
benefit from improvements in the core code and reducing new product development
time. The Scientific Learning database maintains a performance history
containing all the uploaded data from our language and reading training
programs. The database is unique and highly scalable, built on database
technology from Oracle Corporation, and capable of dynamic information queries.
Using a proprietary set of analytical tools, we automatically generate summaries
and reports for use by educators, speech and language professionals, and other
professionals. We can also generate custom demographic reports from specific
groups of users by defining search characteristics such as school, classroom or
common primary language. The resulting reports show exactly how a given user is
performing and what challenges remain. The program databases at the client site
are tightly integrated with our databases to provide seamless service from
professional and technical support to accounting.


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|RESEARCH AND
DEVELOPMENT


Our research and
development expenses were approximately $3.4 million, $5.7 million, and $4.5
million for the years ended December 31, 2001, 2000, and 1999, respectively. At
December 31, 2001, approximately 12% of our employees were engaged in research
and development activities, which include both product development and outcomes
research. Our research and development efforts are presently focused on the
development of improvements to our existing products to enhance the user
experience and on additional language and reading programs based on the
application of our neuroscience expertise. In 2002, we plan to release new
versions of Fast ForWord Language, Language to Reading and Middle and High
School. Among other features, these new versions will no longer require
customers to regularly connect with our database. We now plan to launch Fast
ForWord Advanced Reading, which was originally scheduled for launch in 2001, in
late 2002 or 2003.


INTELLECTUAL
PROPERTY


We have a broad
intellectual property strategy addressing both product technology and product
concepts. We aggressively 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, 2001, we
held 34 issued U.S. patents and 22 pending U.S. applications. We also have 28
pending international patent applications. We were the exclusive licensee under
4 issued U.S. patents, 7 pending U.S. applications and 7 pending international
patent applications. The licensed patents and applications are licensed from 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 adaptivity
technology developed at those institutions. Fast ForWord Language, Fast ForWord
Language to Reading, Fast ForWord Middle and High School, and Fast ForWord
Bookshelf incorporate this licensed technology; Fast ForWord Reading, Reading
Edge, Fast ForWord Basics and the Away We Go! products do not. To date,
approximately 75% of our revenues have been derived from selling products that
use the licensed inventions, and loss of this license agreement would cause
material harm to our business.


Under the terms of this
license, we must pay royalties and milestone payments based upon cumulative net
sales of our products, subject to certain minimum royalty amounts. In connection
with the license, we issued 114,526 shares of Series A preferred stock, which
were converted into 114,526 shares of our common stock upon completion of our
July 1999 initial public offering, to Rutgers and made other up-front payments.
In 2000 and 2001, we had approximately $870,000 and $635,000, respectively in
royalty and milestone expense under the license. In 2002 and each year
thereafter during the term of the license, the minimum royalty expense necessary
to maintain the license will be $150,000. We expect royalties as a percentage of
revenues to decline over time as the royalty rate under the license steps down
and we introduce additional programs that are not subject to license fees.
However, we cannot predict our future product mix.


Unless otherwise terminated
by operation of law or certain acts of the parties, the license remains in
effect until the later of the expiration of the last-to-expire patent licensed
or the abandonment of the last patent application licensed. The Regents 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.


COMPETITION


The educational market in
which we operate is very competitive. We believe that the principal competitive
factors in the industry are efficacy, ability to deliver measurable results,
cost, efficiency of delivery, ability to provide training to educators, parents
and speech and language and other professionals and ability to complement and
supplement public school curriculum. We believe that we compete favorably on the
basis of these factors. Particularly in the public school market, we compete
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. Some of the other companies that provide software and
other programs are more established in the school market than we are, offer a
broader range of products to schools and have greater technical, marketing and
distribution resources than we do. 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.


8
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|EMPLOYEES


As of December 31, 2001, we
had 147 full-time and 3 part-time employees. We believe our relations with
employees are good. None of our employees is represented by a union or subject
to collective bargaining agreements.


RISK FACTORS


The following factors as
well as other information contained in this Report on Form 10K should be
considered in making any investment decision related to our common stock. If any
of the following risks actually occur, our business, financial condition or
results of operations could be materially and adversely affected and the trading
price of our common stock could decline.


Our business depends on
whether we can increase acceptance of our products in the public school market.
Any difficulty in increasing sales in the public school market would adversely
affect our business.


Our principal target market
is public schools. Any difficulty in increasing our sales into this market would
be likely to adversely affect our business. We began selling the Fast ForWord
Language program to public schools in April 1997 and initiated our public
schools sales force in the fall of 1998. At December 31, 2001, we had 25
quota-bearing salespeople focusing on the public school market.


We believe that our success
in the public school market will depend largely on the following factors:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
effectiveness of our sales force, including the new salespeople we expect to
hire during 2002. In 2001, we increased average sales force productivity. In
order to meet our sales goals for 2002, we need to achieve additional increases
in average sales force productivity.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
ability to retain and to continue to hire experienced sales personnel.
|- |  | --------------------------------------------------------------------------

| |  | Acceptance
of our license offerings by our target customers. We offer our software on a
site license basis, through workstation licenses, or for single student use.
Multi-user licenses may have either a limited or a perpetual term.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
ability to convince educators and other key public school decision-makers to use
our products even though the learning methods required by our products differ
from the way schools have traditionally addressed language and learning
problems.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
ability to convince schools and teachers to incorporate our programs into their
curriculum since many of our products are generally designed to be used for 90
to 100 minutes per day, five days per week.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
cost of our programs compared to other available programs and the funding available in
schools and school districts budgets.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------

| |  | The
availability of government funding for public schools and for our programs in
particular, which may be adversely affected by reductions in tax revenue in an
economic downturn.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
extent to which our programs qualify for particular sources of funding,
particularly funding under the No Child Left Behind Act of 2002 and other
specific types of federal education funding.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
ability to continue to demonstrate the efficacy of our programs, as required by evolving
federal and state standards.
|- |  | -------------------------------------------------------------------------------------------------------------------------

| |  | The
impact of general economic and market conditions and specifically the political,
economic and social uncertainties following the attacks of September 11, 2001.
For example, we experienced a significant slowdown in sales in the latter half
of September 2001, which we attribute principally to educators need to
concentrate on the most pressing needs of their students rather than purchasing
decisions.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
offerings of our competitors, and how we compare to our competitors in terms of efficacy,
ease of use, cost and other factors.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------

|9
|-

|Our quarterly operating
results are susceptible to fluctuations, which could cause our stock price to
decline.


Since our formation, our
quarterly operating results have fluctuated significantly. For example, our
revenues for each fiscal quarter in the last two years have been:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2001           |  |            | 
| | -------------- |  | ---------- | 
| | First quarter  |  | $3,431,000 | 
| | Second quarter |  | $3,706,000 | 
| | Third quarter  |  | $4,487,000 | 
| | Fourth quarter |  | $3,637,000 | 

| | 2000           |  |            | 
| | -------------- |  | ---------- | 
| | First quarter  |  | $3,206,000 | 
| | Second quarter |  | $5,016,000 | 
| | Third quarter  |  | $5,594,000 | 
| | Fourth quarter |  | $4,073,000 | 

|We expect these
fluctuations to continue for a number of reasons, including factors described
elsewhere in this Risk Factors section. One reason we expect
quarterly operating results to fluctuate is the long and somewhat unpredictable
sales cycle for our products, particularly in the public school market, which is
the result of many factors, including the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
nature of our products requires us to provide a significant level of education to
decision-makers regarding the use and benefits of our programs and services.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Prospective
purchasers need to consider that our programs involve a significant commitment of time
and resources.
|- |  | -----------------------------------------------------------------------------------------------------------------

| |  | 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.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | School-wide
or district-wide sales can require multiple levels of approval and involve many different
departments.
|- |  | ------------------------------------------------------------------------------------------------------------------

|As a result, our sales
cycle generally takes several months, and in some cases, can take a year or
longer.


An additional reason our
quarterly operating results may fluctuate is that demand for our programs and
services may be subject to seasonal influences. Historically, in the public
school market, our sales in the first quarter have tended to be particularly
slow, as have third quarter sales. Demand has tended to pick up in the second
and fourth quarters, due in part to school budget cycles. The school calendar
can also affect start dates and utilization, and hence affect the timing of when
we recognize revenues related to such sales. In our sales to speech and language
professionals in private practice, demand for our programs tends to be lower
during the school year than in the summer, because the intensive nature of our
products may be more conducive to training during school vacation. However, we
do not have sufficient operating experience to predict the overall effect of
various seasonal factors and their effect on future quarterly sales.


The quarterly revenue
recognized from our sales can also be unpredictable. We offer our public school
customers a range of software and services, and typically they purchase a mix of
our offerings. Different software products and services and different types of
software licenses (single use, limited term or perpetual) have different revenue
recognition periods ranging from immediately upon shipment or delivery to a
period of three years. The beginning of the revenue recognition period may also
vary depending on the start date of the contract, the date we ship the software,
and the date we perform training . The mix of products and services in a sale
frequently varies from customer to customer, and can be unpredictable. See
Managements Discussion and Analysis  Critical Accounting
Policies and Estimates for a discussion of our revenue recognition policy.


Any significant shortfall
of revenues in relation to our or analysts expectations could cause
significant fluctuations in quarterly operating results, and our stock price
could suffer. Prediction of future revenues and expenses is difficult for the
reasons set forth above and in the remainder of this Risk Factors section. Our
expense levels are based on our expectations of future revenues and are
primarily fixed in the short term. We cannot assure you that we will be able to
predict our future revenues accurately or that we will be able to adjust
spending in a timely manner to compensate for any unexpected revenue shortfall.


10
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our common stock may be
delisted from the Nasdaq National Market.


Our common stock trades on the
Nasdaq National Market, which has certain compliance requirements for continued
listing of common stock. Among the requirements applicable to us is the
maintenance of either $50 million in market capitalization or $4 million in net
tangible assets. In November 2001, we received a notice from Nasdaq that we
failed to meet the tangible net asset requirement as of September 30, 2001. On
November 30, 2001, we closed a private equity financing in which Warburg, Pincus
Ventures, L.P., the Companys largest stockholder, purchased 4,000,000
shares of Common Stock for an aggregate purchase price of $5,000,000. This
financing increased our tangible net assets to a level in excess of the Nasdaq
requirement.


As of December 31, 2001,
our tangible net assets were approximately $1,411,000, lower than the required
level. At March 8, 2002, our stock price was $1.85 per share and our market
capitalization was approximately $28.8 million. As a result, Nasdaq may again
initiate a review of the Companys eligibility for continued listing.
Delisting of our common stock from the Nasdaq National Market would be likely to
reduce the liquidity of any investment in our common stock and to have a
material adverse effect on the price of our common stock. Delisting would reduce
the ability of holders of our common stock to purchase or sell shares as quickly
and as inexpensively as they could have done in the past. This lack of liquidity
may make it more difficult for us to raise capital in the future. Although we
are working to comply with the continued listing requirements of Nasdaq, there
can be no assurance that we will be able to satisfy such continued listing
requirements or that, even if we are able to satisfy the requirements, Nasdaq
would terminate delisting procedures.


We have incurred a
significant amount of debt, and we do not expect to repay that debt in 2002.


In March 2001, we entered
into an agreement with Fleet National Bank for a revolving line of credit of $15
million. At December 31, 2001, we had an outstanding obligation of $10 million
under the line. The line of credit is guaranteed by WPV, Inc., an affiliate of
Warburg, Pincus & Co. and Warburg, Pincus Ventures, in exchange for which we
issued WPV, Inc. a warrant to purchase 1,375,000 shares of our Common Stock. The
warrant has a seven-year term and an exercise price of $8.00 per share. We have
agreed to repay WPV, Inc. for any amounts that it may be required to pay in
satisfaction of the loan on account of the guarantee. To secure our
reimbursement obligation, we granted WPV, Inc. a security interest in
substantially all of our assets. In March 2002, we entered into an agreement
with Fleet National Bank and WPV, Inc. to extend the term of the line of credit
to June 2004. We do not expect to have sufficient capital resources to repay the
line of credit during 2002.


This indebtedness and
security interest could have important consequences, including the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | It
may limit our ability to obtain other financing.
|- |  | ---------------------------------------------------

| |  | It
may limit our flexibility in planning for, or reacting to, changes in our business, and
could make us more vulnerable to a downturn in our business or the economy.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
portion of our cash flow will be required to service the indebtedness and will not be
available for other purposes.
|- |  | ---------------------------------------------------------------------------------------------------------------------

|The loan agreement provides
that an event of default under the loan occurs upon certain changes in the
composition of the board of directors or the acquisition of more than 40% of our
stock by a person or group other than Warburg, Pincus or its affiliates. Such a
default could occur at a time when we would be unable to repay the loan.


We have a history of
losses, and we expect to incur additional losses this year.


We started operations in
February 1996 and began generating revenues in the first quarter of 1997. We
have incurred significant operating losses and negative cash flow since
inception. Our net losses were approximately $10.7 million for the year ended
December 31, 1998, $14.1 million for the year ended December 31, 1999,
$20.1 million for the year ended December 31, 2000 and $19.3 million for the
year ended December 31, 2001. We have an accumulated deficit of approximately
$72 millionfrom inception through December 31, 2001. For 2002, we expect
to incur an operating loss, a net loss and negative cash flow for the year as a
whole. During 2002, we also expect to continue to incur substantial sales and
marketing expenses as we strive to generate increased revenue from our target
markets. We cannot assure you that we will meet our targets with respect to
revenues or operating results. If we do not meet our targets, we may be forced
to further reduce our expenses, which may negatively impact our business.


11
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We cannot guarantee that
we will ever generate sufficient revenues to achieve or sustain profitability.


We cannot guarantee that we will
ever generate sufficient revenues to achieve or sustain profitability or
generate positive cash flow. As a result, we may need to obtain additional
equity or debt financing in the future, which may not be available on acceptable
terms, if at all.


To date we have relied
primarily on a single family of products, the Fast ForWord training programs.
Within that family of products, the majority of product usage is attributable to
a single training program. Any failure to increase our sales of our language and
reading training programs could cause our business to suffer.


Since our formation, sales
of licenses of our language and reading training programs have accounted for
almost 82% of our revenues. Within the family of training programs, the number
of participants in one of our training programs, Fast ForWord Language,
represented approximately 50% of all participants during 2001. Our remaining
revenues are primarily from other educational products and related services,
such as professional development courses and technical services relating to
implementing our programs. We anticipate that most of our revenues will be
related to our language and reading training programs for the foreseeable
future. Our business will suffer if we are unable to increase our sales of our
language and reading training programs.


Our sales to the private
channel have declined over the past two years. Further decreases in sales to
this channel could adversely affect our business.


In addition to selling to
public schools, we also sell to and through speech and language professionals in
private practice (SLPs) and, to a lesser extent, to private schools.
Selling through and to SLPs was our initial market, but we have shifted our
emphasis to the public school market because we believe it has greater growth
potential. Our revenues from the private channel fell 26% in 2001 compared to
2000 and 20% in 2000 compared to 1999. Our ability to maintain and grow our
sales to this channel are impacted by the following factors:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
need to convince SLPs to use our products even though the methods employed by
our products differ from the way SLPs have traditionally addressed speech and
language problems.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
fact that our programs permit SLPs to supervise multiple clients at a time, which is
contrary to the one-on-one methods used by many SLPs.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
fact that our programs require use of computers and the Internet, which have not
been adopted as practice tools by all SLPs.
|- |  | --------------------------------------------------------------------------------------------------------------------------------

| |  | The
cost of our programs compared to other programs and techniques available to SLPs.
|- |  | -------------------------------------------------------------------------------------

| |  | Financial
resources available to families for private speech and language therapy, which we believe
to be adversely affected in an economic downturn.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
ability to continue to demonstrate the efficacy of our programs in continuing studies.
|- |  | ------------------------------------------------------------------------------------------

| |  | The
offerings of our competitors, and how we compare to our competitors in terms of efficacy,
ease of use, cost and other factors.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------

|We expect that sales to the
private channel may continue to decline as we continue to focus our limited
resources on the public schools channel.


We may not be able to
compete effectively in the educational technology market or the education market
generally.


The market in which we
operate is very competitive. We compete with other companies offering
educational software products or non-software-based programs to improve reading
or language skills to schools and to speech and language professionals in
private practice. Existing competitors may continue to broaden their product
lines, and potential competitors, including large software developers and
educational publishers, may enter or increase their focus on the school market.
Moreover, we expect that we will face additional competition from new entrants
into the market. Many competitors have substantially greater technical,
marketing and distribution resources than we do. We cannot assure you that we
will be able to compete effectively in the educational technology or education
markets.


We have significantly
reduced our research and development efforts and our business may suffer if we
do not introduce new products.


In 2001, because we wanted
to focus on the public school market and to reduce expenses, and because we
believed our suite of language products was reasonably complete, we
significantly reduced our research and development staff. Our development
efforts are now focused on increasing ease of use, providing additional student
tracking capabilities, and generally increasing flexibility and improving the
customer experience. For example, we are currently working to develop versions
of our core products that do not require Internet connections. We cannot assure
you that we will be successful in developing and marketing any such modified
versions of our products or new products. We may not have sufficient resources
to make the investments to develop or acquire and market the products necessary
to maintain our competitive position. Failure to adapt to evolving technology
and educational standards, to enhance our existing products and to develop new
products based on our proprietary technology may materially and adversely affect
our business and financial condition.


12
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our limited history
makes it difficult to evaluate our current business and prospects.


In 1997, we introduced the
Fast ForWord Language program. In 1998, we introduced the Fast ForWord Language
to Reading program. In 1999, we introduced the Fast ForWord Basics, Fast ForWord
Bookshelf, Reading Edge, Cross Train, Fast ForWord Middle & High School,
Away We Go! and Away We Go! Bookshelf products. In 2000, we introduced the Fast
ForWord Reading program and Brain Connection Professional Development on-line
courses. Consequently, we only have a limited history upon which you can gauge
the success of our suite of software products in penetrating our target
markets.. Companies with limited operating histories, including ours, encounter
high risks and uncertainties, particularly in new and rapidly evolving markets
such as technology-based educational products and services. These risks include,
but are not limited to:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | uncertain
demand for technology-based learning products and our products and services in particular;
|- |  | ----------------------------------------------------------------------------------------------------

| |  | attracting
and retaining key personnel and managing growth;
|- |  | -----------------------------------------------------------

| |  | failure
to select an appropriate growth strategy;
|- |  | -------------------------------------------------

| |  | institutional
or other barriers that hinder our ability to penetrate our target markets; and
|- |  | --------------------------------------------------------------------------------------------

| |  | competition.
|- |  | ------------

|To address these risks, we
must, among other things:
|----------------------------------------------------

| |  | successfully
increase market acceptance for our suite of software products, particularly in the public
school market;
|- |  | ---------------------------------------------------------------------------------------------------------------------

| |  | respond
to competitive developments and execute our growth strategy;
|- |  | --------------------------------------------------------------------

| |  | attract,
integrate, retain and motivate qualified personnel, particularly sales and marketing
professionals; and
|- |  | ----------------------------------------------------------------------------------------------------------------

| |  | address
new or evolving technologies and standards.
|- |  | ---------------------------------------------------

|We cannot assure you that
we will be successful in addressing the risks we face, and our failure to
address those risks will materially and adversely affect our business and
financial condition.


Our business will suffer
if customers delay or forego purchases of our products because of our product
enhancements or new products or because of competitors superior products.


The demand for our existing
products may be reduced or eliminated by our own enhancements or new products
and the revenues generated from our enhancements or new products may not
adequately offset any resulting loss of revenues from our existing products.
Customers may also delay their purchases of our products in anticipation of the
release of our product enhancements or new products, if any. Finally, products
introduced by our competitors may be superior to the products we offer and
reduce the demand for our products.


Economic factors could
cause us to reduce our personnel levels, which could negatively impact our
revenues or results of operations.


In each of 2000 and 2001,
we reduced our personnel levels. We might find it necessary to further reduce
our personnel levels if our revenues fail to grow as planned, due to general
market or economic factors, or for other reasons. Such a reduction in personnel
could adversely affect our revenues or results or operations.


We may be unable to
effectively manage any future growth.


We grew rapidly from five
employees at April 1, 1996, to approximately 200 employees at December 31, 1999.
We ended 2000 with approximately the same number of employees as 1999 due to a
mid-year reduction in the sales force and a reduction in research operations at
the end of the year. During 2001, our employee count fell, reflecting staff
reductions throughout the Company. At December 31, 2001, we had 150 employees.
Our historical growth has placed, and any future growth will place, a
significant strain on our managerial, operational, financial and other
resources. Our future success will depend, in part, upon whether our senior
management can manage growth effectively, particularly with limited personnel.
Future growth, if any, may require us to implement additional management
information systems, to develop additional operating, administrative, financial
and accounting systems and controls, and to maintain close coordination among
our accounting, finance, marketing, sales, and customer support and service
organizations. If we are unsuccessful in managing growth, our business and
financial condition will be materially and adversely affected.


13
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We rely on our
intellectual property rights and may be unable to protect these rights.


Our ability to compete
effectively will depend in part on whether we are able to develop and maintain
the proprietary aspects of our technology and to operate without infringing on
the proprietary rights of others. We rely on a combination of patents,
trademarks, copyrights, trade secret laws, confidentiality procedures and
contractual provisions to protect our proprietary rights in our products and
technology. We cannot assure you that pending patent applications will result in
the issuance of any patents or that issued patents will offer protection against
competitors with similar technology. In addition, any patents issued to us or
our licensors could be challenged, invalidated or circumvented in the future.


It is possible we may
become subject to patent infringement claims and litigation or interference
proceedings conducted in the United States Patent and Trademark Office to
determine the priority of inventions. Litigation may be necessary to enforce
patents issued to us, to protect trade secrets or know-how that we own or to
determine the enforceability, scope and validity of the proprietary rights of
others. Any litigation or interference proceedings will result in substantial
expense and significant diversion of effort by our technical and management
personnel. An adverse determination in litigation or interference proceedings to
which we may become a party could subject us to significant liabilities to third
parties or require us to seek licenses from third parties, which may not be
available on commercially reasonable terms or at all.


Failure to maintain our
exclusive license would materially harm our business by delaying or preventing
new product introductions and necessitating product recalls.


We license certain patents
and applications from the Regents of the University of California and Rutgers,
the State University New Jersey, which relate to the speech and sound
modification and adaptivity technology developed at those institutions. Our
primary products, Fast ForWord Language, Fast ForWord Language to Reading and
Fast ForWord Middle & High School, incorporate this licensed technology. To
date, approximately 75% of our revenues have come from selling programs using
the licensed technology. While our professional development seminars and on-line
courses, Fast ForWord Reading and other products do not make use of this
licensed technology, the vast majority of our product and service revenues
relate to the core products, which do use the licensed technology, and its loss
would cause material harm to our business. If we lose or are unable to maintain
the license agreement during the term of the underlying patents, it would
materially harm our business. It could delay or prevent the introduction of new
products and would likely require the recall of most of our products from the
market. Even if we could identify and license or develop non-infringing
equivalent technology, which is far from certain, the cost and delays from such
a changeover in our core technology would cause material harm to our business.


The Regents 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. For
example, The Regents could terminate the agreement if we fail to perform any of
the following obligations:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Make
royalty and milestone payments.
|- |  | ------------------------------------

| |  | Provide
periodic progress reports;
|- |  | ----------------------------------

| |  | Bear
the costs to prepare, file and prosecute U.S. and foreign patent applications;
|- |  | -----------------------------------------------------------------------------------

| |  | Provide
indemnification;
|- |  | ------------------------

| |  | Insure
our activities in connection with work under the agreement; and
|- |  | ----------------------------------------------------------------------

| |  | Maintain
the confidentiality of information received from The Regents relating to the agreement.
|- |  | ------------------------------------------------------------------------------------------------

|If we fail to retain our
key personnel or attract and retain key employees, our business will suffer.


Our success depends to a
significant extent upon the continued active participation of key members of our
management, including Sheryle J. Bolton, our Chairman and Chief Executive
Officer, Frank M. Mattson, our President and Chief Operating Officer, and Jane
A. Freeman, our Chief Financial Officer, as well as others. While we do not
believe that any of our employees is irreplaceable, we recognize that we are in
an extremely competitive market for executives, and the loss of one or more of
these persons could have a material adverse effect on our business, financial
condition and results of operations. We recently announced a search for a new
Chief Executive Officer. We believe that our future success will depend upon our
ability to continue to attract, motivate and retain highly skilled managerial,
sales and marketing and product development personnel, including a new Chief
Executive Officer. Competition for such personnel is intense. The value of
equity incentives provided to our key personnel may vary due to fluctuations in
our stock price, which may make it more difficult to retain such personnel or
may require us to adopt other types of incentive programs to remain competitive.
Our failure to attract or retain the necessary personnel could materially and
adversely affect our business.


14
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our executive officers
and directors and their affiliates effectively control the voting power of our
company.


At December 31, 2001,
Warburg, Pincus Ventures, our largest shareholder, owned approximately 50% of
the Companys outstanding stock and, as a whole, our executive officers and
directors and their respective affiliates beneficially owned more than 65% of
the Company.As a result, these stockholders will be able to exercise
significant influence over all matters requiring stockholder approval, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership may also delay, prevent or deter a change in
control of our company. In addition, for so long as Warburg, Pincus Ventures
continues to hold specified percentages of our companys stock, we are
required, under the terms of our amended and restated registration rights
agreement, to nominate up to two individuals affiliated with Warburg, Pincus
& Co. for election to the Board of Directors. Warburg, Pincus Ventures has
also agreed with LF SL Holding LLC that so long as LF SL continues to hold at
least 277,778 shares it originally purchased, Warburg, Pincus Ventures will vote
to elect a person nominated by LF SL to the Board.


There is academic debate
regarding the scientific basis underlying our products and the efficacy of our
products, which could significantly affect the market for our programs and
services.


Our training programs are
based on particular theories of how the brain functions and learns and theories
of language acquisition. Our founders are actively involved in academic debate
about their own and opposing scientific theories of neuroscience and language
acquisition. As a result, the theories on which our suite of software products
is based have been, and are likely to be, subject to public debate and
challenges. Although we believe that our suite of software products is based
primarily upon non-controversial scientific theories, some of the principles and
methodologies underlying and associated with our products are opposed by some
academicians and educators, any of whom could influence the market for our
products and services. Consequently, academic publications and debate
challenging the theories of neuroscience and language acquisition propounded by
the founders and others could adversely affect the market for our products and
services. In addition, while we believe that we have established the efficacy of
our products though appropriate scientific research, some question the efficacy
of our products and/or the extent to which the results achieved through the use
of those products can be generalized. Issues relating to the efficacy of our
products could adversely affect our business.


We could lose revenues
as a result of software errors or defects.


Software programs
frequently contain errors or defects, especially when first introduced or when
new versions are released. We could, in the future, lose revenues as a result of
software errors or defects. We cannot assure you that errors will not be found
in our current products or new products or releases, if any, even though
products are tested prior to release. Any errors could result in loss of revenue
or delay in market introduction or acceptance, diversion of development
resources, damage to our reputation or increased service and warranty costs.


We could be subject to
product liability claims from the sale of our products and services.


Because we market products
to the public, we face an inherent business risk of financial exposure to
product liability claims. As a publisher of online content, we face potential
liability for defamation, negligence, copyright, patent or trademark
infringement, or other claims based on the nature and content of materials that
we publish or distribute. We currently carry product and general liability
insurance that, in general, covers product and general liability claims up to
the policy limits. We cannot assure you that we will continue to have access to
this insurance at a reasonable cost, if at all, or that the insurance will be
adequate to satisfy any liability or litigation expenses. Any claim or claims
against us, regardless of their merit or eventual outcome, could materially and
adversely affect our business.


15
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The market price of our
stock may be highly volatile.


The market price of our
common stock has been highly volatile since our July 1999 initial public
offering and could continue to be subject to wide fluctuations for the following
reasons, among others:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
fluctuation of our quarterly results for reasons including the difference
between projected and actual results, the seasonal demand for our products
and our long sales cycle.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
timing of our competitors product releases or variations in their quarterly
financial results.
|- |  | ---------------------------------------------------------------------------------------------------

| |  | Conditions
in the economy in general or in our industry in particular, including conditions
that affect the resources available to schools, speech and language
professionals, and private parties to purchase our products.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Publicity
regarding our products or those of our competitors, including publicity relating
to new scientific studies about how the brain functions.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
release of (or the failure to release) product enhancements or new products.
|- |  | --------------------------------------------------------------------------------

| |  | General
economic conditions that influence stockholder interest in stocks of companies with
Internet or technology applications.
|- |  | --------------------------------------------------------------------------------------------------------------------------------

| |  | Changes
in applicable laws and regulations affecting us or the educational technology industry.
|- |  | -----------------------------------------------------------------------------------------------

| |  | Changes
by financial research analysts in their estimates of our future earnings.
|- |  | ---------------------------------------------------------------------------------

| |  | Stock
market volatility for education and technology companies.
|- |  | ---------------------------------------------------------------

|We may be subject to
litigation due to the volatility of our stock price.


Broad market fluctuations
or a downturn in our prospects may adversely affect the market price of our
common stock and result in class action litigation. For example, in August 2000,
a class action lawsuit was filed against us and certain of our officers and
directors. The suit alleged that we made false and misleading statements and/or
failed to disclose information concerning our projected revenues for the second
quarter of 2000. In early July, we had reported that second quarter revenues
were lower than expected. In February 2001, the lawsuit was voluntarily
dismissed without prejudice. Any securities class action or similar litigation
can result in substantial costs and divert our managements attention and
resources, which could materially and adversely affect our business. Any adverse
determination in such litigation could also subject us to significant
liabilities.


Our business will suffer
if Internet use fails to develop further within schools and among speech and
language professionals in private practice.


One of the key features of
certain of our programs is the periodic uploading and downloading of information
to and from our proprietary database via the Internet. If the use of the
Internet, particularly within schools and among speech and language
professionals in private practice, develops to a lesser extent or more slowly
than expected, our business will suffer.


Any delays or
malfunctions of the Internet on which we rely for the effective functioning of
our products and Websites could adversely affect our business.


We depend on technology,
particularly on the Internet, for the effective functioning of our training
programs and for implementation of our Web-based marketing strategies. One of
the key features of our training programs is the periodic uploading and
downloading of information to and from our proprietary database via the
Internet. Additionally, our ability to establish BrainConnection.com as a
reputable and reliable source for information and on-line professional
development courses depends on the availability of the Internet. If commercially
available browsers fail to provide access to the Internet due to unexpected user
demand or other delays or malfunctions, access to our Websites could be harmed,
our sites could lose credibility and professional development course revenues,
if any, could suffer.


A disaster or
malfunction that disables our computer operations center could harm our
Internet-based services and damage our credibility.


Substantially all of our
computer and communications systems are located in our facilities in Oakland,
California. Our operations depend on our ability to protect these systems
against damage from fire, earthquakes, power loss, rolling blackouts,
telecommunications failures, break-ins, viruses and similar events. Presently,
our databases are redundantly hosted at our site and at the site of a remote
Internet service provider. A disaster or malfunction that disables our
Internet-based services could cause an interruption in our ability to deliver
up-to-date progress reports on individuals currently using our training
programs, could interrupt training schedules for active participants, and could
damage the credibility of our BrainConnection.com Website. Our insurance
policies may not adequately compensate us for any losses that may occur due to
any failures or interruptions in our systems.


16
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Concerns about Internet
security could limit the acceptance of our products and effectiveness of our
Web-based marketing.


One of the key features of
our training programs is the periodic uploading and downloading of information
to and from our proprietary database via the Internet. Concerns about the
security of transmittals of information over the Internet have been a
significant barrier to e-commerce and other communications over the Internet.
Any compromise of security over the Internet could deter people from using our
products or our Websites. We may need to expend significant resources to protect
against security breaches or to address problems caused by such breaches.


We are subject to
government regulations that could impose additional costs on the conduct of our
business.


Our business is potentially
subject to or affected by a variety of federal, state and local laws and
regulations. These include, without limitation, laws and regulations relating
to:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | government
funding for and other matters related to education;
|- |  | --------------------------------------------------------------

| |  | licensing
of speech and language professionals in private practice and delivery of speech and
language testing and remediation services; and
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------

| |  | consumer
protection and anti-fraud and related protections, including the regulation of referrals
by professionals.
|- |  | -------------------------------------------------------------------------------------------------------------------

|Compliance with these and
other laws and regulations impose additional costs on the conduct of our
business, and failure to comply with these laws and regulations, changes in
these laws and regulations, or in their applicability to our business may impose
additional costs.


Although we believe our
existing products are educational training tools not subject to regulation by
the U.S. Food and Drug Administration, we cannot assure you that the U.S. Food
and Drug Administration will not make a contrary determination in the future
with respect to our existing products or new products that we may develop. Our
business could suffer in the event we became subject to such regulation.


Our Internet operations
are subject to government regulation of the Internet and other legal
uncertainties, which could negatively impact our operations.


We are subject to the same
federal, state and local laws as other businesses that employ the Internet.
Today there are relatively few laws directed towards online services. However,
due to the increasing popularity and use of the Internet, it is possible that a
number of laws and regulations may be adopted with respect to the Internet.
Changes in regulation of the Internet could affect our results of operations.
These laws and regulations could cover issues such as user privacy, freedom of
expression, pricing, fraud, content and quality of products and services,
taxation, advertising, intellectual property rights and information security.
Applicability to the Internet of existing laws governing issues such as property
ownership, copyrights and other intellectual property issues, taxation, libel,
obscenity and personal privacy is uncertain. The vast majority of these laws
were adopted prior to the advent of the Internet and related technologies and,
as a result, do not contemplate or address the unique issues of the Internet and
related technologies. The courts have not yet interpreted many laws that
reference the Internet, such as the recently passed Digital Millennium Copyright
Act, and therefore their applicability and reach are uncertain.


Laws and regulations
directly applicable to communications or commerce over the Internet are becoming
more prevalent. The United States Congress recently enacted Internet laws,
including laws relating to childrens privacy, the transmission of sexually
explicit material, taxation of Internet-based enterprises and taxation of
Internet access. In addition, the growth and development of the market for
online commerce may prompt calls for more stringent consumer protection laws.
This occurrence may impose additional burdens on companies conducting business
online by limiting how information can flow over the Internet and the type of
information that can flow over the Internet. The adoption or modification of
laws or regulations relating to the Internet could adversely affect our
business.


17
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our Internet activities
may become subject to additional taxes, which could negatively affect our
results of operations.


Tax authorities in a number
of states are currently reviewing the appropriate tax treatment of companies
engaged in e-commerce. Therefore, our products and services may become subject
to additional sales and income taxes. If consumers of our products and services
are required to pay additional sales or other taxes, they could reduce their
purchases, which would negatively affect our results of operations. Because
BrainConnection.com is available over the Internet in multiple states and
foreign countries, these jurisdictions may claim that we are required to qualify
to do business as a foreign corporation. We are qualified to do business in
21states in the United States, and qualifying in additional states could
subject us to additional taxes. Additionally, failure by us to comply with
foreign laws or to qualify as a foreign corporation in a jurisdiction where we
are required to do so could subject us to taxes and penalties for the failure to
qualify and could result in the inability to enforce contracts in such
jurisdictions.


Our charter provisions
could have the effect of delaying or preventing corporate takeovers.


Our certificate of
incorporation authorizes our board of directors to issue up to 1,000,000 shares
of preferred stock and to determine the price, rights, preferences and
privileges, including voting rights, of those shares without any further vote or
action by the stockholders. The rights of the holders of common stock will be
subject to, and may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The authority to issue this
preferred stock could enable our board of directors to deter acquisitions of our
company. Additionally, our certificate of incorporation and bylaws also contain
the following features which could have the effect of delaying or preventing
corporate takeovers:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
board of directors classified into three classes, which makes it more difficult
to acquire immediate control of our board of directors because only one third of
the directors are elected each year.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Requiring
stockholder actions to occur only at duly called meetings of the stockholders,
thereby reducing the ability of the stockholders to act contrary to the
interests of the board of directors.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Disallowing
cumulative voting in the election of directors, which means that the majority owner(s) of
our voting common stock controls the election of all directors.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Requiring
advance notice from stockholders for director nominations or other stockholder proposals.
|- |  | ---------------------------------------------------------------------------------------------------

|You should not rely on
forward-looking statements contained in this Report.


This Report on Form 10K
contains forward-looking statements. In some cases you can identify
forward-looking statements by terminology such as may,
will, should, expects, plans,
anticipates, believes, estimates,
predicts, potential or continue or the
negative of these terms or other comparable terminology. The outcome of the
events described in these forward-looking statements is subject to known and
unknown risks, and you should not rely on these forward-looking statements.
These risks include, among other things, those identified in this Risk
Factors section. Our actual results could differ materially from those
discussed in the forward-looking statements contained in this Report. This
section, the remainder of this Item 1 and Item 7 (Managements
Discussion and Analysis of Financial Condition and Results of Operations)
contain a discussion of some of the factors that could contribute to those
differences. We undertake no obligation to publicly update any forward-looking
statement and the forward-looking events discussed in this Report on Form 10-K
could change or might not occur.


ITEM 2.
PROPERTIES


We lease approximately
70,000 square feet of office space in Oakland, California under an eight-year
lease that expires in March, 2009. The lease includes an option to expand into
an additional 13,000 square feet and two five-year options to extend the term of
the lease. We have subleased a portion of this space and are seeking to sublease
additional portions. We believe our facilities are more than adequate for our
operations currently and will be sufficient to meet our needs for at least the
next three years.


We also still lease
approximately 25,000 square feet at the location of our former office in
Berkeley, California under a five-year lease that expires in September 2002.


18
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 3. LEGAL
PROCEEDINGS


None.


ITEM 4. SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS


None.


19
|------------------------------------------------------------------------------------------------------------

|EXECUTIVE
OFFICERS


The following table sets
forth various information concerning our executive officers:
|----------------------------------------------------------------------------------------------------------

|NAME                     |  | AGE |  | POSITION                                                      | 
|------------------------ |  | --- |  | ------------------------------------------------------------- | 
|Sheryle J. Bolton        |  | 55  |  | Chairman and Chief Executive Officer                          | 
|                        
|Dr. Michael M. Merzenich |  | 59  |  | Chief Scientific Officer and Member of the Board of Directors | 
|                        
|Frank M. Mattson         |  | 47  |  | President and Chief Operating Officer                         | 
|                        
|Jane A. Freeman          |  | 48  |  | Chief Financial Officer, Vice President, and Treasurer        | 
|                        
|Linda L. Carloni         |  | 48  |  | Vice President, General Counsel and Secretary                 | 
|                        
|Glenn G. Chapin          |  | 46  |  | Vice President, Sales                                         | 
|                        
|Dr. William M. Jenkins   |  | 51  |  | Sr. Vice President, Product Development                       | 
|                        
|Dr. Steven L. Miller     |  | 38  |  | Sr. Vice President, Research and Outcomes                     | 

|Sheryle
J. Bolton became Chairman of the Board of Directors in November 2000. She currently
remains Chief Executive Officer and a director, offices she has held since November 1996.
Ms. Bolton was also President from June 1997 to November 2000. Prior to joining the
Company, Ms. Bolton served as President and Chief Operating Officer of Physicians Online,
Inc., a physicians online service provider, consulted for a number of international
companies, specifically in the areas of strategy, operations and finance, and held senior
management positions at Rockefeller & Co., Inc., a global investment management firm, and
Merrill Lynch Capital Markets, Investment Banking Division. Earlier in her career, she
was a teacher of English as a second language in Africa and a language arts teacher in
public schools in the State of Georgia. Ms. Bolton holds a B.A. in English and an M.A. in
Linguistics from the University of Georgia, and an M.B.A. from Harvard Business School.


Dr. Michael
M. Merzenich is one of our founders. He has served as our Chief Scientific Officer
since November 1996 and as a director since inception. From January 1996 to November
1996, Dr. Merzenich served as the Chief Executive Officer and President of the
Company. During 1997, Dr. Merzenich worked full-time with us during a sabbatical
from his faculty position at UCSF. In January 1998, Dr. Merzenich returned to his
faculty position at UCSF, but continues to direct our research and development activities
under a consulting agreement. Since 1971, Dr. Merzenich has been a member of the
faculty, and since 1980 a full professor, in Neuroscience, Physiology, Biomedical
Engineering and Otolaryngology at UCSF. He is currently the Francis A. Sooy Professor of
Otolaryngology at UCSF. Dr. Merzenich has more than 25 years of experience in
managing large, multidisciplinary brain science/behavior/engineering research projects
that have led to commercial products and numerous publications and awards. In May 1999,
Dr. Merzenich was elected a member of the National Academy of Sciences for
distinguished and continuing achievements in original research. Dr. Merzenich holds
a B.S. in General Science from the University of Portland and a Ph.D. in Physiology from
The Johns Hopkins University, with additional training from the University of Wisconsin.


20
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Frank
M. Mattson became our President in November 2000. In January 2000, he became Chief
Operating Officer and in March 2000 was elected Executive Vice President. He served as
our Chief Financial Officer from January 1997 to January 2000. Mr. Mattson served as
our Secretary from June 1997 through March 2000. Prior to joining the Company, Mr. Mattson
served in senior management positions at MNI Interactive, Inc., a startup
entertainment marketing company and Ingram Entertainment, Inc. (Ingram),
a unit of the Ingram Distribution Group, one of the worlds largest distribution
companies. At Ingram, Mr. Mattson directed the post-merger integration of Ingram and
Commtron Corporation (Commtron), the largest distributor in the home video
industry until its acquisition by Ingram in 1992. From 1986 to 1992, Mr. Mattson
served in a variety of management positions at Commtron, a publicly traded company. Mr. Mattson
holds a B.S. in Business from Miami University (Ohio) and an M.A. in Economics from the
University of Wisconsin in Milwaukee. Mr. Mattson has also served on the faculty of
Drake University.


Jane
A. Freeman joined us as Vice President, Finance and Treasurer in August 1999 and was
named Chief Financial Officer in January 2000. She also served as our Vice President
Business Development from August 1999 until June 2000. From April 1988 through December
1998, she was employed by Rockefeller &Co., a global investment firm. Among her
investment responsibilities at Rockefeller &Co. were the leadership of the
global asset allocation process and the management of the U.S. Small Capitalization
equity product. She also served on the Management Committee of the firm. From January
1978 to March 1988, Ms. Freeman was employed by Scudder, Stevens and Clark as an
analyst and Manager of the Scudder Development Fund. She is a director of four mutual
funds managed by Harding Loevner, LLP. Ms. Freeman holds a B.A. in Mathematics and
Chemistry and an M.B.A. (with distinction) from Cornell University and a License in
Applied Economics from the University of Louvain in Belgium.


Linda
L. Carloni joined the Company as General Counsel in October 1999, became our Secretary
in March 2000 and was elected Vice President in June 2000. From April 1996 to September
1999, Ms. Carloni was a founder and Vice President of Alere Medical Incorporated, a
healthcare services start-up. From May 1994 to April 1996, Ms. Carloni
served as a senior licensing officer for the University of California Office of
Technology Transfer. From April 1992 to April 1994, Ms. Carloni was a
partner at the law firm of Cooley Godward LLP. Earlier in her career, Ms. Carloni
was the general counsel of Nellcor Incorporated, a medical device company, and an
associate and a partner at Cooley Godward. 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.


Glenn
G. Chapin joined the Company as Vice President, Sales in April 2001. Prior to joining
the Company, Mr. Chapin served as a Regional Vice President at CompassLearning, an
educational technology company starting in 1995. Prior to CompassLearning, Mr. Chapin was
a sales executive for National Computer Systems (NCS), a provider of educational
assessment, testing and administrative software and services, where he held positions of
increasing responsibility over a 15 year period from serving as the Midwest territory
sales representative to Southern Region Sales VP. Mr. Chapin is a graduate of St. John
Fischer College in Rochester, NY where he received his Bachelor of Science degree in
Business Administration.


Dr.
William M. Jenkins was elected Senior Vice President, Product Development in November
2000. Dr. Jenkins is a founder and served as our Vice President, Product Development from
June 1997 until November 2000. From March 1996 to June 1997, Dr. Jenkins was our Vice
President, Research and Development. Since 1990, Dr. Jenkins has also served as an
Adjunct Associate Professor at UCSF. Dr. Jenkins has served on the editorial board in the
Systems Plasticity section of Restorative Neurology and Neuroscience. Dr. Jenkins is the
principal developer of our current training programs. 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.


Dr.
Steven L. Miller was elected Senior Vice President, Research and Outcomes in November
2000. Dr. Miller is a founder and served as our Vice President, Outcomes Research or Vice
President, Research from June 1997 until November 2000. From May 1996 to June 1997, Dr.
Miller was our Vice President, Professional Relations and Outcomes. From September 1991
to May 1996, he held research appointments at the Center for Molecular and Behavioral
Neuroscience at Rutgers. Dr. Miller has extensive experience in organizing clinical
research studies and conducting longitudinal studies of children and adults who have
language and reading problems. Dr. Miller holds a B.A. in Psychology from Bloomsburg
University of Pennsylvania, an M.A. in Neuroscience from the University of Hartford and a
Ph.D. in Psychology from the University of North Carolina at Greensboro. He received
additional training in Clinical Neuropsychology at the Bowman Gray School of Medicine at
Wake Forest University.


21
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART II


ITEM 5. MARKET FOR THE
REGISTRANTS COMMON EQUITY AND RELATED SHARE- STOCKHOLDER MATTERS


(a) Our common stock
currently is traded on the Nasdaq National 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 National Market.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2000 | High           | Low |        
| | ---- | -------------- | --- | -------
| |      | First quarter  |     | $36.250
| |      | Second quarter |     | $23.750
| |      | Third quarter  |     | $23.000
| |      | Fourth quarter |     | $7.094 

| | 2001 |                |  |       
| | ---- | -------------- |  | ------
| |      | First quarter  |  | $7.125
| |      | Second quarter |  | $3.900
| |      | Third quarter  |  | $2.250
| |      | Fourth quarter |  | $1.750

|See Risk Factors 
Our common stock may be delisted from the Nasdaq National Market for
a discussion of the possible delisting of our common stock from the Nasdaq
National Market.


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. As of February 28, 2002, the
approximate number of stockholders of record of our common stock was 148.


(b) Not applicable


22
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 6. SELECTED
FINANCIAL DATA
|-------------------------------

|                                     | Year ended December 31, | 
|------------------------------------ | ----------------------- | 
|
|Statement of Operations Data:        |                         | 
|                                    
|Revenue:                             |                         | 
|Programs                             |                         | 
|Services                             |                         | 
|                                     |                         | 
|Total revenues                       |                         | 
|                                    
|Cost of revenues                     |                         | 
|Programs                             |                         | 
|Services                             |                         | 
|                                     |                         | 
|Total cost of revenues               |                         | 
|                                     |                         | 
|                                    
|Gross profit                         |                         | 
|                                    
|Operating expenses                   |                         | 
|Sale and marketing                   |                         | 
|Research and development             |                         | 
|General and administrative           |                         | 
|Restructuring, lease and asset       |                         | 
|impairment write downs               |                         | 
|                                     |                         | 
|Total operating expenses             |                         | 
|                                    
|Operating loss                       |                         | 
|Interest income (expense), net       |                         | 
|Other income (expense), net          |                         | 
|                                     |                         | 
|Net loss                             |                         | 
|                                     |                         | 
|Basic and diluted net loss per share |                         | 
|                                     |                         | 
|Shares used in computing basic and   |                         | 
|diluted net loss per share           |                         | 
|                                     |                         | 
|                                    
|Balance Sheet Data:                  |                         | 
|                                    
|Cash and cash equivalents            |                         | 
|Investments in government securities |                         | 
|Working capital                      |                         | 
|Total assets                         |                         | 
|Long-term debt, including current    |                         | 
|portion                              |                         | 
|Redeemable convertible preferred     |                         | 
|stock                                |                         | 
|Stockholders equity (deficit) (1)   |                         | 

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

|23
|--

|ITEM 7. MANAGEMENT
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The statements contained
in Managements Discussion and Analysis of Financial Condition and Results
of Operations that are not historical in nature 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. These
forward-looking statements include but are not limited to statements relating to
trends or projected levels of revenue, sales, expenses, losses or profits, and
financial resources. Forward-looking statements are subject to risks and
uncertainties that could cause actual results to differ materially from those
indicated in the forward-looking statements. Factors that could cause or
contribute to such are indicated.


Overview


We develop, market and sell
proprietary training software and other educational products and services. Our
programs and services are based on research on how the brain works and learns.
Language and reading skills are the foundation for all learning, and we have
developed products to help children, adolescents and adults learn how to read or
become better readers. Our language and reading programs, the Fast ForWord®
family, are intensive, computer-based training programs that focus on improving
critical language and reading skills. These training programs are based on
scientific research and have been extensively field-tested. Our initial training
program, Fast ForWord Language focuses on oral language comprehension and
executive function skills critical to learning how to read or becoming a better
reader. Fast ForWord Language to Reading trains critical reading skills as
well as providing additional training on the language comprehension skills
addressed in Fast ForWord Language. Fast ForWord Reading  is designed to
rapidly and systematically build reading skills, focusing on the skills that
correlate directly to school curriculum standards. Fast ForWord Middle and High
School  uses a graphical user interface designed for middle and high
school students to train language comprehension and critical reading skills. We
also sell Reading Edge, a language and reading assessment product, Fast
ForWord Basics software and storybooks, and CrossTrain professional
development software. Our BrainConnection.com Website provides easily accessible
information on brain research and its application to learning and everyday life
as well as professional development courses. It reaches its audience both
through its Website and BrainConnection.com conferences.


We offer professional
development to educators, speech and language professionals and other
professionals. They can learn about recent developments in brain research and
their application to education and the practical application of our programs, in
some cases earning continuing education credit. We also provide technical
support services to our customers on the telephone, through the Internet and in
some cases on-site.


Our primary market is US
public schools. We address this market primarily through a direct sales force.
We also sell through other distribution channels including referrals from speech
and language professionals in private practice, a limited number of independent
sales representatives in the public school and adult education markets and, to a
very minor extent, direct-to-consumer channels including through our Websites.
In 2001, sales to public schools represented approximately 76% of total revenues
compared to 60% in 2000, and 35% in 1999.


We commenced operations in
February 1996, and, until April 1997, we devoted substantially all of our
efforts to developing the Fast ForWord Language program, performing a field
trial, recruiting and training personnel, establishing relationships with, and
training educators and speech and language professionals, and raising capital.
Since the commercial launch of Fast ForWord Language in April 1997, we have also
devoted substantial efforts to sales and marketing activities. We have an
accumulated deficit of $71.8 million from inception through December 31, 2001.
Our goal is to report an operating profit in 2003 in accordance with Generally
Accepted Accounting Principles. We expect to incur additional losses until that
time. These losses may be substantial. During the second half of 2001, we
significantly reduced personnel and operating expenses. In addition, we may be
unable to meet our targets with respect to revenues or operating expenses in
2002 and 2003 and incur substantial additional losses. If we do not meet our
targets, we may incur greater losses than expected and we may be forced to
further reduce our expenses, which may negatively impact our business.


Approximately 76% of our
sales for the year ended December 31, 2001 were to public schools. Due to the
inherent complexity of selling to schools and school districts, our sales cycle
has lengthened as we focused on this market. This trend may continue as a higher
proportion of our business comes from the public school market. As a result, we
may have limited visibility on our future revenues, and such revenues may
fluctuate substantially.


24
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company is currently
developing versions of its products that would not require a connection to the
Internet. As these versions become available, we anticipate that the proportion
of sales that are recognized as revenue upon shipment will increase. We plan to
release these products in 2002.


Critical
Accounting Policies and Estimates


Estimates


The preparation of
financial statements in accordance with Generally Accepted Accounting Principles
requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses. On an on-going basis, we
evaluate estimates, including those related to revenue recognition, allowance
for doubtful accounts, software development costs, asset impairment, and
restructuring costs. Estimates are based on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances.
The results of these estimates form the basis for making judgments about the
amount and timing of revenues, costs and expenses, the carrying values of assets
and the recorded amounts of liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.


Revenue
Recognition


We derive revenue from the
sale of licenses to our software and from service fees. Software license revenue
is recognized in accordance with AICPA Statement of Position 97-2,
Software Revenue Recognition, (SOP 97-2) as amended by Statement of
Position 98-9. SOP 97-2 provides specific industry guidance and stipulates that
revenue recognized from software arrangements is to be allocated to each element
of the arrangement based on vendor specific objective evidence of the relative
fair value of the elements. Our revenue recognition policy is also based on the
Securities and Exchange Commissions Staff Accounting Bulletin 101 (SAB
101) that requires companies who provide an ongoing service to recognize revenue
over the term of the services agreement.


The total amount of
software and services invoiced during a particular period is recorded as
deferred revenues until recognized as revenues. Customers license the right to
use Fast ForWord products and do not acquire or otherwise gain unlimited rights
to use the programs.


Revenues from the licensing
of our software are recognized as follows: 1) for limited term site licenses
revenue is recognized over the life of the license, typically 3 to 12 months; 2)
for individual participant licenses revenue is recognized over the average
duration of the programs use, typically 6 weeks; 3) for perpetual licenses
with no ongoing support requirement revenue is recognized when the product has
been shipped, provided that the fees are fixed or determinable; 4) for perpetual
licenses that require ongoing internet based participant tracking services
revenue is recognized over the period in which the Company provides such
services, typically from 1 to 3 years. The fact that revenue is recognized over
significantly different time periods depending on the type of license sold and
that the type of license a customer will purchase can be unpredictable both
contribute to unpredictability and quarterly variability in our public school
revenues.


Service revenues are
derived from the Companys conferences and training seminars. Revenues from
conferences and seminars are recognized when the event is held.


Allowance for
Doubtful Accounts


The Company maintains an
allowance for doubtful accounts for estimated losses for the inability of the
customer to make payments. These estimates are based on historical experience
and, to date, have been approximately 1% to 2% of revenue. Cancellations and
refunds are allowed in limited circumstances, and such amounts have not been
significant. Provisions are made for cancellations and refunds as revenue is
recorded.


Software
Development Costs


The Company capitalizes
software development cost in accordance with Financial Accounting Standards
Board (FASB) No. 86 Accounting for the Costs of Computer Software to Be
Sold, Leased, or Otherwise Marketed, under which software development
costs incurred subsequent to the establishment of technological feasibility are
capitalized and amortized over the estimated life of the related product.


25
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Prior to the establishment
of technological feasibility we expense all software development cost associated
with a product. Technological feasibility is deemed established upon completion
of a working version. The Company estimates the useful life of its developed
products to be 3 years.


On an ongoing basis, the
Company evaluates the net realizable value of the capitalized software
development cost by estimating the future revenue to be generated from the
product and compares this to the unamortized cost of the product. At December
31, 2001, future revenues from sale of these products are anticipated to be well
in excess of the unamortized development costs.


Impairment of
Long Lived Assets


The Company regularly
reviews the carrying value of capitalized software development costs and
property and equipment. We continually make estimates regarding future cash
flows to determine the fair value of the respective assets. If these estimates
or their related assumptions change in the future, the Company may be required
to record impairment charges for these assets.


26
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Results of
Operations


The following table sets
forth, for the periods indicated, various financial data expressed as a
percentage of revenues (unless otherwise noted).
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               | Year ended December 31, | 
|------------------------------ | ----------------------- | 
|
|Revenues:                      |                         | 
|Programs                       |                         | 
|Services                       |                         | 
|                               |                         | 
|Total Revenues                 |                         | 
|                              
|Cost of sales:                 |                         | 
|Cost of programs (1)           |                         | 
|Cost of services (2)           |                         | 
|                               |                         | 
|Total cost of sales            |                         | 
|                               |                         | 
|                              
|Gross Profit                   |                         | 
|                              
|Expenses:                      |                         | 
|Sales and marketing            |                         | 
|Research and development       |                         | 
|General and administrative     |                         | 
|Restructuring, lease and asset |                         | 
|impairment write downs         |                         | 
|                               |                         | 
|Total operating expenses       |                         | 
|                              
|Operating loss                 |                         | 
|                              
|Interest (expense) income, net |                         | 
|Other income (expense), net    |                         | 
|                               |                         | 
|Net loss                       |                         | 
|                               |                         | 

__________

|(1) |  | Program
costs are expressed as a percentage of program revenues
|--- |  | ---------------------------------------------------------------

|(2) |  | Service
costs are expressed as a percentage of service revenues
|--- |  | ---------------------------------------------------------------

|Year Ended December
31, 2001 Compared to Year Ended December 31, 2000


Revenues


Total revenues increased by
$2.6 million, or 17%, to $17.9 million in 2001 compared to 2000. Program revenue
increased by $1.4 million, or 10%, to $15.5 million in 2001 compared to 2000 as
a result of a 43% increase in revenue from public schools. The increase was
partially offset by a 23% decline in revenue through speech and language
professionals. Service revenues increased by $1.2 million, or 97%, to $2.4
million due to an increase in the number of training sessions for public school
customers, partially offset by a decline in trainings for speech and language
professionals in private practice.


New sales (bookings)
increased $5.6 million, or 36%, to $21.2 million in 2001compared to 2000. New
sales to public schools rose 54% and represented approximately 76% of total
sales in 2001compared to approximately 69% of total sales in 2000. The increase
was primarily due to an increase in the number of site license packages sold to
public and private schools. The Company sold 921 site license packages in 2001
compared to 332 in 2000. Sales to speech and language professionals declined 7%
in 2001 compared to 2000.


27
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Cost of
Revenues


Total cost of revenues
increased by $0.5 million, or 15%, to $4.1 million in 2001 compared to 2000. As
a percentage of revenues, cost of revenues in 2001were approximately equal to
2000 at 23%. Cost of programs consists of costs associated with program sales,
including royalties, manufacturing, packaging, documentation, fulfillment,
amortization of capitalized software costs, Internet hosting for the upload of
performance data, and technical support costs. Cost of programs in 2001were
approximately equal to 2000 at 16%. Service costs consist primarily of the costs
of providing training seminars, including personnel, materials, facilities and
travel. Cost of services as a percent of service revenues decreased to 67% from
105% in 2001 compared to 2000 as we made more multiple site sales and combined
training for several schools at one training location. We anticipate the total
cost of revenue will decrease as a percent of total revenue as we move from an
onsite training model to a regional training model in 2002.


Sales and
Marketing Expenses


Sales and marketing
expenses decreased $1.3 million, or 6%, to $19.7 million in 2001 compared to
2000. The decrease is primarily attributable to a reduction in spending on
advertising and trade shows. Sales and marketing expenses consist principally of
salaries and compensation paid to employees engaged in sales and marketing
activities, advertising and promotional materials, public relations costs and
travel. At December 31, 2001, we had 25 quota-bearing sales personnel selling to
public schools. We expect sales and marketing expense to decline further in 2002
as we continue our cost cutting efforts and increase our focus on the public
school market.


Research and
Development Expenses


Research and development
expenses decreased $2.3 million, or 40%, to $3.4 million in 2001 compared to
2000. The decrease was due to a significant reduction in research and
development staff as we decrease our spending on activities other than improving
our core products. Research and development expenses principally consist of
salaries and compensation paid to employees and consultants engaged in research
and product development activities, product testing, and software and equipment
costs. Once technological feasibility has been established, costs associated
with the development of a product are capitalized. For the years ended December
31, 2001 and 2000 we capitalized $1.2 million and $1.5 million, respectively. We
expect research and development expenses to decline further in 2002.


General and
Administrative Expenses


General and administrative
expenses increased $0.6 million, or 10%, to $6.3 million in 2001 compared to
2000. The increase is attributed to cost associated with moving to our new
facility. General and administrative expenses principally consist of salaries
and compensation paid to Company executives and other employees. These expenses
also include travel expenses for these employees, as well as outside legal and
accounting fees. We anticipate that these costs will decline in 2002 as we
continue cost cutting efforts.


Restructuring,
Lease and Asset Impairment Write Down


During the year ended
December 31, 2001 management approved a plan to restructure operations including
consolidating operations to focus on the public school market. In connection
with the plan, the Company recorded a restructuring, lease and asset impairment
charge of $2.6 million in operating expense. The restructuring resulted in a
workforce reduction of approximately 50 employees and a total charge to
operations for severance benefits of $456,000. All affected employees had been
terminated or notified of their severance benefits as of December 31, 2001. As
of December 31, 2001, termination benefits totaling $374,000 had been paid to
employees. Along with reducing the number of employees, the Company recorded an
asset impairment charge of $361,000 to write down the value of long-lived assets
to net realizable value. The write down included the remaining capitalized
development cost for Reword. This program specifically targets the adult
market, which is not our focus. As well, we reduced the value of furniture and
leasehold improvements related to excess office space.


The Company recorded $1.8
million as a charge to operations in conjunction with excess office space in its
current and former corporate office facilities. For our current facility the
cost included a portion of the lease liability and brokerage fees reduced by
estimated sublease income over the remaining lease term. The estimated cost of
excess lease facilities and the estimated value of the sublease were based on
market information provided by a commercial real estate brokerage firm and may
not represent the actual lease settlements. At December 31, 2001 accrued
liabilities included $1.5 million relating to the excess office space and
termination benefits.


28
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The following table sets
forth the restructuring activity during the year ended December 31, 2001 (in
thousands).
|-----------------------------------------------------------------------------------------------------------------

|                       | Charged torestructuringexpense |  | Cash paid |       |  | Asset write downs |      | Accruedrestructuring costs atDecember 31, 2001 | 
|---------------------- | ------------------------------ |  | --------- | ----- |  | ----------------- | ---- | ---------------------------------------------- | 
|                      
|Lease impairment costs |                                |  | $         | 1,791 |  | $                 | (333 | )                                              | 
|Asset write-downs      |                                |  |           | 361   |  |                   |     |                                                | 
|Severance              |                                |  |           | 456   |  |                   | (374 | )                                              | 
|                      
|Total                  |                                |  | $         | 2,608 |  | $                 | (707 | )                                              | 
|                      

|In 2000 the Company
implemented a restructuring program, resulting in a charge of $492,000. Under the plan we reduced
our workforce by 22 employees and incurred legal costs of $200,000 and asset
impairment charges of $164,000. All such amounts had been paid or written off at
December 31, 2000.


Deferred
Compensation


Deferred compensation
represents the difference between the exercise price and the deemed fair value
of certain stock options granted to employees through December 31, 1999. The
amount is being amortized by charges to operations over the vesting periods of
the individual stock options. Deferred compensation was fully amortized at
December 31, 2001. The amortization amounted to $72,000, $429,000 and $776,000
for the years ended December 31, 2001, 2000 and 1999, respectively. We recorded
no deferred compensation during the years ended December 31, 2001 or 2000.


Interest
Income and Expense


In 2001 we recorded $1.4
million in interest expense and $0.4 million in interest income compared to
$1,000 in interest expense and $1.1 million in interest income in 2000. The
shift was a result of lower cash levels, amortization of deferred financing
costs and interest paid on the line of credit from Fleet National Bank in 2001.


Provision for
Income Taxes


We have recorded no
provision for income taxes as we have incurred losses since inception. At
December 31, 2001, we had net operating loss carryforwards for federal income
tax purposes of approximately $63.4 million. The net operating loss carryforwards
will expire in years 2011 through 2021. Utilization of the net operating losses
may be subject to a substantial annual limitation due to the ownership change
limitations provided by the Internal Revenue Code of 1986. Previous or
contemplated equity transactions may result in such an ownership change. The
annual limitation may result in the expiration of net operating losses before
becoming available to reduce future tax liabilities. At December 31, 2001, we
had approximately $26 million of deferred tax assets, comprised primarily of net
operating loss carryforwards. Realization of deferred tax assets is dependent
upon future earnings, if any, the timing and amount of which are uncertain.
Accordingly, the net deferred tax assets have been fully offset by a valuation
allowance.


Year Ended
December 31, 2000 Compared to Year Ended December 31, 1999


Revenues


Total revenues increased by
$5.0 million, or 49%, to $15.3 million in 2000 compared to 1999. Program revenue
in 2000 increased by $4.9 million, or 54%, to $14.1 million compared to 1999 as
a result of new product introductions and increased sales to public schools.
Revenues through speech and language professionals declined 20%. Service
revenues increased by $67,000, or 6%, to $1.2 million due to an increased number of
trainings for public school customers, partially offset by a decline in
trainings for speech and language professionals in private practice.


29
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Cost of
Revenues


Total cost of revenues
increased by $0.9 million, or 32%, to $3.6 million in 2000 compared to 1999. As
a percentage of revenues, cost of revenues decreased to 23% from 26%. Cost of
program revenue remained relatively constant as a percentage of revenue, and
included an increase in the amortization of capitalized software development
costs. Amortization of software development costs was $384,000 and $80,000 for
the years ended December 31, 2000 and 1999, respectively. In 2000, cost of
services revenues decreased to 105% from 108% compared to 1999 as we increased
our efficiency in training and installations in public schools.


Sales and
Marketing Expenses


Sales and marketing
expenses increased $7.4 million, or 55%, to $21 million in 2000 compared to
1999. This increase was primarily attributable to increased personnel, marketing
and travel costs. At December 31, 2000 we had 26 quota-bearing sales personnel
selling to public schools.


Research and
Development Expenses


Research and development
expenses increased $1.2 million, or 26%, to $5.7 million in 2000
compared to 1999. The increase was primarily due to increases in personnel to
develop products targeted at the public school channel.


General and
Administrative Expenses


General and administrative
expenses increased $1.3 million, or 29%, to $5.7 million in 2000 compared to
1999. This increase was primarily attributable to increased personnel,
consulting, legal and travel costs.


Interest
Income and Expense


In 2000 we recorded $1.1
million in interest income compared to $1.0 million in 1999. The increase in
2000 was the result of excess cash provided by our initial public offering in
August 1999.


Liquidity and
Capital Resources


Net cash used in operating
activities was $12.5 million; $19.5 million and $12.8 million for the years ended
December 31, 2001, 2000 and 1999, respectively. The decrease in cash used in
operating activities during 2001 compared to 2000 was primarily attributable to
decreases in expenses in sales and marketing and research and development,
together with increases in accrued liabilities and deferred revenues. The
increase in accrued liabilities was mostly attributed to restructuring costs to
be paid in future periods (see Note 2 of the Notes to Financial Statements
 Restructuring, Lease and Asset Impairment Write-Downs). The increase in
deferred revenue is attributable to the increase in sales of site licenses to
the public school market, which typically have a longer period over which
revenue is recognized. We expect that the cash required to fund operations will
decline in 2002 based on increased sales and a reduction in expenses as we
continue to focus on the public school market. If we are unable to meet our
sales and revenue targets, or our expenses are higher than our current plans,
our cash consumption could be higher than that of 2001.


Net cash provided by
investing activities was $0.9 million and $3.1 million for the years ended
December 31, 2001 and 2000, and was primarily generated from the sale of
government securities. This was partially offset by an increase in capitalized
software development costs of $1.2 million and $1.5 million for the years ended
December 31, 2001 and 2002, as well as an increase in loans to officers totaling
$3.1 million for the year ended December 31, 2001. Net cash used in investing
activities was $15.7 million in the year ended December 31, 1999 primarily for
purchases of short-term investments.


Net cash provided by
financing activities was $15.4 million, $1.5 million, and $37.8 million in the
years ended December 31, 2001, 2000 and 1999, respectively. Net cash provided by
financing activities in 2001 was from the proceeds of issuance of common stock
and from borrowing under our line of credit. The average interest rate for the
year under the line of credit was 4.6%. Net cash provided by financing
activities in 2000 was primarily due to the exercise of stock options. Cash
provided by financing activities in 1999 was from our initial public offering
and the proceeds of the sale of convertible preferred stock in 1999.


30
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|As of December 31, 2001, we
had cash, cash equivalents and government securities of $5.8 million. We believe
that our cash, cash equivalents and investments in government securities,
combined with the available borrowing capacity under the Fleet National Bank
facility will be sufficient to finance our presently anticipated operating
losses and planned capital expenditure requirements over the next 12 months.
However, our business may fail to meet our cash flow projections and, if so, we
cannot be certain that our cash resources will be sufficient. We therefore may
need to obtain additional equity or debt financing in the future. We may not be
able to obtain the additional financing to satisfy our cash requirements on
acceptable terms or at all. To date the Company has paid no dividends. We have
no plans to initiate dividends in the next 12 months.


We currently have an
outstanding balance of $10 million on our line of credit with Fleet National
Bank. The total credit line is $15 million. The original agreement expires
October 2002. In March 2002, we entered into an agreement with the Bank to
extend the $15 million line of credit to June 30, 2004. The terms and conditions
are substantially the same as the current credit agreement. WPV, Inc., an
affiliate of Warburg Pincus Ventures, a significant stockholder of the Company,
has provided an unlimited guarantee for the facility. The guarantee expires in
March 2004. We also have a non-cancelable lease agreement for our corporate
office facilities. The minimum lease payment on our office facility is
approximately $183,000 per month in 2002. The base lease payment increases at a
compound annual rate of 3%. The lease terminates in March 2009. Minimum lease
payments on our former office facility are approximately, $61,000 per month
through August 2002.


The following summarizes
the Companys outstanding borrowings and contractual obligations at
December 31, 2001 and the effects such obligations are expected to have on our
liquidity and cash flow in future periods (in thousands).
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | Total |  | Less than 1year |        | 1 - 3 years |   | 4 - 8 years | 
|----------------------------------- | ----- |  | --------------- | ------ | ----------- | - | ----------- | 
|                                   
|                                   
|Borrowing under bank line of credit |       |  | $               | 10,000 |             | $ |            | 
|Non-cancelable operating leases     |       |  |                 | 17,506 |             |   | 2,683       | 
|                                   
|Total                               |       |  | $               | 27,506 |             | $ | 2,683       | 
|                                   

|At December 31, 2001 we
have accrued $1.5 million of future non-cancelable operating lease payments
included above on excess office space, less estimated future sublease income.


ITEM 7A.
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 we will
pay on our revolving credit facility with Fleet National Bank (Fleet). Interest
rates on loans extended under that facility are at LIBOR (London Interbank
Offered Rate) plus one percent, or at Fleets Base Rate at our
choice. A hypothetical increase or decrease in market interest rates by 10% from
the market interest rates at December 31, 2001 would not have a material affect
on our expenses or loss.


We also have some market
risk related to interest rate changes due to the increase or decrease in the
amount of interest income we can earn on our investment portfolio. We do not use
derivative financial instruments in our investment portfolio. We ensure the
safety and preservation of our invested principal funds by limiting default
risks, market risk and reinvestment risk. We mitigate default risk by investing
in government securities. A hypothetical increase or decrease in market interest
rates by 10% from the market interest rates at December 31, 2001 would not cause
the fair value of our cash and cash equivalents to change by a material amount.
Declines in interest rates over time will, however, reduce our interest income.


31
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


Report of Ernst &Young
LLP, Independent Auditors


The Board of Directors and
Stockholders Scientific Learning Corporation


We have audited the
accompanying balance sheets of Scientific Learning Corporation (the
Company) as of December 31, 2001 and 2000, and the related
statements of operations, redeemable convertible preferred stock and
stockholders equity (deficit), and cash flows for each of the three years
in the period ended December 31, 2001. Our audit also included the
financial statement schedule included in Item 14. These financial statements and
financial statement schedule are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial
statements and financial statement schedule based on our audits.


We conducted our audits in
accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as 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 at December 31, 2001
and 2000, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2001, in conformity with
accounting principles generally accepted in the United States. Also, in our
opinion, the selected 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


Walnut Creek, California
February 8, 2002,
except for the second paragraph of Note 8, as to which the date is 
March 6, 2002.


32
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Scientific Learning Corporation
                                   Balance Sheet
                (In thousands, except share and per share amounts)
|---------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                          | December 31, | 
|------------------------------------------------------------------------- | ------------ | 
|
|Assets                                                                    |              | 
|                                                                         
|Current assets:                                                           |              | 
|Cash and cash equivalents                                                 |              | 
|Investments in government  securities                                     |              | 
|Accounts receivable, net of allowance for doubtful accounts               |              | 
|$248 and $241 at December 31, 2001 and 2000, respectively                 |              | 
|Prepaid expenses and other current assets                                 |              | 
|                                                                          |              | 
|Total current assets                                                      |              | 
|                                                                         
|Property and equipment, net                                               |              | 
|Notes receivable from officers                                            |              | 
|Other assets                                                              |              | 
|                                                                          |              | 
|Total assets                                                              |              | 
|                                                                          |              | 
|                                                                         
|Liabilities and stockholders equity                                      |              | 
|                                                                         
|Current liabilities:                                                      |              | 
|Accounts payable                                                          |              | 
|Accrued liabilities                                                       |              | 
|Deferred revenue                                                          |              | 
|                                                                          |              | 
|Total current liabilities                                                 |              | 
|                                                                         
|Borrowings under bank line of credit                                      |              | 
|Other liabilities                                                         |              | 
|                                                                          |              | 
|Total liabilities                                                         |              | 
|                                                                         
|Commitments and contingencies                                             |              | 
|                                                                         
|Stockholders equity:                                                     |              | 
|Preferred stock, $0.001 par value:                                        |              | 
|Authorized shares - 1,000,000                                             |              | 
|Issued and outstanding shares - none in 2001 and 2000                     |              | 
|Common stock, $0.001 par value:                                           |              | 
|Authorized shares - 40,000,000                                            |              | 
|Issued and outstanding shares - 15,475,619 in 2001 and 11,336,380 in 2000 |              | 
|Deferred compensation                                                     |              | 
|Accumulated deficit                                                       |              | 
|                                                                          |              | 
|Total stockholders equity                                                |              | 
|                                                                          |              | 
|                                                                         
|Total liabilities and stockholders equity                                |              | 
|                                                                          |              | 

|See accompanying notes.


33
|----------------------------

|Scientific Learning Corporation
                             Statement of Operations
                    (In thousands, except per share amounts)
|-------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | Year ended December 31, | 
|------------------------------------ | ----------------------- | 
|
|Revenues:                            |                         | 
|Programs                             |                         | 
|Services                             |                         | 
|                                     |                         | 
|Total revenues                       |                         | 
|                                    
|Cost of sales:                       |                         | 
|                                    
|Cost of programs                     |                         | 
|Cost of services                     |                         | 
|                                     |                         | 
|Total cost of sales                  |                         | 
|                                     |                         | 
|                                    
|Gross profit                         |                         | 
|                                    
|Expenses:                            |                         | 
|                                    
|Sales and marketing                  |                         | 
|Research and development             |                         | 
|General and administrative           |                         | 
|Restructuring, lease and asset       |                         | 
|impariment write downs               |                         | 
|                                     |                         | 
|Total operating expenses             |                         | 
|                                    
|Operating loss                       |                         | 
|                                    
|Interest (expense) income, net       |                         | 
|Other income (expense), net          |                         | 
|                                     |                         | 
|                                    
|Net loss                             |                         | 
|                                     |                         | 
|                                    
|Basic and diluted net loss per share |                         | 
|                                     |                         | 
|                                    
|Shares used in computing basic and   |                         | 
|diluted net loss per share           |                         | 
|                                     |                         | 

|See accompanying notes.


34
|----------------------------

|Scientific Learning
Corporation


Statements of Redeemable Convertible Preferred Stock and Stockholders Equity (Deficit)
                                                 (In thousands, except share amounts)
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                 |  |  | Stockholders Equity (Deficit) |           
|------------------------------------------------ |  |  | ------------------------------ | ----------
|
|
|                                                 |  | 
|Balances at December 31, 1998                    |  |  |                                | 3,730,156 
|Issuance of common stock under stock option plan |  |  |                                |          
|Issuance of Series D preferred stock, net of     |  | 
|issuance costs                                   |  |  |                                | 555,555   
|Issuance of common stock in initial public       |  | 
|offering, net of offering costs                  |  |  |                                |          
|Conversion of preferred stock to common stock    |  |  |                                | (4,285,711
|Deferred compensation related to grant of        |  | 
|stock options                                    |  |  |                                |          
|Amortization of deferred compensation            |  |  |                                |          
|Net loss and comprehensive loss                  |  |  |                                |          
|                                                 |  | 
|Balances at December 31, 1999                    |  |  |                                |          
|Issuance of common stock under stock option plan |  |  |                                |          
|Issuance of stock under employee stock          
|purchase plan                                    |  |  |                                |           
|Reduction of deferred compensation relating to   |  |  |                                |          
|cancelled stock options                          |  | 
|Amortization of deferred compensation            |  |  |                                |          
|Net loss and comprehensive loss                  |  |  |                                |          
|                                                 |  | 
|Balances at December 31, 2000                    |  |  |                                |          
|Issuance of common stock under stock option plan |  |  |                                |          
|Issuance of common stock under employee stock    |  | 
|purchase plan                                    |  |  |                                |          
|Issuance of common stock in a private            |  | 
|placement, net of offering costs                 |  |  |                                |          
|Issuance of common stock warrants in             |  | 
|connection with guarantee of line of credit      |  |  |                                |          
|Amortization of deferred compensation            |  |  |                                |          
|Net loss and comprehensive loss                  |  |  |                                |          
|                                                 |  | 
|Balance December 31, 2001                        |  |  |                                |          
|                                                 |  | 

|                                                 | Stockholders Equity (Deficit) | 
|------------------------------------------------ | ------------------------------ | 
|
|
|                                                 |                                | 
|Balances at December 31, 1998                    |                                | 
|Issuance of common stock under stock option plan |                                | 
|Issuance of Series D preferred stock, net of     |                                | 
|issuance costs                                   |                                | 
|Issuance of common stock in initial public       |                                | 
|offering, net of offering costs                  |                                | 
|Conversion of preferred stock to common stock    |                                | 
|Deferred compensation related to grant of        |                                | 
|stock options                                    |                                | 
|Amortization of deferred compensation            |                                | 
|Net loss and comprehensive loss                  |                                | 
|                                                 |                                | 
|Balances at December 31, 1999                    |                                | 
|Issuance of common stock under stock option plan |                                | 
|Issuance of stock under employee stock           |                                | 
|purchase plan                                    |                                | 
|Reduction of deferred compensation relating to   |                                | 
|cancelled stock options                          |                                | 
|Amortization of deferred compensation            |                                | 
|Net loss and comprehensive loss                  |                                | 
|                                                 |                                | 
|Balances at December 31, 2000                    |                                | 
|Issuance of common stock under stock option plan |                                | 
|Issuance of common stock under employee stock    |                                | 
|purchase plan                                    |                                | 
|Issuance of common stock in a private            |                                | 
|placement, net of offering costs                 |                                | 
|Issuance of common stock warrants in             |                                | 
|connection with guarantee of line of credit      |                                | 
|Amortization of deferred compensation            |                                | 
|Net loss and comprehensive loss                  |                                | 
|                                                 |                                | 
|Balance December 31, 2001                        |                                | 
|                                                 |                                | 

|See accompanying notes


35
|---------------------------

|Scientific Learning Corporation
                         Statement of Cash Flows
|--------------------------------------------------------------------------------

|                                                                        | Year ended December 31, | 
|----------------------------------------------------------------------- | ----------------------- | 
|
|Operating Activities:                                                   |                         | 
|Net loss                                                                |                         | 
|Adjustments to reconcile net loss to cash used in operating activities: |                         | 
|Depreciation                                                            |                         | 
|Amortization of software development costs                              |                         | 
|Amortization of deferred compensation                                   |                         | 
|Amortization of deferred financing costs                                |                         | 
|Asset impairment write downs                                            |                         | 
|Changes in operating assets and liabilities:                            |                         | 
|Accounts receivable                                                     |                         | 
|Prepaid expenses and other current assets                               |                         | 
|Accounts payable                                                        |                         | 
|Accrued liabilities                                                     |                         | 
|Deferred revenues                                                       |                         | 
|Other liabilities                                                       |                         | 
|                                                                        |                         | 
|                                                                       
|Net cash used in operating activities                                   |                         | 
|                                                                       
|Investing Activities:                                                   |                         | 
|Purchase of government securities                                       |                         | 
|Sale of government securities                                           |                         | 
|Purchases of property and equipment, net                                |                         | 
|Notes receivable from officers                                          |                         | 
|Increase in capitalized software development costs                      |                         | 
|(Increase) decrease in other non-current assets                         |                         | 
|                                                                        |                         | 
|                                                                       
|Net cash provided by (used in) investing activities                     |                         | 
|                                                                       
|Financing Activities:                                                   |                         | 
|Proceeds from issuance of preferred stock, net                          |                         | 
|Proceeds from issuance of common stock, net                             |                         | 
|Borrowings under bank line of credit                                    |                         | 
|Repayments of borrowings under bank line of credit                      |                         | 
|Repayments of capital lease obligations                                 |                         | 
|                                                                        |                         | 
|Net cash provided by  financing activities                              |                         | 
|                                                                        |                         | 
|                                                                       
|Increase (decrease) in cash and cash equivalents                        |                         | 
|                                                                       
|Cash and cash equivalents at beginning of year                          |                         | 
|                                                                        |                         | 
|                                                                       
|Cash and cash equivalents at end of year                                |                         | 
|                                                                        |                         | 
|                                                                       
|Supplemental disclosure                                                 |                         | 
|Interest paid                                                           |                         | 
|                                                                        |                         | 
|Supplemental disclosure of noncash investing and financing activities:  |                         | 
|Issuance of common stock warrants in connection with guarantee          |                         | 
|of line of credit                                                       |                         | 
|                                                                        |                         | 
|Issuance of common stock in connection with conversion of               |                         | 
|redeemable preferred stock and convertible preferred stock              |                         | 
|                                                                        |                         | 
|Deferred compensation                                                   |                         | 
|                                                                        |                         | 

|See accompanying notes.


36
|----------------------------

|1. Summary of
Significant Accounting Policies


Description of
Business


Scientific Learning
Corporation (the Company) was incorporated on November 30, 1995 in
the State of California and was reincorporated on May 2, 1997 in the State of
Delaware. The Company commenced operations in February 1996. The Companys
proprietary Fast ForWord® software is designed to improve language and
reading skills. The Company markets and sells the Fast ForWord programs and
other education products primarily to public and private schools, and through
speech and language professionals in private practice. We also offer training,
professional development and support services to our customers.


Liquidity and
Capital Resources


The Company believes that its
cash, cash equivalents and investments in government securities combined with
the available borrowing capacity under its bank line of credit (see Note 8) will
be sufficient to finance presently anticipated operating losses and planned
capital expenditure requirements over the next 12 months. However, the business
may fail to meet cash flow projections and, if so, the Company may need to
further reduce its operating expenses, and/or obtain additional equity or debt
financing. The Company may not be able to obtain the additional financing to
satisfy its cash requirements on acceptable terms or at all.


Use of
Estimates


The preparation of
financial statements in conformity with generally accepted accounting principles
requires management to make certain estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
liabilities at the date of the financial statements and the reported results of
operations during the reporting period. Actual results could differ from those
estimates.


Cash and Cash
Equivalents


Cash and cash equivalents
consist of cash and highly liquid short-term investments with original
maturities of three months or less.


Investments in
Government Securities


The Company classifies all
of its investments as available-for-sale securities. Such investments consist of
United States Government and Federal Agency securities, which are carried at
amounts, which approximate fair value, with unrealized gains and losses on such
securities reflected as other comprehensive income (loss) in stockholders
equity (deficit) until disposition. Unrealized gains and losses have not been
material. Realized gains and losses on investments in government securities are
included in interest income. There were no realized gains or losses in the years
ended December 31, 2001 or 2000. Amortized cost approximates the fair market
value of the available-for-sale securities at December 31, 2001 and 2000.


Accounts
Receivable


The Company conducts
business with public school districts and speech and language professionals
primarily in the United States. Ongoing credit evaluations are performed on
customers and collateral is generally not required. Allowances for uncollectible
accounts are made for potential credit issues and such allowances and issues to
date have not been material. Accounts receivable included unbilled amounts of $0
and $94,000at December 31, 2001 and 2000, respectively.


Fair Value of
Financial Instruments


The carrying amounts of the
Companys cash and cash equivalents, investments in government securities,
accounts receivable, and accounts payable approximate fair value. The Company
determines the fair value of its investments in government securities based on
quoted market prices.


37
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1. Summary of
Significant Accounting Policies (continued)


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.


Software
Development Costs


The Company accounts for
software development costs in accordance with Statement of Financial Accounting
Standards (FAS) No. 86, Accounting for the Costs of Computer
Software to be Sold, Leased or Otherwise Marketed, under which certain
software development costs incurred subsequent to the establishment of
technological feasibility are capitalized and amortized over the estimated lives
of the related products. Technological feasibility is established upon
completion of a working model. The Company capitalized $1,153,000 and $1,452,000
of software development costs for the years ended December 31, 2001 and 2000,
respectively. Software costs are amortized over the estimated useful life of the
software, which is three years. Amortization was $493,000 and $384,000 for the
years ended December 31, 2001 and 2000, respectively.


Accounting for
Stock-Based Compensation


The Company accounts for
employee stock options using the intrinsic value method in accordance with
Accounting Principles Board Opinion No. 25 (APB 25) and makes the
pro forma disclosures required by FAS No. 123, Accounting for Stock-Based
Compensation (FAS 123) (Note 10).


Long-Lived
Assets


In accordance with
Statement of Financial Accounting Standards No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of, the Company continually reviews long-lived assets to assess
recoverability based upon undiscounted cash flow analysis. Impairments, if any,
are recognized in operating results in the period in which a permanent
diminution in value is determined.


Revenue
Recognition


We derive revenue from the
sale of licenses to our software and from service fees. Software license revenue
is recognized in accordance with AICPA Statement of Position 97-2,
Software Revenue Recognition, (SOP 97-2) as amended by Statement of
Position 98-9. SOP 97-2 provides specific industry guidance and stipulates that
revenue recognized from software arrangements is to be allocated to each element
of the arrangement based on vendor specific objective evidence of the relative
fair value of the elements. Our revenue recognition policy is also based on the
Securities and Exchange Commissions Staff Accounting Bulletin 101 (SAB
101) that requires companies who provide an ongoing service to recognize revenue
over the term of the services agreement.


The total value of software
and services invoiced during a particular period is recorded as deferred
revenues until recognized. Customers license the right to use Fast ForWord
programs and do not acquire or otherwise gain unlimited rights to use the
programs.


Revenues from the licensing
of our software are recognized as follows: 1) for limited term site licenses
revenue is recognized over the life of the license, typically 3 to 12 months; 2)
for individual participant licenses revenue is recognized over the average
duration of the programs use, typically 6 weeks; 3) for perpetual licenses
with no ongoing support requirement revenue is recognized when the product has
been shipped, provided that the fees are fixed or determinable; 4) for perpetual
licenses that require ongoing internet based participant tracking services
revenue is recognized over the period in which the Company provides such
services, typically from 1 to 3 years.


Service revenues are
derived from the Companys conferences and training seminars. Revenues from
conferences and seminars are recognized when the event is held.


38
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1. Summary of
Significant Accounting Policies (continued)


Advertising


Advertising costs are
expensed as incurred. Advertising expense was $61,000, $1,313,000 and $357,000
for the years ended December 31, 2001, 2000 and 1999, respectively.


Income Taxes


The Company accounts for
income taxes in accordance with SFAS No. 109, Accounting for Income
Taxes, which requires the use of the liability method in accounting for
income taxes. Under SFAS No. 109, 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 Loss Per
Share


Basic and diluted net loss
per share information for all periods is presented under the requirement of FAS
No. 128, Earnings per Share (FAS 128). Basic earnings
per share have been computed using the weighted-average number of shares
outstanding during the period and excludes any dilutive effects of stock
options, warrants, and convertible securities. Potentially dilutive securities
have been excluded from the computation of diluted net loss per share, as their
inclusion would be antidilutive.


If the Company had reported
net income, the calculation of diluted earnings per share would have included
approximately an additional 36,000, 463,000 and 996,000 common equivalent shares
(computed using the treasury stock method) related to the outstanding options
and warrants not included above for the years ended December 31, 2001, 2000 and
1999, respectively.


Recent
Accounting Pronouncements


In July 2001, the Financial
Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangible Assets, SFAS No. 141 eliminates
the pooling-of interests method of accounting for business combinations, except for
qualifying business combinations that were initiated prior to July 1, 2001. Under SFAS
No. 142, goodwill and indefinite-lived intangible assets are no longer amortized, but are
reviewed annually, or more frequently if impairment indicators arise, for impairment. The
Company is required to adopt SFAS No. 142 effective on January 1, 2002. The Company does
not believe the adoption of SFAS Nos. 141 and 142 will have a material effect on its
financial statements.


In August 2001, the FASB
issued No 143, Accounting for Assets Retirement Obligations. SFAS
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made. The associated asset retirement costs are
capitalized as part of the carrying amount of the long-lived assets. The Company
is required to adopt SFAS No. 143 effective on January 1, 2003, and it does not
believe the adoption of SFAS No. 143 will have a material effect on its
financial statements.


In October 2001, the FASB
issued SFAS No. 144, Accounting for the Impairment of Disposal of
Long-Lived Assets, which supersedes SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets to Be Disposed Of, and provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used and those assets expected to be disposed of by sale. SFAS No. 144 also
broadens the definition of what constitutes a discontinued operation and how the
results of a discontinued operation are to be measured and presented. The
Company is required to adopt SFAS No 144 effective on January 1, 2002, and it
does not believe the adoption of SFAS No. 144 will have a material effect on its
financial statements.


39
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1. Summary of
Significant Accounting Policies (continued)


Reclassifications


Certain reclassifications
have been made to the prior year balances to conform to the current
presentation.


2.
Restructuring, Lease and Asset Impairment Write Downs


During the year ended
December 31, 2001 management approved a plan to restructure operations including
consolidating operations to focus on the public school market. In connection
with the plan, the Company recorded a restructuring, lease and asset impairment
charge of $2.6 million in operating expense. The restructuring resulted in a
workforce reduction of approximately 50 employees and a total charge to
operations for severance benefits of $456,000. All affected employees had been
terminated or notified of their severance benefits as of December 31, 2001. As
of December 31, 2001, termination benefits totaling $374,000 had been paid to
employees. Along with reducing the number of employees, the Company recorded an
asset impairment charge of $361,000 to write down the value of long-lived assets
to net realizable value. The write down included the remaining capitalized
development cost for Reword. This program specifically targets the adult
market, which is not our focus. As well, we reduced the value of furniture and
leasehold improvements related to excess office space.


The Company recorded $1.8
million as a charge to operations in conjunction with excess office space in its
current and former corporate office facilities. For our current facility the
cost included a portion of the lease liability and brokerage fees reduced by
estimated sublease income over the remaining lease term. The estimated cost of
excess lease facilities and the estimated value of the sublease were based on
market information provided by a commercial real estate brokerage firm and may
not represent the actual final lease settlements. At December 31, 2001 accrued
liabilities included $1.5 million relating to the excess office space and
termination benefits.


The following table sets
forth the restructuring activity during the year ended December 31, 2001 (in
thousands).
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                       | Charged torestructuringexpense |  | Cash paid |       |  | Asset write downs |      | Accruedrestructuring costs atDecember 31, 2001 | 
|---------------------- | ------------------------------ |  | --------- | ----- |  | ----------------- | ---- | ---------------------------------------------- | 
|                      
|Lease impairment costs |                                |  | $         | 1,791 |  | $                 | (333 | )                                              | 
|Asset write-downs      |                                |  |           | 361   |  |                   |     |                                                | 
|Severence              |                                |  |           | 456   |  |                   | (374 | )                                              | 
|                      
|Total                  |                                |  | $         | 2,608 |  | $                 | (707 | )                                              | 
|                      

|In 2000 the Company
implemented a restructuring program, resulting in a charge of $492,000. Under the plan we reduced
our workforce by 22 employees and incurred legal costs of $200,000 and asset
impairment charges of $164,000. All such amounts had been paid or written off at
December 31, 2000.


3. Prepaid
Expenses and Other Current Assets


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

| |  | December 31, |                                              | 
| |  | ------------ | -------------------------------------------- | 
|
| |  |              |                                             
| |  |              | Prepaid expenses                             | 
| |  |              | Inventory of product and marketing materials | 
| |  |              | Other receivables                            | 
| |  |              |                                             
| |  |              |                                              | 
| |  |              |                                             

|40
|--

|4. Property
and Equipment


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

| |  | December 31, |                                | 
| |  | ------------ | ------------------------------ | 
|
| |  |              |                               
| |  |              | Computer equipment             | 
| |  |              | Office furniture and equipment | 
| |  |              | Leasehold improvements         | 
| |  |              |                               
| |  |              |                                | 
| |  |              | Less accumulated depreciation  | 
| |  |              |                               
| |  |              |                                | 
| |  |              |                               

|5. Notes
Receivable from Officers


Notes receivable from
officers were $3,114,000 and zero for the years ended December 31, 2001 and
2000, respectively. The Notes are full recourse loans secured by shares of the
Companys Common Stock owned by the Officers and bear interest at 4.94%.
Principal and interest are due December 31, 2005.


6. Other Assets


Other assets consist of the
following (in thousands):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | December 31, |                                 | 
| |  | ------------ | ------------------------------- | 
|
| |  |              |                                
| |  |              | Software development cost       | 
| |  |              | Less accumulated amortization   | 
| |  |              |                                
| |  |              | Software development costs, net | 
| |  |              | Deferred financing cost, net    | 
| |  |              | Other non current assets        | 
| |  |              |                                
| |  |              |                                 | 
| |  |              |                                

|7. Accrued
Liabilities


Accrued liabilities consist
of the following (in thousands):
|-------------------------------------------------------------------------------------

| |  | December 31, |                               | 
| |  | ------------ | ----------------------------- | 
|
| |  |              |                              
| |  |              | Accrued restructuring costs   | 
| |  |              | Accrued vacation              | 
| |  |              | Accrued commissions and bonus | 
| |  |              | Other accrued liabilities     | 
| |  |              | Employee stock purchase plan  | 
| |  |              |                              
| |  |              |                               | 
| |  |              |                              

|8. Bank Line of Credit


In March 2001, the Company
entered into a revolving loan agreement with a bank for an unsecured revolving
credit facility in the amount of $15,000,000, expiring October 2002. Borrowings
under the loan agreement bear interest at the election of the Company at the
rate of Libor plus one percent or the banks Base Rate. WPV,
Inc., an affiliate of Warburg, Pincus Ventures, a significant stockholder of the
Company, has provided an unlimited guarantee for the facility. The guarantee
expires in March 2004. In consideration of the guarantee the Company granted a
security interest in substantially all of the Companys assets and issued
WPV, Inc., a fully


41
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|8. Bank Line of Credit
(continued)


vested warrant to purchase 1,375,000 shares
of common stock of the Company at an exercise price of $8.00. The warrant will
expire March 9, 2008. The estimated value of the warrant at the date of issuance
was $3.6 million and is being amortized by a charge to interest expense over the
three-year term of the guarantee.


In March 2002, we entered
into an agreement with the Bank to extend the $15 million line of credit to June
30, 2004. The terms and conditions are substantially the same as the current
Credit Agreement.


9. Income Taxes


There has been no provision for U.S.
federal, U.S. state or foreign income taxes for any period as the Company has incurred
operating losses in all periods and for all jurisdictions.


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

|                                           | December 31, | 
|------------------------------------------ | ------------ | 
|
|                                           |              | 
|Deferred tax assets:                       |              | 
|Net operating loss carryforwards           |              | 
|Restructuring reserve                      |              | 
|Capitalized research and development costs |              | 
|Deferred revenue                           |              | 
|Research credits carryforwards             |              | 
|Other                                      |              | 
|                                           |              | 
|Total deferred tax assets                  |              | 
|Valuation allowance                        |              | 
|                                           |              | 
|Net deferred tax assets                    |              | 
|                                           |              | 

|Realization of deferred tax
assets is dependent upon future earnings, if any, the timing and amount of which
are uncertain. Accordingly, the net deferred tax assets have been fully offset
by a valuation allowance. The valuation allowance increased by $6,754,000 and
$7,565,000 during the years ended December 31, 2001 and 2000, respectively.


As of December 31, 2001,
the Company had net operating loss carryforwards for federal income tax purposes
of approximately $63,400,000, which expire in the years 2011 through 2021. The
Company had net operating loss carryforwards for state income tax purposes of
approximately $26,500,000 expiring in the years 2003 through 2011.


Utilization of the
Companys net operating loss carryforwards may be subject to substantial
annual limitation due to the ownership change limitation provided by the
Internal Revenue Code and a similar state provision. Such an annual limitation
could result in the expiration of the net operating loss carryforwards before
utilization.


10.
Stockholders Equity


Initial Public
Offering


In July 1999, the Company
issued 2,300,000 shares of common stock in an initial public offering at a price
of $16.00 per share. The net proceeds to the Company from that offering were
approximately $33.1 million after deducting the underwriters discount and
offering expenses. In addition, upon completion of the initial public offering,
each outstanding share of the Companys convertible preferred stock was
automatically converted into one share of common stock.


42
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Common Stock


At December 31, 2001, the
Company had reserved shares of common stock for future issuance as follows:
|--------------------------------------------------------------------------------------------------------------------

| |  |  | Stock Options outstanding                 |  |  |  | 1,653,166 | 
| |  |  | ----------------------------------------- |  |  |  | --------- | 
| |  |  | Stock Options available for future grants |  |  |  | 654,596   | 
| |  |  | Common stock warrants                     |  |  |  | 1,498,888 | 
| |  | 
| |  |  |                                           |  |  |  | 3,806,650 | 
| |  | 

|Stock Split


In May 1999, the
Companys stockholders approved a two-for-three reverse stock split of
issued and outstanding common and preferred stock. All common and preferred
share prices, and amounts associated with rights, preferences, dividends and
privileges in the accompanying financial statements have been retroactively
adjusted to reflect the stock split.


Stock Options


The Companys stock
option plans provide for the issuance of incentive stock options (ISO) or
nonstatutory stock options (NSO) to eligible participants. The ISOs may be
granted at a price per share not less than the fair market value at the date of
grant. The NSOs may be granted at a price per share not less than 85% of the
fair market value at the date of grant. Certain options previously granted can
be exercised prior to vesting, but, if so exercised, these unvested shares are
subject to repurchase by the Company. Options and unvested shares granted
generally vest over a period of four or five years. Options under the plan have
a maximum term of 10 years. In the event option holders cease to be employed by
the Company, all unvested options are forfeited and all vested options may be
exercised within a 90-day period after termination. The 90-day exercise period
is sometimes extended by agreement with the optionee, which could result in
modification charges to operations. The Company also has the right to repurchase
at the original purchase price any unvested (but issued) shares if the holder is
no longer employed by the Company. At December 31, 2001 there were no
outstanding shares subject to such repurchase. At December 31, 2000, there were
6,181 outstanding shares subject to such repurchase.


In May 1999, the
Companys stockholders approved the 1999 Equity Incentive Plan, which
amends and restates the Companys existing stock option plan. There are
3,292,666 shares of common stock authorized for issuance under the plan,
including shares originally authorized under predecessor plans and shares added
to the plan in 2000.


In May 1999, the
Companys stockholders approved the 1999 Non-Employee Directors Stock
Option Plan and reserved an aggregate of 75,000 shares of common stock for
grants of stock options under the plan.


43
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.
Stockholders Equity (continued)


A summary of the
Companys stock option activity under the plans is as follows:
|----------------------------------------------------------------------------------------------------------------------

|                                 | Outstanding Options
|-------------------------------- | -------------------
|
|                                 |                    
|Outstanding at December 31, 1998 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 1999 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 2000 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 2001 |                    
|                                 |                    
|Exercisable                      |                    
|                                 |                    

|The following table
summarizes information concerning outstanding and exercisable stock options at
December 31, 2001:
|---------------------------------------------------------------------------------------------------------------------

|                        | Outstanding | Vested andExercisable
|----------------------- | ----------- | ---------------------
|
|
|                        |             |                      
|$   0.2600  $   6.0000 |             |                      
|$   6.0313  $   6.1250 |             |                      
|$   6.2500  $ 11.2500  |             |                      
|$ 14.0000  $ 17.7500   |             |                      
|$ 18.5000  $ 39.8750   |             |                      
|                        |             |                      
|                        |             |                      
|                        |             |                      

|The Company recorded
deferred compensation of $278,000 during the year ended December 31, 1999,
representing the difference between the exercise price and the deemed fair value
of certain of the Companys stock options granted to employees. The amount
is being amortized by charges to operations over the vesting periods of the
individual stock options using a graded method. Such amortization amounted to
$72,000, $429,000, and $776,000, for the years ended December 31, 2001, 2000,
and 1999, respectively. Deferred compensation has now been fully amortized to
operating expense. No deferred compensation was recorded in the years ended
December 31, 2001 or 2000.


44
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Common Stock
Warrants


In 2001 the Company issued
a fully vested non-forfeitable warrant to purchase 1,375,000 shares of common
stock of the Company at an exercise price of $8.00. The warrant was issued to
WPV, Inc., an affiliate of a significant stockholder of the Company, in
connection with the guaranty of a line of credit to the Company. The warrant
will expire in 2008. The estimated value of the warrant at the date of issuance
was $3.6 million. The value of the warrant was determined using the
Black-Scholes model with the following assumptions: a share price of $3.88,
volatility of .85, a risk-free internet rate of 4.94%, no dividend yield and an
expected life of seven years.


In 1999 the Company issued
a fully vested warrant to purchase 7,222 shares of Series D Preferred Stock of
the Company at an exercise price of $7.50. The warrant was issued to the
placement agent in the Series D Preferred Stock offering and was converted to an
equivalent number of common stock on completion of the initial public offering.
The warrant will expire in 2004.


In 1998 the Company issued
warrants to purchase 116,666 shares of common stock at $9.00 per share. The
warrants were issued to a significant stockholder of the Company in connection
with loans and loan guarantees to the Company. The warrants expire in 2003. The
Company estimated the fair value of the warrants to be $780,000, which was
amortized by charges to interest expense during the year ended December 31,
1998.


Pro Forma
Disclosures of the Effect of Stock-Based Compensation


Pro forma information
regarding results of operations and net loss per share is required by FAS 123,
which also requires that the information be determined as if the Company had
accounted for its employee stock options under the fair value method of FAS 123.
The fair value for these options was estimated at the date of grant using the
minimum value method with the following weighted-average assumptions: a
risk-free interest rate of 4.5%, 5.8%, and 6.0%, for the years ended December
31, 2001, 2000, and 1999, respectively, no dividend yield, and a
weighted-average expected life of the option of five years.


The option valuation models
were developed for use in estimating the fair value of traded options that have
no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions, including
the expected life of the option. Because the Companys employee stock
options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially
affect the fair value estimate, in managements opinion, the existing
models do not necessarily provide a reliable single measure of the fair value of
its employee stock options.


Had compensation cost for
the Companys stock-based compensation plans been determined using the fair
value at the grant dates for awards under those plans calculated using the
minimum value method of FAS 123, the Companys net loss and pro forma basic
and diluted net loss per share would have been increased to the pro forma
amounts indicated below:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               | Year ended December 31, | 
|---------------------------------------------- | ----------------------- | 
|
|Pro forma net loss (in thousands)              |                         | 
|                                               |                         | 
|Pro forma basic and diluted net loss per share |                         | 
|                                               |                         | 

|45
|--

|10.
Stockholders Equity (continued)


The weighted-average fair
value of options granted, which is the value assigned to the options under FAS
123, was $2.51, $10.70, and $8.58 for options granted during the years ended
December 31, 2001, 2000 and 1999, respectively.


1999 Employee
Stock Purchase Plan


In May 1999 the
stockholders approved the 1999 Employee Stock Purchase Plan, which became
effective upon the completion of the initial public offering of the
Companys common stock. The Company has reserved a total of 350,000 shares
of common stock for issuance under the plan. Eligible employees may purchase
common stock at 85% of the lesser of the fair market value of the Companys
common stock on the first day of the applicable one-year offering period or the
last day of the applicable six-month purchase period. The Company issued 131,844
and 94,240 shares of common stock under the plan during the years ended December
31, 2001 and 2000, respectively. At December 31, 2001, 123,916 shares were
available for issuance under the Plan.


11. Commitments


Leases


The Company leases its
corporate office facilities under a non-cancelable operating lease with a term
of eight years. As well, the Company has an ongoing lease obligation through
September 2002, for space in its former office facility. Future minimum payments
under both leases as of December 31, 2001 are as follows (in thousands):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             | 
|---------------------------- | 
|2002                         | 
|2003                         | 
|2004                         | 
|2005                         | 
|2006 and thereafter          | 
|                             | 
|Total minimum lease payments | 
|                             | 

|During the year ended
December 31, 2001 the Company signed a sublease agreement for approximately 20%
of the space at its current corporate office facility. Under the sublease
agreement the Company will receive $400,000 and $240,000 for the years ended
December 31, 2002 and 2003, respectively.


Rent expense under all
operating leases was $2,000,000, $1,022,000 and $1,068,000 for the years ended
December 31, 2001, 2000 and 1999, respectively.


The Company has the option
to extend the operating lease covering its new corporate office facility for two
five-year terms at the end of the original lease term, provided that certain
conditions of the lease agreement are met.


License
Agreement


In September 1996, the
Company entered into a license agreement with a university for the use of the
intellectual property underlying its training methods. In exchange for the
license, the Company issued 131,192 shares of Series A preferred stock and paid
the university a license-issue fee of $200,000. In March 1997, the number of
shares of Series A preferred stock issued under the agreement was reduced to
114,526. On completion of the initial public offering these shares were
converted to an equivalent number of common shares.


46
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|11.
Commitments (continued)


Under the agreement,
additional royalties and milestone payments are payable to the university based
upon revenues from products using the licensed technology. Royalty and milestone
expenses were $635,000, $870,000, and $612,000 for the years ended
December 31, 2001, 2000, and 1999, respectively, and are included in cost
of revenues.


If the Company loses or is
unable to maintain the license agreement during the term of the underlying
patents, it would materially harm its business. It could delay or prevent the
introduction of new products and would likely require the recall of most of the
Companys products from the market. Even if the Company could identify and
license or develop non-infringing equivalent technology, which is far from
certain, the cost and delays from such a changeover in the Companys base
technology would cause material harm to the Companys business. The
University may terminate the license agreement if the Company fails to perform
or violates its terms without curing the violation within 60 days of receiving
written notice of the violation.


12. Employee
Retirement and Benefit Plan


The Company has 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.
The Company does not match contributions by plan participants.


13. Interim financial
information (unaudited)


Quarterly financial data (in thousands)
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                    | 2001 | 
|------------------- | ---- | 
|
|
|                    |      | 
|Net sales           |      | 
|                   
|Gross Profit        |      | 
|                   
|Net Loss            |      | 
|Net Loss per share  |      | 
|(basic and diluted) |      | 

|                    | 2000 | 
|------------------- | ---- | 
|
|
|                    |      | 
|Net sales           |      | 
|                   
|Gross Profit        |      | 
|                   
|Net Loss            |      | 
|Net Loss per share  |      | 
|(basic and diluted) |      | 

|ITEM 9. CHANGES IN AND
DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


Not applicable.


47
|-------------------------------------------------------------------------------------------------------------------

|Part III


ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES


The information required by
this item with respect to our executive officers is contained in Part I
Executive Officers.


Information respecting our
directors is set forth under the caption Election of Directors in
our Proxy Statement relating to our 2002 Annual Meeting of Stockholders 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 respecting
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.


ITEM 11.
EXECUTIVE COMPENSATION


Information concerning
executive compensation is set forth under the captions Executive
Compensation, Stock Option Grants and Exercises,
Aggregated Option Exercises in 2001 and Year-end Option Values and
Compensation Committee Interlocks and Insider Participation in the
Proxy Statement and is incorporated by reference into this Form 10-K Report.


ITEM 12. SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


Information 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.


ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


Information concerning
certain relationships and related transactions is set forth under the captions
Employment Agreements and Certain Transactions in the
Proxy Statement and is incorporated by reference into this Form 10-K Report.


48
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART IV


ITEM 14. EXHIBITS,
FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|----------------------------------------------------------------------------------

|(a) |  | Documents
filed as part of this report.
|--- |  | ---------------------------------------

| |  | (1) |  | Financial
Statements
| |  | --- |  | --------------------

| | Independent Auditors Report
              Balance Sheet  December 31, 2001 and 2000
              Statement of Operations  Years Ended December 31, 2001, 2000 and 1999
              Statements of Redeemable Convertible Preferred Stock and
                 Stockholders Equity (Deficit)  Years Ended December 31, 2001, 2000 and 1999
              Statement of Cash Flows  Years Ended December 31, 2001, 2000 and 1999
              Notes to the 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)
| | -------------------------------------------------------------

| | Valuation
and Qualifying Accounts which are deducted in the Balance Sheet from the assets to which
they apply:
| | --------------------------------------------------------------------------------------------------------------

| | Allowance
for Doubtful Accounts Years ended December 31:
| | --------------------------------------------------------

| |  | OpeningBalance | Charges toOperatingExpenses | Charges toAllowance (1) | Deductions | ClosingBalance |    
| |  | -------------- | --------------------------- | ----------------------- | ---------- | -------------- | ---
| | 
| |  |                | 2001                        |                         |            | $              | 241
| |  |                | 2000                        |                         |            | $              | 271
| |  |                | 1999                        |                         |            | $              | 33 

| |  | (3) |  | Exhibits
| |  | --- |  | --------

| |  | Exhibit No. |  | Description
of Document
| |  | ----------- |  | -----------------------

| |  | 3.3(1) |  | Restated
Certificate of Incorporation.
| |  | ------ |  | --------------------------------------

| |  | 3.4(1) |  | Amended
and Restated Bylaws.
| |  | ------ |  | ----------------------------

| |  | 4.1(1) |  | Reference
is made to Exhibits 3.3 and 3.4.
| |  | ------ |  | ------------------------------------------

| |  | 4.2(2) |  | Amended
and Restated Registration Rights Agreement, dated as of December 31, 1998.
| |  | ------ |  | ----------------------------------------------------------------------------------

| |  | 4.3(1) |  | Specimen
Stock Certificate.
| |  | ------ |  | ---------------------------

| |  | 4.4(3) |  | Amendment
No. 1 by and among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P. and
WPV, Inc., effective as of March 9, 2001 to Amended and Restated Registration Rights
Agreement entered into as of December 30, 1998
| |  | ------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 4.5(12) |  | Amendment
No. 2 By and Among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P. and
WPV, Inc., Effective as of November 30, 2001 to Amended and Restated Registration Rights
Agreement Entered Into as of December 30, 1998
| |  | ------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.1(1) |  | Form
of Indemnity Agreement with each of our directors and executive officers.
| |  | ------- |  | ------------------------------------------------------------------------------

|_____________
|-------------

|(1) |  | The
Company invoiced certain customers whose accounts were deemed potentially uncollectible.
As such, the accounts were entirely reserved for and no amounts were recognized as
revenue.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|49
|--

|
|

| |  | 10.2(4) |  | 1999
Equity Incentive Plan, as amended.
| |  | ------- |  | ---------------------------------------

| |  | 10.3(5) |  | Form
of Stock Option Agreement under the Incentive Plan.
| |  | ------- |  | --------------------------------------------------------

| |  | 10.4(5) |  | Form
of Stock Option Grant Notice under the Incentive Plan.
| |  | ------- |  | -----------------------------------------------------------

| |  | 10.5(1) |  | 1999
Non-Employee DirectorsStock Option Plan.
| |  | ------- |  | ----------------------------------------------

| |  | 10.6(1) |  | Form
of Nonstatutory Stock Option Agreement under the Non-Employee DirectorsStock Option
Plan (Initial Grant).
| |  | ------- |  | ---------------------------------------------------------------------------------------------------------------

| |  | 10.7(1) |  | Form
of Nonstatutory Stock Option Agreement under the Non-Employee DirectorsStock Option
Plan (Annual Grant).
| |  | ------- |  | --------------------------------------------------------------------------------------------------------------

| |  | 10.8(1) |  | 1999
Employee Stock Purchase Plan.
| |  | ------- |  | ----------------------------------

| |  | 10.9(1) |  | Form
of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan.
| |  | ------- |  | ------------------------------------------------------------------------------------------

| |  | 10.10(1) |  | Consulting
Agreement, dated as of September 20, 1996, with Dr. Michael M. Merzenich, as modified on
January 19, 1998.
| |  | -------- |  | ---------------------------------------------------------------------------------------------------------------------

| |  | 10.11(1) |  | Consulting
Agreement, dated as of September 19, 1996, with Dr. Paula A. Tallal, as modified on
January 22, 1998.
| |  | -------- |  | ----------------------------------------------------------------------------------------------------------------

| |  | 10.12 |  | Letter
agreements dated as of December 12, 2001, extending the Consulting Agreements filed as
Exhibits 10.10 and 10.11
| |  | ----- |  | ----------------------------------------------------------------------------------------------------------------------

| |  | 10.13(1) |  | Exclusive
License Agreement, dated September 27, 1996, with the Regents of the University of
California.
| |  | --------- |  | --------------------------------------------------------------------------------------------------------

| |  | 10.14(1) |  | Lease
Agreement, dated as of July 31, 1997, with GBC-University Associates, L.P.
| |  | -------- |  | --------------------------------------------------------------------------------

| |  | 10.15(1) |  | Securities
Purchase Agreement, dated September 24, 1996, with Warburg, Pincus Ventures, L.P.
| |  | -------- |  | --------------------------------------------------------------------------------------------

| |  | 10.16(4) |  | Lease,
dated as of March 20, 2000, with Rotunda Partners II.
| |  | -------- |  | ------------------------------------------------------------

| |  | 10.17(6) |  | First
Amendment and Second Amendment to Lease dated as of March 20, 2000, with Rotunda Partners
II.
| |  | -------- |  | ---------------------------------------------------------------------------------------------------

| |  | 10.18(7) |  | Revolving
Loan Agreement dated as of March 9, 2001 by and between Scientific Learning Corporation
and Fleet National Bank
| |  | -------- |  | -------------------------------------------------------------------------------------------------------------------------

| |  | 10.19(8) |  | Agreement
to Issue Warrant and Grant of Security Interest dated as of March 9, 2001 by and between
Scientific Learning Corporation and WPV, Inc
| |  | -------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.20(9) |  | Warrant
to Purchase 1,375,000 Shares of Common Stock of Scientific Learning Corporation
| |  | -------- |  | ---------------------------------------------------------------------------------------

| |  | 10.21(10) |  | Loan
agreements, promissory notes and pledge agreements with each of Sheryle Bolton, Frank
Mattson, Steve Miller, and James Mills
| |  | --------- |  | ---------------------------------------------------------------------------------------------------------------------------------

| |  | 10.22(11) |  | Stock
Purchase Agreement dated November 9, 2001 between Scientific Learning Corporation and
Warburg Pincus Ventures, L.P.
| |  | --------- |  | -------------------------------------------------------------------------------------------------------------------------

| |  | 10.23 |  | Letter
Agreement dated March 12, 2002 between the Company and Sheryle Bolton.
| |  | ----- |  | -----------------------------------------------------------------------------

| |  | 10.24 |  | First
Amendment Agreement, dated March 26, 2002, between the Company and Fleet National Bank
amending the agreement filed as Exhibit 10.18.
| |  | ----- |  | -------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.25 |  | 2002
Management Incentive Plan.
| |  | ----- |  | -------------------------------

| |  | 23.1 |  | Consent
of Ernst &Young LLP, Independent Auditors
| |  | ---- |  | -------------------------------------------------

| |  | (1) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys
Registration Statement on Form S-1 (SEC File No. 333-77133).
| |  | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (2) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-K for the year ended December 31, 1999 (SEC File No. 000-24547).
| |  | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (3) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
8-K on March 12,2001 (SEC File No. 000-24547).
| |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

| |  | (4) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended June 30, 2000 (SEC File No. 000-24547).
| |  | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (5) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended March 31, 2001 (SEC File No. 000-24547).
| |  | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (6) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended June 30,2001 (SEC File No. 000-24547).
| |  | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (7) |  | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------

| |  | (8) |  | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------

|50
|--

|
|

| |  | (9) |  | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------

| |  | (10) |  | Incorporated
by reference to Exhibit 10.20 previously filed with the Companys Form 10-Q for the
quarter ended March 31, 2001 (SEC File No. 000-24547).
| |  | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (11) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended September 30, 2001 (SEC File No. 000-24547).
| |  | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (12) |  | Incorporated
by reference to Exhibit 4.4 previously filed with the Companys Form 8-K on December
7,2001 (SEC File No. 000-24547).
| |  | ---- |  | ----------------------------------------------------------------------------------------------------------------------------------

| |  |  |  | Certain
portions of this exhibit have been omitted based upon our request for confidential
treatment for portions of the referenced exhibit.
| |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------

|(b) |  | The
Company filed a report on Form 8-K, dated December 7, 2001, furnishing under Item 5
information with respect to the purchase of stock in the Company by Warburg Pincus
Ventures, pursuant to a Stock Purchase Agreement dated November 9, 2001 and including a
pro forma balance sheet showing the effect of that purchase as of September 30, 2001.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|51
|--

|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 CORPORATION
By /s/ Sheryle J. Bolton

   Sheryle J. Bolton
   Chief Executive Officer |  | March 29, 2002
|----------------------------------------------------------------------------------------------------------------------- |  | --------------

|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/ Sheryle J. Bolton 

Sheryle J. Bolton |  | Chairman, Chief Executive Officer and Director (Principal Executive Officer) |  | March 29, 2002
|----------------------------------------------------- |  | ---------------------------------------------------------------------------- |  | --------------

|/s/ Jane A. Freeman

Jane A. Freeman |  | Chief Financial Officer, Vice President Finance and Treasurer (Principal Financial and Accounting Officer) |  | March 29, 2002
|------------------------------------------------ |  | ---------------------------------------------------------------------------------------------------------- |  | --------------

|/s/ Dr. Michael M. Merzenich  

Dr. Michael M. Merzenich |  | Chief Scientific Officer and Director |  | March 29, 2002
|-------------------------------------------------------------------- |  | ------------------------------------- |  | --------------

|/s/ Dr. Paula A. Tallal

Dr. Paula A. Tallal |  | Director |  | March 29, 2002
|-------------------------------------------------------- |  | -------- |  | --------------

|/s/ Carleton A. Holstrom   

Carleton A. Holstrom |  | Director |  | March 29, 2002
|------------------------------------------------------------- |  | -------- |  | --------------

|/s/ Rodman W. Moorhead, III   

Rodman W. Moorhead, III |  | Director |  | March 29, 2002
|------------------------------------------------------------------- |  | -------- |  | --------------

|/s/ Ajit Dalvi  

Ajit Dalvi |  | Director |  | March 29, 2002
|---------------------------------------- |  | -------- |  | --------------

|/s/ Dr. Joseph Martin 

Dr. Joseph Martin |  | Director |  | March 29, 2002
|----------------------------------------------------- |  | -------- |  | --------------

|52
|--

|EXHIBIT INDEX
|-------------

|Exhibit No. |  | Description of Document
|----------- |  | -----------------------

|3.3(1) |  | Restated
Certificate of Incorporation.
|------ |  | --------------------------------------

|3.4(1) |  | Amended
and Restated Bylaws.
|------ |  | ----------------------------

|4.1(1) |  | Reference
is made to Exhibits 3.3 and 3.4.
|------ |  | ------------------------------------------

|4.2(2) |  | Amended
and Restated Registration Rights Agreement, dated as of December 31, 1998.
|------ |  | ----------------------------------------------------------------------------------

|4.3(1) |  | Specimen
Stock Certificate.
|------ |  | ---------------------------

|4.4(3) |  | Amendment
No. 1 by and among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P. and
WPV, Inc., effective as of March 9, 2001 to Amended and Restated Registration Rights
Agreement entered into as of December 30, 1998
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5(12) |  | Amendment
No. 2 By and Among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P. and
WPV, Inc., Effective as of November 30, 2001 to Amended and Restated Registration Rights
Agreement Entered Into as of December 30, 1998
|------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.1(1) |  | Form
of Indemnity Agreement with each of our directors and executive officers.
|------- |  | ------------------------------------------------------------------------------

|10.2(4) |  | 1999
Equity Incentive Plan, as amended.
|------- |  | ---------------------------------------

|10.3(5) |  | Form
of Stock Option Agreement under the Incentive Plan.
|------- |  | --------------------------------------------------------

|10.4(5) |  | Form
of Stock Option Grant Notice under the Incentive Plan.
|------- |  | -----------------------------------------------------------

|10.5(1) |  | 1999
Non-Employee DirectorsStock Option Plan.
|------- |  | ----------------------------------------------

|10.6(1) |  | Form
of Nonstatutory Stock Option Agreement under the Non-Employee DirectorsStock Option
Plan (Initial Grant).
|------- |  | ---------------------------------------------------------------------------------------------------------------

|10.7(1) |  | Form
of Nonstatutory Stock Option Agreement under the Non-Employee DirectorsStock Option
Plan (Annual Grant).
|------- |  | --------------------------------------------------------------------------------------------------------------

|10.8(1) |  | 1999
Employee Stock Purchase Plan.
|------- |  | ----------------------------------

|10.9(1) |  | Form
of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan.
|------- |  | ------------------------------------------------------------------------------------------

|10.10(1) |  | Consulting
Agreement, dated as of September 20, 1996, with Dr. Michael M. Merzenich, as modified on
January 19, 1998.
|-------- |  | ---------------------------------------------------------------------------------------------------------------------

|10.11(1) |  | Consulting
Agreement, dated as of September 19, 1996, with Dr. Paula A. Tallal, as modified on
January 22, 1998.
|-------- |  | ----------------------------------------------------------------------------------------------------------------

|10.12 |  | Letter
agreements dated as of December 12, 2001, extending the Consulting Agreements filed as
Exhibits 10.10 and 10.11
|----- |  | ----------------------------------------------------------------------------------------------------------------------

|10.13(1) |  | Exclusive
License Agreement, dated September 27, 1996, with the Regents of the University of
California.
|--------- |  | --------------------------------------------------------------------------------------------------------

|10.14(1) |  | Lease
Agreement, dated as of July 31, 1997, with GBC-University Associates, L.P.
|-------- |  | --------------------------------------------------------------------------------

|10.15(1) |  | Securities
Purchase Agreement, dated September 24, 1996, with Warburg, Pincus Ventures, L.P.
|-------- |  | --------------------------------------------------------------------------------------------

|10.16(4) |  | Lease,
dated as of March 20, 2000, with Rotunda Partners II.
|-------- |  | ------------------------------------------------------------

|10.17(6) |  | First
Amendment and Second Amendment to Lease dated as of March 20, 2000, with Rotunda Partners
II.
|-------- |  | ---------------------------------------------------------------------------------------------------

|10.18(7) |  | Revolving
Loan Agreement dated as of March 9, 2001 by and between Scientific Learning Corporation
and Fleet National Bank
|-------- |  | -------------------------------------------------------------------------------------------------------------------------

|10.19(8) |  | Agreement
to Issue Warrant and Grant of Security Interest dated as of March 9, 2001 by and between
Scientific Learning Corporation and WPV, Inc
|-------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------

|10.20(9) |  | Warrant
to Purchase 1,375,000 Shares of Common Stock of Scientific Learning Corporation
|-------- |  | ---------------------------------------------------------------------------------------

|10.21(10) |  | Loan
agreements, promissory notes and pledge agreements with each of Sheryle Bolton, Frank
Mattson, Steve Miller, and James Mills
|--------- |  | ---------------------------------------------------------------------------------------------------------------------------------

|10.22(11) |  | Stock
Purchase Agreement dated November 9, 2001 between Scientific Learning Corporation and
Warburg Pincus Ventures, L.P.
|--------- |  | -------------------------------------------------------------------------------------------------------------------------

|10.23 |  | Letter
Agreement dated March 12, 2002 between the Company and Sheryle Bolton.
|----- |  | -----------------------------------------------------------------------------

|10.24 |  | First
Amendment Agreement, dated March 26, 2002 between the Company and Fleet National Bank
amending the agreement filed as Exhibit 10.18.
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------

|10.25 |  | 2002
Management Incentive Plan.
|----- |  | -------------------------------

|23.1 |  | Consent
of Ernst &Young LLP, Independent Auditors
|---- |  | -------------------------------------------------

|(1) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys
Registration Statement on Form S-1 (SEC File No. 333-77133).
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|53
|--

|
|

|(2) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-K for the year ended December 31, 1999 (SEC File No. 000-24547).
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
8-K on March 12,2001 (SEC File No. 000-24547).
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended June 30, 2000 (SEC File No. 000-24547).
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended March 31, 2001 (SEC File No. 000-24547).
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended June 30,2001 (SEC File No. 000-24547).
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(8) |  | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(9) |  | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on March
12,2001 (SEC File No. 000-24547).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(10) |  | Incorporated
by reference to Exhibit 10.20 previously filed with the Companys Form 10-Q for the
quarter ended March 31, 2001 (SEC File No. 000-24547).
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) |  | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
10-Q for the quarter ended September 30, 2001 (SEC File No. 000-24547).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) |  | Incorporated
by reference to Exhibit 4.4 previously filed with the Companys Form 8-K on December
7,2001 (SEC File No. 000-24547).
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------

| |  | Certain
portions of this exhibit have been omitted based upon our request for confidential
treatment for portions of the referenced exhibit.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------

|54
|--