UNITED
STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM
10-K |X|
Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934 For
the fiscal year ended December 31, 2003 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
  
  94-3234458(State or other
  jurisdiction of
  incorporation or organization)
  
  (IRS Employer Identification Number)300 FRANK H. OGAWA
  PLAZA, SUITE 600OAKLAND, CA 94612-2040(Address of principal executive offices, including zip code)510-444-3500(Registrants telephone number, including area code) Securities registered pursuant to
Section 12 (b) of the Act: 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. |_| Indicate by check mark
whether the Registrant is an accelerated filer (as defined in Exchange Act Rule
12b-2).  Yes: |_| No: |X| The aggregate market
value of the voting and non-voting common equity held by non-affiliates of the
Registrant, based upon the closing sale price of the Common Stock on June 30,
2003 as reported on the OTC Bulletin Board was approximately $25,362,500. 
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. 1   As of March 15, 2004 the
Registrant had outstanding 16,157,716 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy
Statement for the Registrants 2004 Annual Meeting of Stockholders to be held
on June 7, 2004, are incorporated by reference in Part III.
2

TABLE OF CONTENTS

PAGE NO.PART IItem 1.
  Business
  4Item 2.
  Properties
  16Item 3.
  Legal Proceedings
  16Item 4.
  Submission of Matters to a Vote of Security Holders
  16PART IIItem 5.
  Market for Registrants Common Equity and Related
  Stockholder Matters
  19Item 6.
  Selected Financial Data
  20Item 7.
  Managements Discussion and Analysis of Financial
  Condition and Results of Operations
  21Item 7A.
  Quantitative and Qualitative Disclosures about
  Market Risk
  31Item 8.
  Financial Statements and Supplementary Data
  32Item 9.
  Changes in and Disagreements with Accountants on
  Accounting and Financial Disclosure
  49Item 9A.
  Controls and Procedures
  49PART IIIItem 10.
  Directors and Executive Officers of the Registrant
  50Item 11.
  Executive Compensation
  50Item 12.
  Security Ownership of Certain Beneficial Owners and
  Management
  50Item 13.
  Certain Relationships and Related Transactions
  50Item 14.
  Principal Accounting Fees and Services
  50PART IVItem 15.
  Exhibits, Financial Statement Schedules, and Reports
  on Form 8-K
  51SIGNATURES
  553

SPECIAL
NOTE ON FORWARD-LOOKING STATEMENTS

This
report on Form 10-K, including the sections captioned Item 1. Business, and
Item 7. Managements Discussion and Analysis of Financial Condition and Result
of Operations, contains 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. In some cases, you can identify
forward-looking statements by terminology such as may, will, should, expects,
intends, plans, anticipates, believes, estimates, predicts,
potential, continue or the negative of these terms or by other comparable
terminology.  These forward-looking
statements relate to future events or conditions or our future performance and
involve known and unknown risks, uncertainties and other factors that may cause
our actual results, levels of activity, performance or achievements to differ
materially from that expressed or implied by these forward-looking statements.
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Our actual results may differ materially
from those expected or anticipated in the forward-looking statements. Specific
factors that might cause such a difference include, but are not limited to,
risks and uncertainties discussed in this Report in Item 1, including but not
limited to those discussed under the caption Factors That May Affect our
Results or Stock Price, those described in Item 7, Managements Discussion
and Analysis of Financial Condition and Results of Operations, and those that
are or may be discussed from time to time in our public announcements and filings
with the SEC, including our future Forms 8-K, 10-Q and 10-K. We undertake no
obligation to update or revise publicly any forward-looking statements, whether
as a result of new information, future events or otherwise after the date of
this report.

ITEM 1.
  BUSINESSWe develop and distribute
the Fast ForWord® family of reading intervention software.  Our innovative products apply advances in
neuroscience and cognitive research to build the fundamental cognitive skills
required to read and learn.
Reading is essential for
success in school and in life, yet according to the National Assessment of
Educational Progress conducted by the U.S. Department of Education, 69% of
fourth graders in the U.S. are unable to read proficiently at grade level.  Learning to read proficiently is a complex
task involving multiple cognitive processes that have become much better
understood in recent years.  Our
products incorporate learning from more than 30 years of research on the brain,
language, and reading.

Extensive outcomes
research by independent researchers, our founding scientists, and our company
demonstrate that the Fast ForWord products help students attain rapid, lasting
gains in the skills critical for reading. Our major products include an
optional easy-to-use web-based tool that provides reports on detailed learning
results for individuals and groups of students.
To encourage best
practices in the use of our products, we provide on-site and remote services,
including product training and professional development, implementation
management, consulting and technical installation.  We also provide technical, professional and customer support and
a wide variety of web-based resources.
At the end of 2003,
approximately 2,200 schools had purchased at least $10,000 of our Fast ForWord
product licenses and services, and over 325,000 individuals had enrolled in one of
our products.
MARKETS
Our primary market is
K-12 schools in the United States.   In
2003, the K-12 sector represented more than 90% of our business.  Since we began building our school sales
force in late 1998, our business in K-12 schools has grown each year, both in
absolute dollars and as a percentage of our business.
The K-12 market is large
and is projected to grow.  According to
the National Center for Education Statistics, part of the U.S. Department of
Education, and Market Data Retrieval, a supplier of market information to the
education industry, U.S. K-12 schools now enroll more than 54 million students,
and enrollment is projected to continue growing through 2013.  There are approximately 14,200 public school
districts in the U.S., and approximately 114,000 public and private school
buildings, or sites.
4

Eduventures, a strategic
consulting firm in the education industry, has estimated that in 2001, K-12
schools spent $3.2 billion (46% of the total amount schools spent on all
instructional products) on supplementary materials of all types. Simba
Information, Inc., a marketing information company, estimates the K-12 market
for instructional software at $1.63 billion in 2003.

The general availability
of funding for public schools fluctuates from time to time, and state and local
funding is presently negatively affected by reduced levels of tax revenues due
to the economic slowdown.  During 2002
and 2003, the education technology industry generally experienced soft sales,
typically attributed to tight funding. 
State and local education funding is expected to continue to be tight
during 2004.  If the economy continues
to grow stronger, more funding may be available in 2005.   Nevertheless, substantial federal funding
resources remain, and many of those resources are focused on reading
improvement.
The federal No Child Left
Behind (NCLB) Act of 2001 established as important national priorities reading
achievement and grade level proficiency accomplished through proven practices
and products grounded in scientifically based research.  Our products, which build language and
reading skills and are based on more than 30 years of neuroscience and cognitive
research, align well with these objectives.
For fiscal year 2005,
President Bushs education funding requests include $13.3 billion for Title 1,
Part A, grants to local education agencies; $1.125 billion for Reading First;
$132 million for Early Reading First; $12.2 billion for special education
grants to states; $692 million for educational technology; $1 billion for 21st
Century Community Learning Centers; and $682 million for English Language
Acquisition programs.  All of these
sources of federal funding have been used by our customers to purchase Fast
ForWord licenses.
We believe that the
funding for a substantial portion of our K-12 sales comes from federal funding,
so continuing to qualify for major sources of federal funding is critical to
our sales success.  The current federal
budget deficit may impact the availability of federal education funding. For
example, for 2005 the administration has requested no money for Comprehensive
School Reform, Even Start and Dropout Prevention, and the funding for several
other categories has stayed the same as 2004. 
Nevertheless, the total amount of federal funding for education has
increased each year since 1996.
In addition to selling to
K-12 schools, we also sell through private practice professionals, and to
learning centers, hospitals, clinics and psychologists.  These speech and language or other
professionals recommend the use of our products to appropriate clients and then
supervise the use of those products, often in connection with their other
services.  Since 1999, our business in
this sector has decreased each year, both in absolute dollars and as a
percentage of our business.  We expect
that this sector will continue to decline as a percentage of our business.

However, these
professionals remain significant to us. 
Private practice professionals were our first market, and they have
extensive knowledge about our products and their use that can be valuable for
us and for all of our customers.  These
professionals sometimes provide contract services to schools, and from time to
time recommend Fast ForWord products for students in those schools.
PRODUCTS
Our Fast ForWord software
products develop cognitive skills required to read and learn effectively. 
Based on more than 30 years of research in neuroscience, reading and language,
our products use established neuroscience principles to help students
learn.   Extensive efficacy research
(see Outcomes
and Scientific Basis below) has demonstrated the results that can be
achieved through use of our products.
5

COGNITIVE SKILLS
DEVELOPMENT
Reading and learning
require a variety of foundational cognitive skills, all functioning
together.  The Fast
ForWord products develop prerequisite skills that enable students to take
greater advantage of their reading instruction and improve their reading
proficiency.  Fast ForWord products do this by developing Learning MAPs skills:
Memory. The ability to hold information
short- and long-term, essential for comprehension of complex sentences and for
remembering instructions.
Attention.  The ability to focus on
tasks and ignore distractions.
Processing.  The ability to address
information such as images and sounds quickly enough, and in the correct
sequence, to discriminate their differences, a prerequisite for phonemic
awareness (the ability to distinguish among and manipulate the smallest sounds
in language that can change meaning) and reading.

Sequencing.  The ability to quickly
and accurately determine which of two events or stimuli comes first, which is
supported by memory, attention, and processing.  Sequencing is essential for developing phonemic awareness, word
fluency, and oral and reading comprehension.

FAST POWER LEARNING FORMULA
Neuroscience research has
demonstrated the importance of frequency, intensity, adaptivity, simultaneous
development, and timely motivation for learning new tasks.  The Fast ForWord products use these
principles to help students learn more rapidly.

Frequency and intensity: 
Brain plasticity research demonstrates that completing a set of learning tasks
in a frequent, intense timeframe is needed to make the changes in brain
functioning that enhance learning.  To maximize the efficacy of our
products, we recommend protocols for our major products that require between 48
and 100 minutes of product use a day, 5 days per week.
During 2003, a
significant portion of our research resources were devoted to developing
alternate protocols to offer educators greater flexibility in fitting Fast
ForWord products into school schedules, while maintaining the products
effectiveness.  Our original protocols
required product use for 90 to 100 minutes per day, 5 days a week, for a period
of 4 to 8 weeks.  We have now introduced
protocols for each of our major products that require only 48 to 50 minutes of
use, 5 days a week, over a longer period of 6 to 10 weeks.  Our research shows that students working
under the new protocols achieve substantially the same results as those using
the original protocols.  The shortened
daily time protocols make fitting our products into the school day much easier,
although the required time commitment still can present challenges to selling
and implementation.
Adaptivity: 
The interactive exercises in the Fast ForWord products adapt to each students
skill level and progress, automatically adjusting content exposure in a variety
of ways.  For example, many of the exercises automatically adjust the
specific content presented to the student so that the student can make correct
responses approximately 80% of the time for each discrete skill. This
adjustment is designed to keep the exercises challenging and engaging, while
allowing the student to experience a feeling of accomplishment and to avoid the
frequent failure that can discourage a students learning.

Simultaneous Development:  The Fast ForWord products simultaneously
develop both major and supporting cognitive skills, for enduring learning
improvements.  While each exercise focuses on a specific set of reading or
language tasks, it is also designed to develop underlying cognitive skills such
as memory, attention, processing and sequencing.
6

Timely Motivation:  For the brain to learn, the student must be
attentive and engaged, so motivation is critical to maintaining learning
improvements.  In the Fast ForWord products, learners are rewarded for a
correct answer on their first attempt only, a scientifically validated
motivational technique.  Other
motivational techniques include a bonus point system and the delivery of mastery
animations that signify milestones as students progress.
PRODUCTS IN THE FAST
FORWORD FAMILY
During 2003, our Fast
ForWord family of products accounted for 81% of revenue.  These software products function with a wide
variety of hardware and software configurations and are designed to work with
the computer technology widely available in schools and homes.
In 2003 we introduced the
Fast ForWord Gateway Editionof
our major products.  The Gateway Edition
was designed to:

    Make our products easier
        to implement and use, through alternative protocol options, simplified
        administrative procedures, and a unified interface;
    Improve student results,
        by adding easier introductory levels for some exercises and providing
        individualized intervention recommendations based on a students
        actual performance;
    Better connect Fast
        ForWord use to classroom activities, through a teacher interface that
        aligns the Fast ForWord products to state learning standards and selected
        core reading programs; and
    Provide additional
        progress tracking capabilities, including reports that enable sub-group
        tracking, to help educators respond to increased accountability demands.Customers who purchased
earlier editions and wish to move to the Fast ForWord Gateway Edition may do so
for an additional charge.
Fast ForWord Language software includes
seven exercises focused on developing oral language comprehension and listening
skills, including phonological awareness (the understanding that words are
composed of sounds and the ability to identify and manipulate the sounds of
language), listening accuracy and comprehension, working memory, and
familiarity with language structures, along with building the requisite
underlying MAPs skills.

Fast ForWord Middle and High School
software is designed for adolescents and teenagers who lack reading
proficiency.  The exercises are similar
to those in Fast ForWord Language, but deliver content in an age-appropriate
sports-themed user interface.

Fast ForWord Language to Reading software
includes five exercises that help students make the link between spoken
language and written language, focusing on word analysis, listening
comprehension, working memory, grammar, syntax, and vocabulary, while
continuing to further develop the underlying MAPs skills.

Fast ForWord to Readingis a series of products that build essential
reading skills such as phonemic awareness, vocabulary, fluency, and
comprehension while simultaneously developing the underlying MAPs skills.  At more advanced levels, students use these
products to build spelling skills and familiarity with writing conventions,
extend word level knowledge of semantic, phonological, morphological and
syntactic structures, and advance their sentence and passage comprehension
skills.  (Morphology relates to the use
of words, letters, and letter combinations that change the meaning of a
word.  Syntax relates to how grammatical
markers and words are combined to make meaningful sentences.)  Each Fast ForWord to Reading product is
correlated directly to generally-accepted grade-level reading standards.  In 2003, we introduced the Fast ForWord
to Reading 4 product, which is correlated to end of fourth grade
standards and joined our earlier Fast ForWord to Reading 3 product.  In 2004, we plan to introduce Fast ForWord
to Reading 1 and Fast ForWord to Reading 2.
7
Our major products, Fast
ForWord Language, Language to Reading, Middle & High School and Fast
ForWord to Reading, include an optional remote progress tracking system, Fast ForWord Progress Tracker.  This easy-to-use web-based tool provides
reports on detailed learning results for individuals or groups of students for
all exercises in each of these products. 
These reports, generated from learner data securely transmitted by
customers to Scientific Learnings database, permit educators to see exactly
how each student is progressing on specific skills.  Overview reports provide summary-level data for a class or other
group and provide a quick update on the groups progress and participation
levels.  Customers can configure the
system to send automatic emails to parents, administrators or others to provide
easy periodic updates.  Progress Tracker
data can be reported by subgroup, providing a tool for educators to analyze
their progress towards their Annual Yearly Progress requirements, which are
mandated by NCLB.
We also sell Fast
ForWord
Basics, software that prepares pre-readers aged 4 to 7 for learning and reading;
Reading
Edge, a reading assessment instrument for students from kindergarten
to 2nd grade; and Fast ForWord Bookshelf, an early reading
kit that includes five colorful storybooks and a multimedia CD-ROM.
LICENSE TERMS
We license our products
in a variety of configurations to meet the customers needs.  Schools typically purchase site or
workstation licenses, which are available either for a perpetual term or on a
subscription or limited term basis.  The
license package typically contains at least two of our major products and
varying quantities of our other products. 
An annual support fee is included in the package license price.  New customers are also required to purchase
implementation services, which are critical to successful use of the
products.  Our license list prices range
from $10,000 to $65,000 per site, depending on the number of products, the
number of workstations, the duration of the license and the volume
purchased.
Products licensed for
administration by private practice professionals are generally purchased on a
per product per student basis.  Our
major products list for $850 per product per student.  The private practice professional charges separately for his or
his services.  Hospitals, clinics and
learning centers purchase both per-product per-student licenses and site or
workstation licenses, depending on their size and needs.
FAST FORWORD TO LEARNING SERVICES AND SUPPORT

One of our key strategic
goals is to reach beyond early adopters and sell to a broader group of
mainstream reading intervention customers. We believe that selling more
services is critical to achieving that goal, because mainstream customers tend
to require more implementation support than do early adopters.  In 2003, services and support accounted for
19% of revenue, compared to 17% in 2002. 
At the end of 2003, our service and support organization included 23
employees, supplemented by 37 contractors who provide on-site customer training
and technical services.

SERVICES
School districts have
limited resources to support technology at dispersed sites, so they seek
products that are easy to implement and maintain.  To facilitate effective implementation, we offer product
training, technical installation, implementation management, consulting, and
professional development services. 
These services are generally provided on-site by independent contractors
who have been trained and certified on our products.  Some of these services are also offered remotely, including Fast
ForWord Getting Started, a self-paced web-based course that provides training
on the science behind and the use of our products.
To help our customers
obtain the best possible student achievement results, our product training and
professional development sessions provide an extensive hands-on introduction to
our products, effective implementation strategies, and an introduction to the
science behind our products.  In
addition, customers can look to Scientific Learning for implementation
management services and consulting on data analysis and interpretation,
intervention and motivation strategies, connecting with classroom teachers and
other topics of interest to the customer.
8

We host forums,
workshops, and seminars for customers and prospective customers.  At these gatherings, speakers provide
information on advances in neuroscience and learning, and current customers
offer actual case studies on how Fast ForWord products impact student
achievement.  These sessions provide
Fast ForWord users with opportunities to network and develop informal support
relationships, and in some cases, are offered with continuing education
credits.
SUPPORT

We provide extensive
remote support to Fast ForWord customers, who can access our technical,
professional, and customer support via telephone, email, and web-based chat, in
whatever combination works best for them. 
Level 1 support services are provided by a third party that specializes
in providing telephone support.  More
difficult questions are escalated to internal support staff.  In our customer surveys, customers using
Fast ForWord products generally give excellent ratings to the support they
receive and the professionalism of our support team.
OUTCOMES
and SCIENTIFIC BASIS
From the founding of our
company, we have devoted significant resources to demonstrating that our
products improve learning, and today we continue to accumulate outcomes data
from students in classrooms across the country.  Research by our users, independent academics and our own
scientists has demonstrated that Fast ForWord products improve language and
reading skills across a broad spectrum of demographic groups.
USER OUTCOMES
To date, more than 325,000 individuals have enrolled in Fast ForWord products, and we have
accumulated research outcomes on more than 25,000 individuals, including approximately 17,000 controls.  Gains have been confirmed among a variety of
groups, including African-American students, Hispanic students, students with
limited English proficiency, students struggling with reading, and students of
low socio-economic status.  Gains on
specific reading skills have been confirmed using several standardized,
nationally normed reading tests.  In
addition, schools that have used Fast ForWord products have provided us with
state achievement test scores from students before and after they have used Fast
ForWord products.  Analyses of these
data have demonstrated that following Fast ForWord participation, students, on
average, achieve significant improvements on a wide variety of high-stakes
tests.
BRAIN IMAGING AND READING
IMPROVEMENTS

A Stanford University
study of students aged 8 to 12 who were identified as dyslexic, published in
2003 in the Proceedings
of the National Academy of Sciences, confirmed that after using Fast
ForWord, students on average showed significant improvements in reading
performance, coupled with changes in brain activation patterns.  Before beginning the study, the students
underwent assessments for reading, reading skills, and language, as well as
functional magnetic resonance imaging (fMRI) of their brains during a series of
reading-related tasks.  The students then
used the Fast ForWord Language product for five days a week, 100 minutes per
day, for an average of 28 days.  The
fMRIs and assessment tests were then repeated. 
After Fast ForWord use, the brain activation patterns of the students
showed increased neurological activity in regions of the brain involved in
skills critical to reading.  These later
images more closely resemble the patterns exhibited by students reading on or
above grade level.  A control group
showed no similar changes in fMRI results. 
The students who used the Fast ForWord product also showed statistically
significant improvements in a variety of reading skills, including word
decoding, single word reading, naming fluency, and reading comprehension.
9

RESEARCH BASIS and FIELD
TRIALS
The technology that forms
the basis of most of our major products grew out of a scientific collaboration
between neuroscientists working at Rutgers, the State University of New Jersey
(Rutgers) and the University of California at San Francisco (UCSF) combining
insights about language development and learning to read with research on brain
plasticity.
One of a childs early
tasks is to learn to extract meaning from speech by identifying its basic
auditory building blocks, or phonemes. 
Children must be able to recognize and process these phonemes before
they can become skilled in language or reading.  The Rutgers group noted that children who have difficulty
distinguishing between closely related phonemes frequently have problems in
other language and cognitive skill areas as well, such as morphology, syntax,
semantics, grammar, short-term memory, attention, and event sequencing. The
UCSF group had long investigated how the human brain changes in response to
stimuli, a phenomenon known as brain plasticity.  Their work demonstrated that specific techniques drive the brain
to change over time, adjusting how it processes information.  Bringing together their work at Rutgers and
UCSF, our founders developed computerized exercises that use thousands of
repetitions, adapted according to complex and sophisticated formulas and
presented with timely motivational sequences, to allow children to quickly
master the language and cognitive skills that are critical to reading.
Results from the original
research studies combining the work of our scientific founders were published
in the journal Science in early
1996.  These results were
revalidated by a national field trial of Fast ForWord Language later in 1996,
which demonstrated gains of one to two years on standardized tests of skills
critical to reading, after just four to eight weeks of training.  A second national field trial in 1997, among
students in 19 public schools in nine districts across five states,
demonstrated significant gains in language and reading skills as measured on
standardized tests, yielding average improvement of more than 1 1⁄2 years in four
to eight weeks  gains that were significantly greater than those made by
students in the control group.

SALES
AND MARKETING
We sell to our principal
market, K-12 school districts throughout the United States, primarily using a
direct sales force.  As of December 31,
2003, we employed 30 quota-bearing sales representatives, led
by four regional sales directors.  These
sales personnel typically are experienced professionals with backgrounds in
selling technology-based curriculum products to the K-12 segment.  Most bring strong relationships with
educators built over many years.  We support
our sales representatives with a strong field sales management team with over
100 years of collective experience in this market and with strategic
consultants, who frequently are retired school district superintendents and
other senior district administrators, and who have extensive experience and
relationships in K-12 education.
To reach smaller and
rural schools, to a limited extent we also sell our products through school
consortiums and regional service centers.
We participate in
industry conferences and trade shows and conduct our own Executive Forums for
educational decision makers.  Our sales
force typically targets sales at the school district level, although early
seeding sales are also made at the individual school level.
We sell to clinical
professionals, learning centers, hospitals and clinics principally through direct
marketing (mail, web and telesales) and conferences (both industry conferences
and forums we conduct ourselves).
We have also recently
begun to sell our products outside North America through resellers in a limited
number of countries.  To date, the level
of these sales has been minimal.

COMPETITION
The educational market in
which we operate is very competitive. 
We believe that the principal competitive factors in the industry are
ability to deliver measurable improvements in student achievement, cost,
existing relationships with
customers, ability to provide effective and efficient product implementation,
and ability to complement and supplement the school curriculum.  We believe that we compete favorably on the
basis of these factors.
10

Our products are highly
differentiated by their neuroscience basis and their focus on the development
of cognitive skills through scientifically based methods.However,
we compete vigorously for available funding against other companies offering
educational software and other language and reading programs, as well as with
providers of traditional methods of teaching language and reading.  Many of the companies providing these
competitive offerings are much larger than Scientific Learning, are more
established in the school market than we are, offer a broader range of products
to schools, and have greater financial, technical, marketing and distribution
resources than we do.  Competitors may
enter our market segment and offer actual or claimed results similar to those
achieved by our products.  In addition,
although the traditional approaches to language and reading are fundamentally
different from the approach we take, the traditional methods are more widely
known and accepted and, therefore, represent significant competition for
available funds.
DEVELOPMENT
AND RESEARCH
The markets in which we
compete are characterized by frequent product introductions and evolving
educational standards and approaches. 
Our future success will depend in part on our ability to continue to
enhance and update our existing products or to develop and successfully
introduce new products.
Our research and
development expenses were approximately $3.5 million, $3.0 million, and $3.4 million for the years ended December 31,
2003, 2002 and 2001, respectively.  At
December 31, 2003, 18 of our employees were engaged in research and development
activities, which include both product development and outcomes research.

DEVELOPMENT
Our development efforts
focus on making our products more effective and easier to use, and broadening
our product line.  All of our current
development efforts are focused on products related to reading and language,
principally for use in a school environment.
Our new products rely on
market-tested technology and uniform platforms and are developed in a shared
authoring environment, so that customers can easily broaden their Fast ForWord
implementations, as well as move students easily among our products.  We analyze the data that is uploaded through
our Progress Tracker tool to identify trends in product use and efficacy and
help us develop improvements to our products.
In
2003, we launched Fast ForWord Gateway Edition, a new edition of our major
products. Our customers received the added features and benefits of the Gateway
Edition enthusiastically.  However, we
encountered technical issues with the new release that required significant
time from our sales and service teams. 
This led to additional service and support costs and slowed the
purchasing decisions for a number of transactions, resulting in lower than
expected fourth quarter sales.
In
2003 we also launched the second product in our Fast ForWord to Reading series,
Fast ForWord to Reading 4.  During 2004,
we expect to launch two additional products in the Fast ForWord to Reading
series, Fast ForWord to Reading 1 and 2, which are currently in
development.  We cannot guarantee that
we will meet the projected introduction schedule for future products, or that
future products will be free of technical issues or be well received in the
market.
RESEARCH
We believe that the
emphasis in the No Child Left Behind Act on scientifically based instructional
approaches validates our long-standing support of research on the efficacy of
our products, which has included projects at some of the countrys top research
universities.  We continue to support
research to demonstrate the outcomes
of our products, as well as to identify and support new product and product
improvement opportunities.
11

Support of Outcomes Research
School districts
throughout the country are studying the impact of Fast ForWord products on
their students reading achievement. 
Many of these studies focus on outcomes related to state standards and
accompanying state assessment programs. 
We encourage these studies, assist with data analysis when appropriate
and, whenever practical, make the results available on our Scientific Learning
web site.
Researchers at Stanford
University are planning a randomized controlled study on the additive effects
of using multiple Fast ForWord products. The study plans to include a wide
variety of students in a broad spectrum of educational settings.  An advisory board of reading research
experts is planned to monitor the research design, methods and data analyses procedures.  We are providing a donation to the Haan
Foundation to fund a portion of the study.
Product Enhancements and
New Products
The data that is uploaded
to our database from participants who use our products is a valuable resource
for improving our products.   Analyzing
the patterns among groups of participants allows us to understand, in detail,
how students generally progress, where students have difficulty and where
intervention might be appropriate.  In
2003, we released alternate protocols for each of our major products after
demonstrating that the alternate protocols resulted in substantially similar
student progress as the original protocols, using analyses of students
Progress Tracker data as well as pre and post test results.  We also released Progress Tracker flags
providing individualized intervention recommendations based on the students
actual performance and new, easier introductory levels for exercises where
students may tend to experience difficulty when starting the products.  We continue to explore potential product
enhancements and alternative usage protocols that will make our products more
useful to educators and more effective for students.
INTELLECTUAL PROPERTY

We have a broad
intellectual property strategy addressing both product technology and product
concepts. Our policy is to 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, 2003, we
held 50 issued U.S. patents and 5 pending U.S. applications.  We also held
4 issued patents from other countries and had 13 applications pending
abroad.   We were the exclusive licensee
under 11 issued U.S. patents, 3 issued foreign patents, and 2 pending foreign
patent applications.  The U.S. patents
expire between 2014 and 2019.


We also have 17 US trademark
registrations, including registrations for marks including Fast ForWord, our
most important trademark. During 2002, we were involved in litigation regarding
another partys use of a mark that was similar to our Fast ForWord mark, which was
resolved amicably.

The licensed patents and
applications are owned by the Regents of the University of California and
Rutgers, the State University of New Jersey, and relate to the basic speech and
sound modification and adaptive technology developed at those
institutions.  In 2003, approximately
74% of our product booked sales were derived from selling products that use the
licensed inventions.  If we were to lose our rights under this license,
it would materially harm our business.  This
license requires payment of royalties based upon cumulative net sales of our
products, subject to certain minimum royalty amounts.  In 2002 and each year thereafter, the minimum royalty payment is
$150,000.  In 2003, 2002 and 2001, we
had approximately $909,000, $723,000 and $635,000, respectively in royalty and
milestone expense under the license. 
The final milestone payment under the license was paid in 2001.
12

In September 2003, we
transferred certain of our technology to Neuroscience Solutions Corporation
(NSC) for use in the healthcare field. 
The transaction includes a license of the patents we own, a sublicense
of the patents we license from UCSF and Rutgers, the license of certain
software we developed, and the sale of some research-related assets.  All of the rights licensed to NSC are
limited to the healthcare field and most of the licenses are exclusive in that
field.  We will continue to use the
licensed patents and technology in the fields of education and speech and
language therapy, and retain all rights to our technology outside of the health
field.
The rights were acquired
by Neuroscience Solutions for a combination of cash, stock, and future
royalties. The two companies also have agreed to share certain additional
technology as it is developed.  NSC is a
San Francisco-based company that plans to develop and sell a series of
software-based products for healthcare markets based on research in
neuroplasticity.  NSCs first products
are expected to focus on issues of aging. 
Dr. Michael M. Merzenich, who is a founder, director, significant
stockholder and former officer of the Company, is also a founder, director,
significant shareholder and officer of NSC.

ADDITIONAL
INFORMATION
As of December 31, 2003,
we had 130 full-time and three 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.
We maintain two websites,
scientificlearning.com and brainconnection.com, which provide information and
support.  Scientificlearning.com
provides information about our company and our products and services, as well as
extensive technical and customer support resources.  Brainconnection.com provides practical, easily understandable
information about how the brain works and how students learn, web-based
professional development courses on the brain, language, and reading, and links
to information about Fast ForWord products that relate to the topics discussed
on the site.

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.
FACTORS THAT
MAY AFFECT OUR RESULTS OR STOCK PRICE
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.
The success of our business depends on
increasing acceptance of our products in the K-12 sector, particularly among
mainstream purchasers, who may be resistant to our non-traditional products.
To continue to grow, we
need to increase the acceptance of our products among mainstream educational
purchasers.  At the end of 2003,
approximately 2,200 schools had purchased at least $10,000 of our Fast ForWord
product licenses and services and over 325,000 individuals had enrolled in one of
our products. We believe that to
date most educators who have used Fast ForWord products are early
adopters.  We believe that our success
in moving our products beyond early adopters to the mainstream market will
depend largely on the following critical factors:


 Our ability to convince key
  education decision-makers to use Fast ForWord products even though our methods
  differ from the way schools have traditionally addressed reading
  problems.  K-12 educational practices
  are slow to change, and it can be difficult to convince educators of the
  value of a substantially different approach.
  Our ability to convince schools
  and teachers to incorporate our products into their curriculum.  Our new protocols have significantly
  reduced the daily time required to use our program, significantly decreasing
  one of the most critical challenges in broadly implementing our products.
  However, implementing the products still requires a substantial time
  commitment, which can be difficult for schools.
  Our ability to effectively
  implement our products in schools and better connect to classroom teachers,
  in a scaleable and efficient model.
  Our ability to continue to
  demonstrate that our products achieve significant gains in student
  achievement.  Unless our products are
  implemented well and using in accordance with one of our protocols, they may
  not achieve the desired student achievement results.13


  The availability of government
  funding for public school reading intervention purchases and for our products
  in particular.  The general
  availability of funding for public schools fluctuates from time to time, and
  state and local funding is presently negatively
  affected by reduced levels of tax revenues due to the economic slowdown.  During 2002 and 2003, the education
  technology industry generally experienced soft sales, typically attributed to
  tight funding.  State and local education
  funding is expected to continue to be tight during 2004.  However, if the economy continues to grow
  stronger, more funding may be available in 2005.
  The extent to which our
  products qualify for federal education funding.  Future federal education funding could be adversely affected by
  the federal budget deficit.Our business experiences seasonal
fluctuations and a long sales cycle, which may make it difficult to predict our
results accurately.
Since our formation, our
quarterly operating results have fluctuated significantly, and we expect these
fluctuations to continue.  Like other
companies in the instructional market, our sales to K-12 schools are typically
particularly slow in the first quarter. 
Demand for our products through
private clinicians tends to be lower during the school year than in the summer,
because our products intensive nature can be more conducive to use during
school vacation.

In addition, the cost of
some of our K-12 license packages requires multiples levels of approval in a
political environment, which results in a time-consuming sales cycle that can
be difficult to predict.  When a
district decides to finance its license purchase, the time required to obtain
these approvals can be extended even further. 
In addition, sales to schools are
subject to budgeting constraints, which may require schools to find available
discretionary funds, obtain grants or wait until subsequent budget cycles.  As a result, our sales cycle generally takes
several months, and in some cases, can take a year or longer.
The timing of revenue
recognized from our sales can also be unpredictable.  Our various license and service packages have substantially
differing revenue recognition periods, and it may be difficult to predict which
license package a customer will purchase, even when the amount and timing of a
sale can be projected.  See Managements
Discussion and Analysis Application of Critical Accounting Policies
for a discussion of our revenue recognition policy.   In addition, the timing of a single large
order or its implementation can significantly impact the level of sales and
revenue in a given quarter.
Our
expense levels are based on our expectations of future revenues and are
primarily fixed in the short term. We may not be able to adjust spending in a
timely manner to compensate for any unexpected revenue shortfall.
We may experience difficulties in
launching new products efficiently, without significant technical issues, and
on schedule.
We are developing
additional products in our Fast ForWord to Reading series as part of our
strategy to reach mainstream reading intervention customers.  Unexpected challenges could make these
development projects longer or more expensive. 
In addition, we cannot be certain of market acceptance of our new
products.
New technology products
usually contain bugs that were not discovered in the testing process and tend
to be more challenging to implement when they are first introduced, especially
in the diverse and challenging K-12 technology environment.  During the second quarter of 2003, we
launched the new Gateway Edition of our major products.   Although
our customers received the added features and benefits of the Gateway Edition
enthusiastically, we encountered technical issues with the new release that
required significant time from our sales and service teams.  This led to additional service and support
costs, and slowed the purchasing decisions for a number of transactions,
resulting in lower than expected fourth quarter sales.

14

We may not be able to compete
effectively in the education market.
The
market in which we operate is very competitive.  Our products are highly differentiated by their
neuroscience basis and their focus on the development of cognitive skills
through scientifically based methods.However, we compete vigorously
for available funding against other companies offering educational software and
other language and reading programs, as well as with providers of traditional
methods of teaching language and reading. 
Many of the companies providing these competitive offerings are much
larger than Scientific Learning, are more established in the school market than
we are, offer a broader range of products to schools, and have greater
financial, technical, marketing and distribution resources than we do.  Encouraged by the No Child Left Behind Act,
competitors may enter our market segment and offer actual or claimed results
similar to those achieved by our products. 
In addition, although the traditional approaches to language and reading
are fundamentally different from our approach, the traditional methods are more
widely known and accepted and, therefore, represent significant competition for
available funds.
Our intellectual property rights may be
challenged.
Our
ability to compete effectively depends in part on whether we are able to
maintain the proprietary aspects of our technology and to operate without
infringing on the proprietary rights of others.  It is possible that our issued patents will not offer sufficient
protection against competitors with similar technology, that our trademarks
will be challenged or infringed by competitors, or that our pending patent
applications will not result in the issuance of patents.  In addition, we could become party to patent
or trademark infringement claims, litigation or interference proceedings.  These proceedings could result from claims
that we are violating the rights of others or may be necessary to enforce our
own rights.  Any such proceedings would
result in substantial expense and significant diversion of management
effort.  An adverse determination in
such proceedings could subject us to significant liabilities or require us to
seek licenses from third parties, which may not be available on commercially
reasonable terms or at all.
Our most important
products are based on licensed inventions owned by two universities.  If we
were to lose our rights under this license, it would materially harm our
business.  The licensor may terminate
the license if we fail to perform our obligations and do not timely cure the
violation.  We believe that we are
currently in compliance with the license in all material respects.

We have only recently become
profitable.
We
started operations in February 1996 and until this year incurred significant
operating losses.  In the second quarter
of 2004, we recorded our first operating profit, and in the third quarter, our
first net profit.  2004 was our first
profitable year.  At December 31, 2003,
we had an accumulated deficit of approximately $81 million from inception.  We first generated positive cash flow from operating activities
in 2002 and our cash flow from operations was again positive in 2003.  During
2004, our objectives include increasing our profit margin and generating
positive cash flow from operations. 
However, accomplishing these objectives will require achieving higher
sales goals in a soft K-12 market, which depends on many factors, some of which
are outside of our control.  To meet our
sales targets, we will need to make substantial expenditures.  We cannot assure you that we will meet our
targets with respect to sales, revenues or operating results.
Our directors and executive officers and
their affiliates effectively control the voting power of our company.
At
March 1, 2004, Warburg, Pincus Ventures, our largest shareholder, owned
approximately 47% of the
Companys outstanding stock and, in the aggregate, our directors and executive
officers and their affiliates beneficially owned more than 64% of the
outstanding stock.As
a result, these stockholders are able to exercise significant influence over
all matters requiring stockholder approval, including the election of directors
and approval of significant corporate transactions, and may have interests that
diverge from those of other stockholders. 
This concentration of ownership may also delay, prevent or deter a
change in control of our company.
15

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

Our common stock
presently trades on the Nasdaq Small Cap Market, and our trading volume is
low.  For example, during the fourth
quarter of 2003, our average daily trading volume was approximately 8,400
shares.   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.

After our initial public
offering, our common stock was traded on the Nasdaq National Market.  On July 22, 2002, we were delisted from the Nasdaq
National Market for failure to meet the market capitalization or tangible net
assets alternative tests.  Our common
stock then traded on OTC Bulletin Board until December 30, 2003, when we became
listed on the Nasdaq Small Cap Market.
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 provide for a classified board of directors,
prevent stockholders from acting by written consent, disallow cumulative voting
and require advance notice of director nominations and stockholder proposals,
all of which could have the effect of delaying or preventing corporate
takeovers.
ITEM 2.
  PROPERTIESWe
lease approximately 30,500 square feet of office space in Oakland,
California under a lease that expires in December 2013.  The lease includes two five-year options to
extend the term of the lease.  We
believe our facilities are sufficient for our operations currently and should
be adequate to meet our needs for at least the next two years.
ITEM 3.
  LEGAL PROCEEDINGSNone

ITEM 4.
  SUBMISSION OF MATTERS TO A VOTE OF
  SECURITY HOLDERSNone.
16

EXECUTIVE
OFFICERS
The following table sets
forth various information concerning our executive officers, as of March 19, 2004:
NAME
  
  AGE
  
  POSITIONRobert C. Bowen
  
  62
  
  Chairman and Chief Executive OfficerJames R. Bray
  
  59
  
  Vice President, Business
  Development and Government AffairsLinda L. Carloni
  
  50
  
  Vice President, General Counsel
  and SecretaryGlenn
  G. Chapin
  
  48
  
  Vice
  President, SalesJane A. Freeman
  
  50
  
  Sr. Vice President, Chief
  Financial Officer, and TreasurerDr. William M. Jenkins
  
  53
  
  Sr. Vice President, Product
  DevelopmentDr. Steven L. Miller
  
  40
  
  Sr. Vice President, Research
  and OutcomesGillian M. Rutter
  
  48
  
  Vice President, OperationsSherrelle J. Walker
  
  57
  
  Chief Education OfficerRobert C. Bowen joined us as Chairman and
Chief Executive Officer in June 2002. 
From 1989 to 2001, he served as a senior executive and officer of
National Computer Systems, a provider of educational assessment and
administrative software and services. 
His last assignment there, from 1995 to 2001, was as President of NCS Education,
a leading provider of enterprise software for K-12 school districts.  NCS was acquired by Pearson, PLC, in
2000.  After retiring from NCS in 2001,
Mr. Bowen consulted for various businesses in education until joining us.  Previously, Mr. Bowen held senior executive
positions with other leading education and publishing companies, including
seventeen years with McGraw-Hill.  Early
in his career, Mr. Bowen was a high school math teacher, a coach, and a school
district administrator.  Mr. Bowen
received his bachelors and masters degrees from the University of Tennessee,
Chattanooga.
James R. Bray joined us as Vice
President, Business Development and Government Affairs in January 2003.  Starting in 1990, Mr. Bray held a variety of
executive positions at NCS Pearson and its predecessors in their education,
assessment, and testing products businesses. 
From 1999 through 2002, Mr. Bray was Vice President Business Development
of Pearson Education Technologies and its predecessors.  During 2001 and 2002, Mr. Bray also served
as chairman of NCS Pearsons corporate marketing committee.  During 1998 and 1999 Mr. Bray was Vice
President and General Manager of Realskills, an NCS company.  Prior to joining NCS, Mr. Bray spent more
than 20 years at IBM/Science Research Associates in Chicago.  Mr. Bray is a former member of the St. Paul
(Minn.) School District Foundation and received his bachelors degree in
marketing from Northwestern University.

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.

17

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 NCS 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.
Jane A. Freeman is our Senior Vice President, Chief Financial
Officer and Treasurer.  She joined us as
Vice President, Finance and Treasurer in August 1999 and was named Chief
Financial Officer in January 2000. She was elected Senior Vice President
in January 2004. 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 where she served on the Management Committee of
the firm.  She is a director of three
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.

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.  From 1990 to 1996,
Dr. Jenkins was an Adjunct Associate Professor at UCSF. Dr. Jenkins
is the principal developer of our current software products. Dr. Jenkins
holds a B.S. in Psychology, an M.A. in Psychobiology and a Ph.D. in
Psychobiology from Florida State University, with additional post-doctoral
training from UCSF.

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 in charge of research or outcomes
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.

Gillian M. Rutterjoined us as Vice
President, Operations in October 2002. 
Prior to joining us, Ms. Rutter had served as vice president of
professional and technical services for NCS Learn (Pearson Education) beginning
in 2000.  From 1994 through 2000, she
was the vice president of customer support for NovaNET, an E-learning
company.  Earlier in her career, Ms.
Rutter worked in management and field positions at Jostens Learning, an
educational software company.  Ms.
Rutter began her career as an elementary and middle school teacher and was a
master of teacher training in Tucson, Arizona. 
She holds a bachelor of science in elementary education and a bachelor
of science in special education and learning disabled K-12 from the University
of Arizona.

Sherrelle J. Walker joined us as Chief
Education Officer in July 2002.  Prior
to joining us, Ms. Walker had served as Vice President Curriculum at NCS
Pearson, an educational software company beginning in 1998.  During 1998, Ms. Walker was vice president
products at American Cybercasting Corporation, which provided on-line curriculum
products for teachers and students. Ms. Walker also has more than 25 years
experience as an educator and educational administrator, beginning as a teacher
in the Hartford Public Schools, and serving as an Assistant Principal,
Principal and Director of Secondary Education in the Renton, Washington Public
Schools and as Assistant Superintendent of the public schools in Federal Way,
Washington.  Ms. Walker played a leading
role in the development of the Washington State Essential Academic Learning
Requirements and has been an adjunct professor at the University of
Washington.  Ms. Walker completed her BS
in teaching at Hampton University in Hampton Virginia, and her MA at the
University of Connecticut.

18

PART II
ITEM 5.   MARKET
  FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

(a) Market Information.
Our common stock currently is traded on the Nasdaq Small Cap Market under the
symbol SCIL.  From July 22, 2002 until
December 30, 2003, our common stock was traded on the OTC Bulletin Board.  From January 1, 2002 through July 21, 2002,
our common stock was traded on the Nasdaq National Market.  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, the OTC Bulletin Board
or the Nasdaq Small Cap Market, as applicable.

High
    
    Low2002First
        quarter
    
    $
    2.900
    
    $
    1.110Second
        quarter
    
    $
    2.001
    
    $
    1.200Third
        quarter
    
    $
    1.650
    
    $
    0.700Fourth
        quarter
    
    $
    2.400
    
    $
    1.2102003First
        Quarter
    
    $
    3.100
    
    $
    1.400Second
        Quarter
    
    $
    4.500
    
    $
    2.300Third
        Quarter
    
    $
    5.150
    
    $
    4.100Fourth
        Quarter
    
    $
    5.000
    
    $
    4.150Holders.  As of March 18, 2004, the approximate number
of stockholders of record of our common stock was 145.
Dividend Policy.
We have never declared or paid cash dividends on our common stock, and we do
not anticipate paying any cash dividends in the foreseeable future.  Our current Loan and Security Agreement with
Comerica Bank provides that we may not pay any dividends other than stock
dividends during the term of the Agreement.

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

(b) Not applicable

(c) Not applicable
19

ITEM 6.   SELECTED
  FINANCIAL DATA

In
thousands, except per share amounts
Year ended December 31,2003
  
  2002
  
  2001
  
  2000
  
  1999Statement of Operations Data:Revenues (2):Products
  
  $
  23,225
  
  $
  16,917
  
  $
  14,109
  
  $
  11,693
  
  $
  7,353Services and support
  
  
  5,471
  
  
  3,369
  
  
  3,780
  
  
  3,568
  
  
  2,899Total revenues
  
  
  28,696
  
  
  20,286
  
  
  17,889
  
  
  15,261
  
  
  10,252Cost of revenues (2):Products
  
  
  2,217
  
  
  1,979
  
  
  1,690
  
  
  1,687
  
  
  629Services and support
  
  
  3,867
  
  
  1,499
  
  
  2,395
  
  
  1,870
  
  
  2,059Total cost of revenues
  
  
  6,084
  
  
  3,478
  
  
  4,085
  
  
  3,557
  
  
  2,688Gross profit
  
  
  22,612
  
  
  16,808
  
  
  13,804
  
  
  11,704
  
  
  7,564Total operating expenses
  
  
  20,983
  
  
  25,680
  
  
  32,047
  
  
  32,899
  
  
  22,527Operating income (loss)
  
  
  1,629
  
  
  (8,872
  )
  
  (18,243
  )
  
  (21,195
  )
  
  (14,963
  )Interest income (expense), net
  
  
  (1,209
  )
  
  (1,332
  )
  
  (1,053
  )
  
  1,077
  
  
  892Other income from related party
  
  
  448
  
  
  
  
  
  
  
  
  
  
  
  Other income (expense), net
  
  
  
  
  
  91
  
  
  21
  
  
  2
  
  
  (16
  )Net income (loss)
  
  $
  868
  
  $
  (10,113
  )
  $
  (19,275
  )
  $
  (20,116
  )
  $
  (14,087
  )Basic and diluted net income (loss) per share
  
  $
  0.05
  
  $
  (0.65
  )
  $
  (1.64
  )
  $
  (1.80
  )
  $
  (2.24
  )Shares used in computing basic net income (loss) per
  share
  
  
  16,007
  
  
  15,641
  
  
  11,777
  
  
  11,148
  
  
  6,279Shares used in computing diluted net income (loss)
  per share
  
  
  16,908
  
  
  15,641
  
  
  11,777
  
  
  11,148
  
  
  6,279Balance Sheet Data:Cash and cash equivalents
  
  $
  3,648
  
  $
  4,613
  
  $
  4,610
  
  $
  818
  
  $
  15,662Investments in government securities
  
  
  
  
  
  
  
  
  1,169
  
  
  7,667
  
  
  13,903Working capital
  
  
  (10,647
  )
  
  (8,311
  )
  
  2,764
  
  
  7,431
  
  
  27,397Total assets
  
  
  15,554
  
  
  18,643
  
  
  23,288
  
  
  18,953
  
  
  36,324Long-term debt, including current portion
  
  
  
  
  
  5,000
  
  
  10,000
  
  
  
  
  
  Stockholders (deficit) equity (1)
  
  
  (6,566
  )
  
  (8,123
  )
  
  1,411
  
  
  11,601
  
  
  29,740(1)
  We have paid no cash
  dividends since our inception(2)
  Revenues and cost of
  revenues for 2002 and prior years have been 
  reclassified to conform to the presentation adopted in 2003.20

ITEM 7.
  MANAGEMENTS
  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverview
We develop and distribute
the Fast ForWord® family of reading intervention software.  Our innovative products apply advances in
neuroscience and cognitive research to build the fundamental cognitive skills
required to read and learn.  Extensive
outcomes research by independent researchers, our founding scientists, and our
company demonstrates that the Fast ForWord products help students attain rapid,
lasting gains in the skills critical for reading.  To facilitate the use of our products, we offer a variety of
on-site and remote professional and technical services, as well as phone, email
and web-based support.  Our primary
market is K-12 schools in the United States, to which we sell using a direct
sales force. In 2003, K-12 schools accounted for 91% of our booked sales.  By the end of 2003, approximately 2,200
schools had purchased at least $10,000 of our Fast ForWord product licenses and
services, and over 325,000 individuals had enrolled in one of
our products.
Business Highlights
In 2003 our revenue grew
41% over 2002 to reach $28.7 million. 
The increase was due to strong performance in the K-12 school market,
partially offset by a continued decline in sales to private practice
professionals.
Our service and support
revenue increased 62%, more rapidly than product revenue.  Because we believe that services are
critical to good product implementation, we have had a major initiative to
increase the amount of services we sell to customers, and we have an increasing
number of customers who renew their support agreements.   These initiatives are continuing and we
expect service and support revenue to again grow more rapidly than product
revenue in 2004.

Because a significant
portion of our software, services and support revenue is recognized in periods
after the invoice date, our 2003 revenue growth rate was due in part to strong
2002 booked sales, which represented a 35% increase over 2001.  (For more explanation of booked sales, see Revenue below.) We do not expect 2004
revenue growth to continue at this rate.
Our 2003 total booked
sales increased by 8% over 2002, and K-12 booked sales increased 11%.  Our results, while stronger than industry
results in the K-12 market, were below our expectations.   We encountered technical difficulties with
the new Gateway Edition of Fast ForWord, which we introduced in June 2003.  This resulted in lower than expected sales
in the fourth quarter.  We have released
a major update of our software and believe that the negative impact of Gateway
technical issues on sales force focus is now behind us.
One of our major goals is
to increase the number of large sales, which we believe to be an important
indicator of mainstream education industry acceptance and an important factor
in continuing to increase the productivity of our sales force.  In 2003, we closed 59 transactions in excess
of $100,000 compared to 48 in 2002.  Our
goal is to continue to increase this number in 2004.
We reported our first net
profit in 2003 of $868,000, 3% of revenue compared to a $10.1 million loss in
2002.  Achieving a profit was one of our
major financial goals for the year.  In
2004, our goals include increasing both our net income and our profit margin. To
achieve these goals, we must increase our sales, achieve the necessary product
mix, and improve sales force productivity.
During the year, we paid
off our outstanding debt of $5.0 million. 
Net cash from operating and investing activities was $3.6 million.  This was the second year we generated cash
from operations.  Because our generation
and use of cash is seasonal, we borrowed money for working capital purposes in
the first quarter of 2004 and may again do so from time to time.
21

Results of Operations
Revenue
December 31,(dollars in thousands)
  
  2003
  
  Change
  2002
  
  Change
  2001Products
  
  $
  23,225
  
  
  37
  %
  $
  16,917
  
  
  20
  %
  $
  14,109Service and support
  
  
  5,471
  
  
  62
  %
  
  3,369
  
  
  -11
  %
  
  3,780Total revenues
  
  $
  28,696
  
  
  41
  %
  $
  20,286
  
  
  13
  %
  $
  17,8892003 revenue compared to 2002:  The growth in product revenues in 2003 was
largely attributable to an 8% growth in 2003 booked sales and the continued
impact of strong 2002 sales.  Our
product license sales are initially recorded as deferred revenue and recognized
to revenue over the term of the licenses. 
Because the license term frequently crosses over two fiscal years,
our strong 2002 license sales positively affected product revenue in both 2003
and 2002. In addition, sales of our products with no Internet connection
feature increased, which had a positive impact on revenue because these sales
are recognized into revenue over a shorter period than are products licensed
with an Internet connection feature.  
Service and support revenues increased, primarily due to increased
delivery of on-site services.  The sale
and delivery of on-site services to schools has been a major focus for us in
2003 to enhance school implementations. 
Service and support revenue also increased as a result of the increase
in the number of schools on support contracts.
2002 revenue compared to 2001:  The increase in product revenue in 2002
resulted from a 35% increase in booked sales. 
2002 service revenues decreased 11%. In 2002, we changed our service
business to offer training and implementation services at a lower price than in
2001.  In addition, we sold fewer
training days than in 2001 as the percentage of our business from existing
customers increased.  Existing customers
are less likely to buy services. 
Revenue grew more slowly than sales primarily due to a lower proportion
of services in our sales mix, together with a shift in sales mix to perpetual
licenses, which resulted in a longer average period to recognize revenue on
sales. For 2002 and 2001 support revenues have been reclassified to be
comparable with 2003, when we began including support revenues with service
revenues.

Booked sales and selling activity: 
Because a significant portion of our software, services and support
revenue is recognized in periods after the invoice date, management uses booked
sales to evaluate current selling activity. 
Booked sales is a non GAAP financial measure that we believe is useful
for investors as well as management as a measure of current demand for our
products and services.  Booked sales
equals the total value (net of allowances) of software, services and support
invoiced in the period.  We record
booked sales and deferred revenue when all of the requirements for revenue
recognition have been met, other than the requirement that the revenue for
software licenses and services has been earned. We use booked sales information
for resource allocation, planning, compensation and other management
purposes.  However, booked sales should
not be considered in isolation from, and is not intended to represent a
substitute measure of revenues or any other performance measure calculated
under GAAP.

The following
reconciliation table sets forth our booked sales, revenues and change in
deferred revenue for the years ended December 31, 2003, 2002 and 2001,
respectively.

Year ended December 31,(dollars in thousands)
  
  2003
  
  Change
  2002
  
  Change
  2001Booked sales
  
  $
  30,634
  
  
  8
  %
  $
  28,272
  
  
  35
  %
  $
  20,924Less revenue
  
  
  28,696
  
  
  41
  %
  
  20,286
  
  
  13
  %
  
  17,889Net increase in deferred revenue
  
  
  1,938
  
  
  
  
  
  7,986
  
  
  
  
  
  3,035Current and long-term deferred revenue beginning of
  the period
  
  
  15,584
  
  
  
  
  
  7,598
  
  
  
  
  
  4,563Current and long-term deferred revenue end of the
  period
  
  $
  17,522
  
  
  12
  %
  $
  15,584
  
  
  105
  %
  $
  7,59822

Booked sales in the K-12
sector, which accounted for over 91% of sales in 2003, grew 11% to $27.8
million, compared to $24.9 million in 2002. 
The increases were achieved in a difficult K-12 market with tight state
funding.  We sold 862 site license
packages over $10,000 compared to 828 in the same period in 2002.  The average sale per school for customers
purchasing site license packages increased slightly due to the introduction of
our new Gateway Edition and sales of increased training and implementation
services, partially offset by purchases of more limited use licenses.   In 2003 we began reporting private school
booked sales in the K-12 sector rather than in the private sector where they
had been reported in previous years.  We
have retroactively revised 2002 and 2001 booked sales numbers to be comparable.

In 2003 we continued to
focus our sales force on multi-site sales. 
The number of sales over $100,000 increased to 59 in 2003 from 48 in
2002 and 24 in 2001.  In 2003, we had
our first $2 million sale, our largest sale to date. Sales in the fourth
quarter were negatively impacted by technical issues in our new Gateway
Edition, which diverted the focus of our sales and service organizations and
delayed some customer purchases.  We recorded a revenue reserve of $337,000 to
reflect the potential extension of term licenses and customer support due to the Gateway issues.
In 2002 K-12 sector
booked sales increased by 52% to $24.9 million compared to $16.4 million in
2001.  The K-12 sector represented 88%
of booked sales in 2002, compared to 78% in 2001.  The average sale per school increased by 61% in 2002 compared to
2001 since we did not repeat a lower priced sampling package introduced in
2001.  In addition, in 2002, perpetual
licenses, which have a higher average price per school, became a more
significant portion of our sales mix.
Booked sales to the
private sector declined by 14% in 2003 to $2.9 million compared to $3.3 million
in 2002 and declined 26% in 2002 from $4.5 million in 2001.  We attribute the decline in both 2003 and
2002 to the continued focus of our resources on the K-12 market.
In 2004, we plan to
continue to concentrate our sales effort on large multiple site opportunities
in the K-12 market.  We believe that our
new update to the Gateway Edition has resolved the significant Gateway Edition
technical issues. Although funding uncertainty continues, we believe that we
are positioned to achieve steady growth in the K-12 market during 2004.  We expect that the sales of services will
continue to grow as a percent of total sales. 
Sales to the private sector are expected to decline modestly, as we
continue to focus on the K-12 market.
Unpredictability:To achieve our sales
growth objectives will depend on increasing mainstream customer acceptance of
our products, which requires us to continue to focus on improving our products
ease of use, their fit with school requirements, and our connection with
classroom teachers and administrators. 
Our sales force numbers are limited, which requires us to achieve
increased sales productivity levels, in a K-12 market that is still negatively
impacted by a difficult state and local funding environment.  In addition the revenue recognized from our
sales can be unpredictable.  Our various
license and service packages have substantially differing revenue recognition
periods, and it is often difficult to predict which license package a customer
will purchase, even when the amount and timing of a sale can be projected.  See
Managements Discussion and Analysis 
Application of Critical Accounting Policies for a discussion
of our revenue recognition policy.   In
addition, the timing of a single large order or its implementation can
significantly impact the level of sales and revenue at any given time.

Gross
Profit and Cost of Revenues

Year ended
  December 31,(dollars in thousands)
  
  2003
  
  2002
  
  2001Gross profit on products
  
  $
  21,008
  
  $
  14,938
  
  $
  12,419Gross
  profit margin on products
  
  
  90
  %
  
  88
  %
  
  88
  %Gross profit on service and support
  
  
  1,604
  
  
  1,870
  
  
  1,385Gross
  profit margin on services and support
  
  
  29
  %
  
  56
  %
  
  37
  %Total gross profit
  
  $
  22,612
  
  $
  16,808
  
  $
  13,804Total
  gross profit margin
  
  
  79
  %
  
  83
  %
  
  77
  %23

The overall gross profit
margin fell in 2003 compared to 2002, largely due to increased service and
support costs and an increase in the proportion of revenues made up of
lower-margin service and support.  In
the first quarter of 2003, we reorganized our service and support business to
increase the number of people available to provide service and support to our
customers.  In addition, products tend
to be more challenging to implement when they are first introduced.  We also incurred additional service costs in
the second half of 2003 associated with our new Gateway Edition.  Service and support costs consist primarily
of the cost of personnel, materials and travel.

In 2003, the gross margin
on products increased slightly due to slightly lower materials costs and
amortization of capitalized software cost.  
Product costs consist of manufacturing, packaging and fulfillment costs,
amortization of capitalized software and royalties.
In 2002, overall gross
margin improved compared to 2001 primarily due to the increased proportion of
high margin product sales in our revenue mix and lower customer service and
support costs.  Lower service and
support costs resulted from improved product usability and a decline in the
cost to provide services to our customers. 
In 2002, we primarily used per diem consultants rather than full time
employees to provide training services.
In 2004, we expect gross
profit margins to improve for service and support and for products.  Improving our service margins will depend on
higher utilization of staff.  We expect
that lower amortization of capitalized software cost, a lower average royalty
rate, and a higher proportion of product sales on which we do not pay royalties
will contribute to improved product margins. 
However, overall gross margin is not expected to improve significantly
because we expect a higher proportion of services and support in our revenue
mix.
Operating Expenses
Year ended December 31,(dollars in thousands)
  
  2003
  
  Change
  2002
  
  Change
  2001Sales and marketing
  
  $
  12,961
  
  
  -11
  %
  $
  14,554
  
  
  -26
  %
  $
  19,701Research and development
  
  
  3,500
  
  
  17
  %
  
  2,985
  
  
  -12
  %
  
  3,390General and administrative
  
  
  4,529
  
  
  -5
  %
  
  4,776
  
  
  -25
  %
  
  6,348Restructuring, lease and asset impairment write-down
  
  
  (7
  )
  
  n/a
  
  
  3,365
  
  
  29
  %
  
  2,608Total operating expenses
  
  $
  20,983
  
  
  -18
  %
  $
  25,680
  
  
  -20
  %
  $
  32,047Sales and Marketing Expenses:In
2003, our sales and marketing expenses decreased primarily because some
staff formerly classified in sales and marketing became part of our expanded
service and support team.  Sales and
marketing expenses consist principally of salaries and incentive compensation
paid to employees engaged in sales and marketing activities, travel costs,
tradeshows, conferences, and marketing and promotional materials.  At December 31, 2003, we had 30
quota-bearing sales personnel selling to public schools.  In 2002 sales and marketing expenses decreased,
compared to 2001, primarily due to a decrease in personnel in the marketing
department, as well as lower spending on conferences, trade shows and marketing
materials.
During 2004, we expect to
increase our investment in sales and marketing as we focus on increasing sales
in the K-12 market.

Research and Development Expenses:Research
and development expenses increased in 2003 compared to 2002, due to increased
development activity to complete and release our new Gateway Edition in June
2003.  Research and development expenses
principally consist of compensation paid to employees and consultants engaged
in research and product development activities and product testing, together
with software and equipment costs. 
Research and development expenses decreased in 2002 compared to 2001,
due to a reduction in research and development staff as we continued to reduce
spending on activities other than improving our core products.
24

In 2003, no software
development costs were capitalized.  
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.  In 2003,
costs incurred subsequent to the establishment of technological feasibility
were not significant, and were charged to research and development
expense.  In 2002, $116,000 in software
development costs were capitalized compared to $1.2 million in 2001.
We expect research and
development expenses to increase in 2004 as we continue to invest in improving
our current product suite and introducing new products.  Two new products in our Fast ForWord to
Reading series are scheduled for launch in 2004.
General and Administrative Expenses: General and administrative expenses decreased
in 2003 compared to 2002, primarily due to lower personnel and rent expenses of $300,000 and $226,000,
as well as an adjustment to our allowance for doubtful accounts to reflect an
improvement in our bad debt experience in 2003 of $177,000, partially offset by an increase
in legal expense of $260,000, and an increase in consulting expenses of $180,000. General and administrative expenses principally consist of
salaries and compensation paid to our executives, accounting staff and other
support personnel, as well as travel expenses for these employees, and outside
legal and accounting fees.  General and
administrative expenses decreased in 2002 compared to 2001, primarily because
of decreases in personnel and legal costs.
We anticipate that
general and administrative expenses will continue to decrease in 2004 as a
percentage of revenues, but increase slightly on a dollar basis to support
growth in sales.

Restructuring, Lease and Asset Impairment Write Downs: In October 2003 we entered into a lease
termination agreement with our landlord to terminate the lease on our Oakland
headquarters and entered into a new lease agreement for a reduced amount of
space in the same building. The reduction in space is expected to reduce future
lease payments by $6.5 million (net of lease termination fees described below)
through 2008.  Under the lease
termination agreement we paid an increased security deposit of
$550,000 and lease termination fees totaling $490,000 in 2003.  The balance of the lease termination fees of
$1.8 million will be paid over the next 12 months.  A net credit adjustment of $7,000 was charged to restructuring
expense.  The adjustment represented an
addition to the restructuring reserve of $350,000 for lease and asset
impairment charges, offset by a reduction in deferred rent of $357,000 to
account for the reduction in space under the new lease agreement.
In 2001 management
restructured and consolidated operations to focus on the K-12 market.  We recorded a restructuring, lease and asset
impairment charge of $2.6 million in operating expenses.  This charge included $1.8 million to reflect
the value of excess unoccupied office space in our 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. The
restructuring also resulted in a workforce reduction of approximately 50
employees.  We also 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 the ReWord software
product, which targeted the aphasic adult market, which is not our focus.  As well, we reduced the value of furniture
and leasehold improvements related to excess office space.  At December 31, 2001 accrued liabilities included
$1.5 million relating to the excess office space and termination benefits.
During 2002, we recorded
restructuring charges totaling $3.4 million, reflecting employee severance
benefits and rent for excess office space. 
The restructuring resulted in a workforce reduction of approximately 30
employees and a total charge to operations for severance benefits of $1.1
million.  Most of the employees affected
by the workforce reduction were located in our Oakland office in the marketing
and customer service departments.  Due
to continued weakness in the commercial real estate market in 2002 we recorded
an additional charge for excess office space at our Oakland headquarters of
$2.3 million. This charge reflected adjustments to the assumptions on which the
2001 write down for excess office space had been made, including our
assumptions about the time period that the excess office space would be vacant and potential
sublease terms. We calculated the estimated costs for the additional facilities
restructuring charge based on current market information provided by a
commercial real estate broker.

25

The following table sets
forth the restructuring activity for the years ended December 31, 2003, 2002
and 2001.
(dollars in thousands)
  
  Lease
  obligation
  
  Asset
  write-downs
  
  Severance
  benefits
  
  TotalCharged to restructuring expense in 2001
  
  $
  1,791
  
  $
  361
  
  $
  456
  
  $
  2,608Cash paid in 2001
  
  
  (333
  )
  
  
  
  
  (374
  )
  
  (707
  )Asset write-downs
  
  
  
  
  
  (361
  )
  
  
  
  
  (361
  )Accrued restructuring costs, December 31, 2001
  
  
  1,458
  
  
  
  
  
  82
  
  
  1,540Restructuring Charges in 2002
  
  
  2,306
  
  
  
  
  
  1,059
  
  
  3,365Cash paid in 2002
  
  
  (759
  )
  
  
  
  
  (632
  )
  
  (1,391
  )Accrued restructuring costs, December 31, 2002
  
  
  3,005
  
  
  
  
  
  509
  
  
  3,514Restructuring Charges in 2003
  
  
  154
  
  
  196
  
  
  
  
  
  350Cash paid in 2003
  
  
  (1,386
  )
  
  
  
  
  (509
  )
  
  (1,895
  )Asset write-downs
  
  
  
  
  
  (196
  )
  
  
  
  
  (196
  )Accrued restructuring costs, December 31, 2003
  
  $
  1,773
  
  $
  
  
  $
  
  
  $
  1,773Other
Income from Related Party
During 2003 we recorded
$478,000 as other income from a transaction that included the sale and
licensing of certain intellectual property, patents and software to Neuroscience
Solutions Corporation (NSC). One of our
co-founders, substantial shareholders, and board members is also a co-founder,
officer, director and substantial shareholder of NSC.  See Transaction with Neuroscience Solutions below.  Amounts received to date and any future
receipts are being reported as other income as we do not consider the sale of
these rights to be part of reoccurring operations. There was no
comparable transaction for the same period of 2002 or 2001.

Interest
Expense, net
December 31,(dollars in thousands)
  
  2003
  
  Change
  2002
  
  Change
  2001Interest expense, net
  
  
  (1,209
  )
  
  -9
  %
  
  (1,332
  )
  
  26
  %
  
  (1,053
  )Interest expense, net decreased in 2003, compared to
2002, and increased in 2002 compared to 2001. The decrease in 2003 was
attributable to lower borrowing in 2003 compared to 2002, and the increase in
2002 was due to increased borrowing in 2002 compared to 2001.  In 2004 we expect interest expense, net to
be significantly lower because only $232,000 of deferred financing cost remains
to be amortized to interest expense during the year.  Deferred financing cost amortized in 2003 was $1.2 million.
In 2003 interest expense, net included $159,000 in interest income primarily from loans to current and former officers.
26


Provision for Income Taxes
We have recorded no
provision for income taxes as we have incurred a net loss for tax purposes
since inception.  At December 31, 2003,
we had net operating loss carryforwards for federal income tax purposes of
approximately $71 million.  Unutilized
net operating loss carryforwards will expire in years 2011 through 2023.  Utilization of the net operating losses may
be subject to a substantial annual limitation due to the ownership change
limitations.  Previous or future equity
transactions may result in such an ownership change.  The annual limitation may result in the expiration of net
operating losses before they become available to reduce future tax
liabilities.  At December 31, 2003, we
had approximately $29.7 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.
Liquidity and Capital Resources
Our cash and cash equivalents
were $3.6 million at December 31, 2003, compared to $4.6 million at December
31, 2002 and 2001.  During 2002 and 2003
we generated cash flow from operations, which was used to pay down bank
borrowing from 2001.  At December 31,
2001 we had $10 million outstanding on our bank line of credit; at December 31,
2003 there were no borrowings outstanding under the line. We expect that our
cash flow from operations and our current cash balances will be the primary
source of the funds for our operations and capital expenditures during
2004.  During 2004, we plan to continue to generate
positive cash flow from operations and to generate a profit.  However, accomplishing these objectives will
require us to achieve specific sales targets in the K-12 market.  We
cannot assure you that we will meet our targets with respect to sales, revenues
or operating results.
Net
cash provided by operating activities in 2003 was $4.6 million, compared to
$3.7 million in 2002.  Net cash
increased in both 2003 and 2002 primarily because booked sales increased at a
faster rate than spending and our collection experience was good.  Accounts receivable at year end was $5.1
million in 2003 compared to $4.7 million in 2002 and $5.8 million in 2001. The
net cash used in operating activities in 2001 was $12.5 million, primarily from
our net loss of $19.3 million, partially offset by an increase in deferred
revenue and an increase in the restructuring reserve.
Net cash used in
investing activities in 2003 was $959,000, consisting primarily of an increase
in non-current assets for the additional deposit of $550,000 under our new
lease.  In 2002, net cash of $849,000
was provided by investing activities, primarily from the sale of the $1.2
million balance of our portfolio of government securities.  In 2001, net cash was provided by the sale
of $6.5 million in government securities, partially offset by loans to officers
of $3.1 million and investments in property and equipment of $1.4 million and
capitalized software development of $1.2 million   Our level of capital expenditures was quite low in both 2003 and
2002, approximately $256,000 and $124,000, respectively.   In 2004, we expect that our capital
spending will be modestly higher than in 2003 as we continue to upgrade
computer equipment and purchase new software to improve operations.

Financing activities used
$4.6 million in cash in both 2003 and 2002, primarily to pay down $5 million,
net, on our line of credit in both years, partially offset by cash raised from
the sale of stock upon option exercises and through our employee stock purchase
plan.  In 2001 financing activities
provided $15.4 million from net borrowings of $10 million and $5.4 million from
the issuance of common stock.
Because of the
seasonality that affects operations, we may have negative cash flow in
particular quarters, particularly the first quarter.  We borrowed money for working capital purposes in the first
quarter of 2004 and may borrow again from to time.  On January 30, 2004 we entered into a revolving line of credit
agreement with Comerica Bank.  The line
totals $7.0 million through July 22, 2004; after that date, the maximum that
can be borrowed under the agreement is $5.0 million for the remainder of the
term.  The line expires on January 14,
2005. The facility is partially secured by a letter of credit provided by WPV,
Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The
letter of credit is for $4.0 million through May 30, 2004 and $3.0 million from
May 31, 2004 to July 30, 2004.  The
nonguaranteed portion of the line is subject to limitations based on our
accounts receivable balance.  To further
secure the line we granted Comerica a
security interest in all of our assets other than our intellectual property,
and agreed not to restrict our ability to grant a security interest in our
intellectual property.  The Banks
security interest is second to the security interest granted to WPV to secure
our obligation to reimburse WPV for amounts it is required to pay in the event
of a drawdown under the letter of credit. 
Borrowings under the line are subject to various covenants, which may
limit our financial and operating flexibility.
27

In January 2004 we
terminated the $10.0 million revolving loan agreement with Fleet National Bank,
which was also guaranteed by WPV, Inc. The guarantee was due to expire in March
2004.
After 2004, we expect
that cash flow from operations will continue to be our primary source of funds
for the next several years.  Again, this
will require us to achieve certain levels of sales.  If the Company is unable to achieve sufficient levels of cash
flow from operations, the Company may seek other sources of debt or equity
financing, or may be required to reduce expenses.  Reducing the Companys expenses could adversely affect its
operations by reducing the resources available for sales, marketing, research
or development efforts.   We cannot
assure you that we will be able to secure additional debt or equity financing
on acceptable terms.
Contractual
Obligations and Commitments
We have a non-cancelable
lease agreement for our corporate office facilities.  In 2003, we renegotiated the lease, terminating the prior
agreement and entering into a new lease agreement for a reduced amount of space
in the same location.  The minimum lease
payment under the new agreement on our office facility (excluding lease
termination charges) is approximately $78,000 per month through 2008. After
2008 the base lease payment increases at a compound annual rate of
approximately 5%. The lease terminates in December 2013.
The following table
summarizes our outstanding borrowings and contractual obligations at December
31, 2003 and the effects such obligations are expected to have on our liquidity
and cash flow in future periods.
(dollars in thousands)
  
  Total
  
  1 year
  
  1 - 3
  years
  
  4 - 5
  years
  
  Thereafter(1)Lease termination agreement
  
  $
  1,760
  
  
  $
  1,760
  
  
  
  $
  
  
  
  
  $
  
  
  
  
  $
  Non-cancelable operating leases
  
  
  10,107
  
  
  
  940
  
  
  
  
  1,880
  
  
  
  
  1,880
  
  
  
  
  5,407Minimum royalty payments
  
  
  1,650
  
  
  
  150
  
  
  
  
  300
  
  
  
  
  300
  
  
  
  
  900Total
  
  $
  13,517
  
  
  $
  2,850
  
  
  
  $
  2,180
  
  
  
  $
  2,180
  
  
  
  $
  6,307(1) Non-cancelable operating leases expires December
31, 2013.  Minimum royalty payments
expire in 2014.


Our purchase order commitments at
December 31, 2003 are not material.

Loans to Current and Former Officers

In
March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million.  The total receivable including accrued
interest at December 31, 2003 and 2002 was $3.5 million and $3.4 million,
respectively.  Accrued interest of
$419,000 and $265,000 for the years ended December 31, 2003 and 2002
respectively was included in Other Assets on the Balance Sheet.  In 2002 some of these officers left our Company.  The Notes are full recourse loans
secured by shares of our Common Stock owned by the current and former
officers.  The loans bear interest at
4.94%.  Principal and interest are due
December 31, 2005.

Transaction
with Neuroscience Solutions Corporation
In September 2003, we
signed an agreement with Neuroscience Solutions Corporation (NSC),
transferring technology to NSC for use in the health field.  The transaction includes a license of the
patents we own, a sublicense of the patents we license from others, the license
of certain software we developed, and the transfer of assets related to certain
research projects.  All of the rights
licensed to NSC are limited to the health field and most are exclusive in that
field.  We will continue to use the
licensed patents and technology in the fields
of education and speech and language therapy, and retain all rights to our
technology outside of the health field.
28

We also agreed with NSC
that we would license one another certain patents that may be issued in the
future, on which royalties would be paid, and that we would provide NSC certain
technology transfer, hosting and support services.
NSC
is a start-up company located in San Francisco that plans to develop, market,
and sell a series of software-based products for healthcare markets based on
neuroplasticity research.  NSCs first
products are expected to focus on addressing issues that commonly arise as a
result of aging.  Dr. Michael M.
Merzenich, who is a founder, director, significant stockholder and former
officer of our company, is also a founder, director, significant shareholder
and officer of NSC.
The terms of the
transaction were determined through arms length negotiations between NSC and
us, in which Dr. Merzenich did not participate.  We received an initial payment of $500,000 and will be entitled to
a 2 to 4% royalty on future products of NSC that use the licensed
technology.  We were also issued
1,772,727 shares of Series A Preferred Stock in NSC.  Because NSC is a start-up venture the shares of which are not
actively traded, in our financial statements we have assigned a value of zero
to the NSC shares we received.

Application of Critical Accounting Policies
Our financial statements
are prepared in accordance with accounting principles generally accepted in the
United States (GAAP). These accounting principles require us to make certain
estimates, assumptions and judgments. We believe that the estimates,
assumptions and judgments upon which we rely are reasonable based upon information
available to us at the time. The estimates, assumptions and judgments that we
make can affect the reported amounts of assets and liabilities as of the date
of the financial statements, as well as the reported amounts of revenues and
expenses during the periods presented. To the extent there are material
differences between these estimates and actual results, our financial
statements would be affected.
The estimates,
assumptions and judgments pertaining to revenue recognition, allowance for
doubtful accounts, software development costs and long lived assets are the
most critical assumptions to understand in order to evaluate our reported
financial results.  A detailed
discussion of our use of estimates, assumptions and judgments as they relate to
these polices is presented below.  We
have discussed the application of these critical accounting policies with the
Audit Committee of the Board of Directors.
Revenue Recognition
We derive revenue from
the sale of licenses to our software and from service and support fees.  Software license revenue is recognized in
accordance with 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 four basic criteria, which must be met to recognize revenue. These are: 1)
persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed
or determinable fee; and 4) the probability that the fee will be collected. For
software orders with multiple elements, we allocate revenue to each element of
a transaction based upon its fair value as determined in reliance on vendor
specific objective evidence. Vendor specific objective evidence of fair value
for each element of an arrangement is based upon the normal pricing and
discounting practices for those products and services when sold separately and,
for support services, is additionally measured by the renewal price.
Our revenue recognition
policy is also based on the Securities and Exchange Commissions Staff
Accounting Bulletin 101 (SAB 101), which requires companies that provide an
ongoing service to recognize revenue over the term of the services
agreement.

29

Revenues from the
licensing of software are recognized as follows: 1) for perpetual licenses purchased
with Internet-based participant tracking services, revenue is recognized over a
one-year period; 2) for limited term site licenses,
revenue is recognized over the life of the license, typically 3 to 12 months;
3) for individual participant licenses, revenue is recognized over the average
duration of the products use, typically 6 weeks; and 4) for perpetual licenses
that are not purchased with Internet-based services,  revenue is recognized when the product has been shipped, provided
that the other criteria stated above are met.
Service and support
revenues are derived from a combination of on-site and remote training,
implementation, technical and professional services and customer support.  Revenue from services is recognized on
delivery.  Revenue from support is
recognized over the contractual support period.
The value of software
licenses, services and support invoiced during a particular quarter is recorded
as deferred revenue until recognized.  
Typically 20%-30% of software licenses, services and support invoiced in
a particular quarter has been recognized as revenue during that period.  This proportion varies with our product mix
and is affected by the particular season. 
For example, in the third quarter, we typically provide a significant
portion of the implementation services invoiced during that period as schools
begin their year, while a lesser proportion of services invoiced is usually
recognized in the second quarter, when many schools close for the summer.
Allowance
for Doubtful Accounts
We maintain an allowance
for doubtful accounts for estimated losses due to the inability of customers to
make payments.  These estimates are
based on historical experience. In 2001 and early 2002 our experience was that
bad debt expense was about 2% of revenue. 
In the later half of 2002 and 2003 our bad debt experience improved
significantly to less than 1% of revenue and in the 4th quarter of
2003 we adjusted our bad debt allowance to reflect the improvement in our
experience.  To the extent experience
requires it, we may in the future again adjust this reserve. Cancellations and
refunds are allowed in limited circumstances, and such amounts have not been
significant.
Software Development Costs

We capitalize 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.

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.  We estimate the useful
life of our developed products to be 3 years.
On an ongoing basis, we
evaluate the net realizable value of the capitalized software development cost
by estimating the future revenue to be generated from the product and compare
this estimate to the unamortized cost of the product.  At December 31, 2003 future revenues from sale of products for
which development costs remain on the balance sheet are anticipated to exceed
the $710,000 of unamortized development costs.
Impairment of Long-Lived Assets
We regularly review the
carrying value of loans to current and former officers, capitalized software
development costs and property and equipment.  
We continually make estimates regarding the probability of repayment,
future cash flows and other factors 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.
See the Notes to our
Condensed Financial Statements, which contain additional information regarding
our accounting policies and other disclosures required by GAAP.
30

Recent Accounting Pronouncements
In November 2002, the
Emerging Issues Task Force reached a consensus on Issue No. 00-21 (EITF
00-21), Revenue Arrangements with Multiple
Deliverables.EITF 00-21 provides guidance on how to account for
arrangements that involve the delivery or performance of multiple products,
services and/or rights to use assets. The provisions of EITF 00-21 apply to
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. We believe that our revenue recognition policies conform to the
requirements of EITF 00-21.
In December 2003, the
Securities and Exchange Commission issued Staff Accounting Bulleting
No. 104 Revenue Recognition (SAB 104), which updates and summarizes the
Commissions views on the application of generally accepted accounting
principles to revenue recognition in financial statements. We believe that our
revenue recognition policies conform to the requirements of SAB 104.

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 new revolving credit facility with Comerica Bank.  Interest rates on loans extended under that
facility are at the banks prime rate plus 0.5%.  A hypothetical increase or decrease in market interest rates by
10% from the market interest rates at December 31, 2003 would not have a
material affect on our results of operations.
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, 2003 and 2002, and the related statements of
operations, stockholders (deficit) equity, and cash flows for each of the
three years in the period ended December 31, 2003. Our audit also included
the financial statement schedule included in Item 15. 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, 2003 and 2002, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 2003, 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 6, 2004
32

Scientific
Learning Corporation
Balance Sheet(In thousands, except share and per share amounts)
December 31,2003
  
  2002AssetsCurrent assets:Cash and cash equivalents
  
  $
  3,648
  
  $
  4,613Accounts receivable, net of allowance for doubtful
  accounts $139 and $270 at December 31, 2003 and 2002, respectively
  
  
  5,117
  
  
  4,867Prepaid expenses and other current assets
  
  
  1,134
  
  
  1,340Total current assets
  
  
  9,899
  
  
  10,820Property and equipment, net
  
  
  537
  
  
  1,198Notes receivable from current and former officers
  
  
  3,114
  
  
  3,114Other assets
  
  
  2,004
  
  
  3,511Total assets
  
  $
  15,554
  
  $
  18,643Liabilities and stockholders
  deficitCurrent liabilities:Accounts payable
  
  $
  481
  
  $
  287Accrued liabilities
  
  
  3,832
  
  
  5,411Deferred revenue
  
  
  16,233
  
  
  13,433Total current liabilities
  
  
  20,546
  
  
  19,131Borrowings under bank line of credit
  
  
  
  
  
  5,000Deferred revenue, long-term
  
  
  1,289
  
  
  2,151Other liabilities
  
  
  285
  
  
  484Total liabilities
  
  
  22,120
  
  
  26,766Commitments and contingenciesStockholders deficit:Preferred stock, $0.001 par value; 1,000,000 shares
  authorized, no shares issued or outstanding
  
  
  
  
  
  Common stock, $0.001 par value; 40,000,000 shares
  authorized, 16,150,551 and 15,879,083 shares issued and outstanding at
  December 31, 2003 and 2002, respectively
  
  
  74,460
  
  
  73,771Accumulated deficit
  
  
  (81,026
  )
  
  (81,894
  )Stockholders deficit:
  
  
  (6,566
  )
  
  (8,123
  )Total liabilities and stockholders
  deficit
  
  $
  15,554
  
  $
  18,643See
accompanying notes.
33



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

Year ended
  December 31,2003
  
  2002
  
  2001Revenues:Products
  
  $
  23,225
  
  $
  16,917
  
  $
  14,109Service and
  support
  
  
  5,471
  
  
  3,369
  
  
  3,780Total
  revenues
  
  
  28,696
  
  
  20,286
  
  
  17,889Cost of
  revenues:Cost of
  products
  
  
  2,217
  
  
  1,979
  
  
  1,690Cost of
  service and support
  
  
  3,867
  
  
  1,499
  
  
  2,395Total cost
  of revenues
  
  
  6,084
  
  
  3,478
  
  
  4,085Gross profit
  
  
  22,612
  
  
  16,808
  
  
  13,804Operating expenses:Sales and
  marketing
  
  
  12,961
  
  
  14,554
  
  
  19,701Research and
  development
  
  
  3,500
  
  
  2,985
  
  
  3,390General and
  administrative
  
  
  4,529
  
  
  4,776
  
  
  6,348Restructuring
  charges
  
  
  (7
  )
  
  3,365
  
  
  2,608Total
  operating expenses
  
  
  20,983
  
  
  25,680
  
  
  32,047Operating
  income (loss)
  
  
  1,629
  
  
  (8,872
  )
  
  (18,243
  )Other income
  from related party
  
  
  448
  
  
  
  
  
  Interest
  expense, net
  
  
  (1,209
  )
  
  (1,332
  )
  
  (1,053
  )Other income
  (expense), net
  
  
  
  
  
  91
  
  
  21Net income
  (loss)
  
  $
  868
  
  $
  (10,113
  )
  $
  (19,275
  )Basic and
  diluted net income (loss) per share:
  
  $
  0.05
  
  $
  (0.65
  )
  $
  (1.64
  )Shares used
  in computing basic net income (loss)
  
  
  16,006,565
  
  
  15,641,849
  
  
  11,777,415Shares used
  in computing diluted net income (loss)
  
  
  16,908,361
  
  
  15,641,849
  
  
  11,777,415See accompanying notes.
34


Scientific Learning Corporation
Statements of Stockholders(Deficit) Equity(In thousands,
except share amounts)
Common
        Stock
    
    Deferred
        Compensation
    Accumulated
        Deficit
    
    TotalStockholders
        (Deficit) EquityShares
    
    AmountBalances
        at December 31, 2000
    
    
    11,336,380
    
    $
    64,179
    
    $
    (72
    )
    $
    (52,506
    )
    $
    11,601Issuance
        of common stock under stock option plan
    
    
    7,395
    
    
    29
    
    
    
    
    
    
    
    
    29Issuance
        of common stock under employee stock purchase plan
    
    
    131,844
    
    
    373
    
    
    
    
    
    
    
    
    373Issuance
        of common stock in a private placement, net of offering costs
    
    
    4,000,000
    
    
    4,964
    
    
    
    
    
    
    
    
    4,964Issuance
        of common stock warrants in connection with guarantee of line of credit
    
    
    
    
    
    3,647
    
    
    
    
    
    
    
    
    3,647Amortization
        of deferred compensation
    
    
    
    
    
    
    
    
    72
    
    
    
    
    
    72Net
        loss and comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    (19,275
    )
    
    (19,275
    )Balance
        December 31, 2001
    
    
    15,475,619
    
    
    73,192
    
    
    
    
    
    (71,781
    )
    
    1,411Issuance
        of common stock under stock option plan
    
    
    274,471
    
    
    318
    
    
    
    
    
    
    
    
    318Issuance
        of common stock under employee stock purchase plan
    
    
    116,861
    
    
    119
    
    
    
    
    
    
    
    
    119Compensation
        charge relating to granting of common stock options
    
    
    
    
    
    122
    
    
    
    
    
    
    
    
    122Stock
        issued in exchange for services
    
    
    12,132
    
    
    20
    
    
    
    
    
    
    
    
    20Net
        loss and comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    (10,113
    )
    
    (10,113
    )Balance
        December 31, 2002
    
    
    15,879,083
    
    
    73,771
    
    
    
    
    
    (81,894
    )
    
    (8,123
    )Issuance
        of common stock under stock option plan
    
    
    207,438
    
    
    264
    
    
    
    
    
    
    
    
    264Issuance
        of common stock under employee stock purchase plan
    
    
    52,912
    
    
    180
    
    
    
    
    
    
    
    
    180Compensation
        charge relating to granting of common stock options
    
    
    
    
    
    198
    
    
    
    
    
    
    
    
    198Stock
        issued in exchange for services
    
    
    11,118
    
    
    47
    
    
    
    
    
    
    
    
    47Net
        income and comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    868
    
    
    868Balance
        December 31, 2003
    
    
    16,150,551
    
    $
    74,460
    
    $
    
    
    $
    (81,026
    )
    $
    (6,566
    )See accompanying notes
35


Scientific Learning Corporation
Statement of Cash Flows(In thousands)
Year ended
  December 31,2003
  
  2002
  
  2001Operating Activities:Net income
  (loss)
  
  $
  868
  
  $
  (10,113
  )
  $
  (19,275
  )Adjustments
  to reconcile net income (loss) to cash provided by operating activities:Depreciation
  
  
  721
  
  
  1,082
  
  
  1,262Amortization
  of software development costs
  
  
  763
  
  
  666
  
  
  493Amortization
  of deferred financing costs
  
  
  1,215
  
  
  1,216
  
  
  984Stock based
  compensation
  
  
  245
  
  
  142
  
  
  72Asset
  impairment write downs
  
  
  
  
  
  50
  
  
  360Changes in
  operating assets and liabilities:Accounts
  receivable
  
  
  (250
  )
  
  887
  
  
  (1,029
  )Prepaid
  expenses and other current assets
  
  
  438
  
  
  (52
  )
  
  121Accounts
  payable
  
  
  194
  
  
  (157
  )
  
  (704
  )Accrued liabilities
  
  
  (1,383
  )
  
  1,813
  
  
  2,071Deferred
  revenues
  
  
  1,938
  
  
  7,986
  
  
  3,035Other liabilities
  
  
  (199
  )
  
  197
  
  
  123Net cash
  provided by (used in) operating activities
  
  
  4,550
  
  
  3,717
  
  
  (12,487
  )Investing Activities:Sale of
  government securities
  
  
  
  
  
  1,169
  
  
  6,498Purchases of
  property and equipment, net
  
  
  (256
  )
  
  (124
  )
  
  (1,445
  )Notes
  receivable from current and former officers
  
  
  
  
  
  
  
  
  (3,114
  )Increase in
  capitalized software development costs
  
  
  
  
  
  (116
  )
  
  (1,153
  )(Increase)
  decrease in other non-current assets
  
  
  (703
  )
  
  (80
  )
  
  126Net cash
  (used in) provided by investing activities
  
  
  (959
  )
  
  849
  
  
  912Financing Activities:Proceeds
  from issuance of common stock, net
  
  
  444
  
  
  437
  
  
  5,367Borrowings
  under bank line of credit
  
  
  2,000
  
  
  4,000
  
  
  14,000Repayments
  of borrowings under bank line of credit
  
  
  (7,000
  )
  
  (9,000
  )
  
  (4,000
  )Net cash
  (used in) provided by financing activities
  
  
  (4,556
  )
  
  (4,563
  )
  
  15,367(Decrease)
  increase in cash and cash equivalents
  
  
  (965
  )
  
  3
  
  
  3,792Cash and
  cash equivalents at beginning of year
  
  
  4,613
  
  
  4,610
  
  
  818Cash and
  cash equivalents at end of year
  
  $
  3,648
  
  $
  4,613
  
  $
  4,610Supplemental disclosureInterest
  paid
  
  $
  134
  
  $
  294
  
  $
  432Supplemental disclosure of noncash investing and financing
  activities:Issuance of
  common stock warrants in connection with guarantee of line of credit
  
  $
  
  
  $
  
  
  $
  3,647See accompanying notes.
36


Notes to Financial
Statements
1. Summary of
Significant Accounting Policies
Description of
Business
Scientific Learning Corporation (the Company) is the leading provider
of neuroscience-based software products that develop underlying cognitive
skills required for reading and learning. 
The Companys Fast ForWord® products are a series of reading
intervention products for children, adolescents and adults.   We sell primarily to K-12 schools through a
direct sales force.  The Company also
sells to speech and language professionals.  
To support our products, we provide on-site and remote training and
implementation services, as well as technical, professional and customer
support and a wide variety of Web-based resources.
The Company was incorporated in 1995 in the State of California and was
reincorporated in 1997 in the State of Delaware.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
certain estimates and assumptions that affect the reported amounts of assets
and liabilities as of the date of the financial statements as well as the
reported amounts of revenues and expenses during the periods presented. Actual
results may differ from those estimated.
Revenue Recognition
The Company derives revenue from the sale of licenses to its software
and from service and support 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 four basic criteria, which must be met to recognize
revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of
the product; 3) a fixed or determinable fee; and 4) the probability that the
fee will be collected. For software orders with multiple elements, the Company
allocates revenue to each element of a transaction based upon its fair value as
determined in reliance on vendor specific objective evidence. Vendor specific
objective evidence of fair value for each element of an arrangement is based
upon the normal pricing and discounting practices for those products and
services when sold separately and, for support services, is additionally
measured by the renewal price.
The Companys revenue recognition policy is also based on the
Securities and Exchange Commissions Staff Accounting Bulletin 101 (SAB 101),
which requires companies who provide an ongoing service to recognize revenue
over the term of the services agreement.

Revenues from the licensing of software are recognized as follows: 1)
for perpetual licenses purchased with Internet-based participant tracking
services, revenue is recognized over a one-year period; 2) for limited term
site licenses, revenue is recognized over the life of the license, typically 3
to 12 months; 3) for individual participant licenses, revenue is recognized
over the average duration of the products use, typically 6 weeks; and 4) for
perpetual licenses that are not purchased with Internet-based services,  revenue is recognized when the product has
been shipped, provided that the other criteria stated above are met.
Service and support revenues are derived from a combination of on-site
and remote training, implementation, technical and professional services and
customer support.  Revenue from services
is recognized on delivery.  Revenue from
support is recognized over the contractual support period.
37

Notes to Financial Statements  (continued)
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.
Accounts Receivable
The Company conducts business primarily with public school districts
and speech and language professionals 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 based on past experience and management assessment of current
risks.
Fair Value of
Financial Instruments
The carrying amounts of the Companys cash and cash equivalents, accounts
receivable, notes receivable from current and former officers, and accounts
payable approximate fair value.
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.  In 2003, costs incurred subsequent to the establishment of
technological feasibility were not significant, and were charged to research
and development expense.  The Company capitalized
$116,000 of software development costs for the year ended December 31,
2002.  Software costs are amortized to
cost of revenues over the estimated useful life of the software, which is three
years: amortization was $763,000, $666,000 and $493,000 for the years ended
December 31, 2003, 2002 and 2001, respectively.
Long-Lived Assets
The Company regularly reviews the carrying value of long-lived
assets.   We continually make estimates
regarding the probability of repayment, future cash flows and other factors 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.
Accounting for
Stock-Based Compensation
The Company accounts for stock issued to
employees in accordance with Accounting Principles Board Opinion No. 25 (APB
25), Accounting for Stock Issued to
Employees and complies with the disclosure provisions of SFAS No.
123 (SFAS 123), Accounting for Stock-Based
Compensation and SFAS No. 148 (SFAS 148), Accounting for Stock-Based Compensation  Transition
and Disclosure.Under APB 25, compensation expense of fixed stock options is based on the difference,
if any, on the date of the grant between the fair value of the Companys stock
and the exercise price of the option. The Company accounts for stock issued to
non-employees in accordance with the provisions of SFAS 123 and EITF No. 96-18, Accounting for Equity Instruments That are Issued
to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services.
38


Notes to Financial
Statements  (continued)
Pro Forma Disclosures
of the Effect of Stock-Based Compensation
Pro forma information regarding the results of operations and net
income (loss) per share is determined as if the Company had accounted for its
employee stock options using the fair value method. The fair value of each
option granted is estimated on the date of grant using the Black Scholes
valuation model with the following assumptions:
Year ended
  December 31,2003
  
  2002
  
  2001Weighted
  average expected life of option
  
  
  5 years
  
  
  5 years
  
  
  5 yearsRisk-free
  interest rate
  
  
  3.0
  %
  
  3.0
  %
  
  4.5
  %Dividend
  yield
  
  
  0.0
  %
  
  0.0
  %
  
  0.0
  %Volatility
  
  
  85
  %
  
  85
  %
  
  85
  %Weighted
  average fair value
  
  $
  2.05
  
  $
  0.90
  
  $
  2.51The Company
has elected to use the intrinsic value method in accounting for its employee
stock options because, as discussed below, the alternative fair value accounting
requires the use of option valuation models that were not developed for use in
valuing employee stock options. Under the intrinsic value method, when the
exercise price of the Companys employee stock options equals the market price
of the underlying stock on the date of grant, no compensation expense is
recognized.
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 of the 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 Black Scholes valuation model, the Companys net
income (loss) and basic and diluted net income (loss) per share would have been
changed to the pro forma amounts indicated below (in thousands, except per
share amounts):
Year Ended
  December 31,2003
  
  2002
  
  2001Net income
  (loss), as reported
  
  $
  868
  
  $
  (10,113
  )
  $
  (19,275
  )Add:
  Stock-based employee compensation expense included in the determination of
  net income (loss), as reported
  
  
  
  
  
  142
  
  
  72Deduct:
  Total stock-based employee compensation expense determined under fair value
  based method for all awards
  
  
  (1,465
  )
  
  (2,472
  )
  
  (3,066
  )Net loss,
  proforma
  
  $
  (597
  )
  $
  (12,443
  )
  $
  (22,269
  )Basic and
  diluted net income (loss) per share, as reported
  
  $
  0.05
  
  $
  (0.65
  )
  $
  (1.64
  )Basic and
  diluted net loss per share, pro forma
  
  $
  (0.04
  )
  $
  (0.80
  )
  $
  (1.89
  )The pro forma
impact of options on the net income (loss) for the years ended December 31,
2003, 2002 and 2001, is not representative of the effects on net income
(loss) for future years, as future years will include the effects of
additional years of stock option grants.
39


Notes to Financial
Statements  (continued)
Advertising
Advertising costs are expensed as incurred.  Advertising expense was $1,000, $4,000, $61,000 for the years
ended December 31, 2003, 2002 and 2001, 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 Income (Loss) per
Share
Under the provisions of SFAS No. 128, Earnings per Share,basic net income
(loss) per share is computed using the weighted-average number of common shares
outstanding during the period. Diluted net income (loss) per share reflects the
potential dilution of securities by adding common stock equivalents to the
weighted-average number of common shares outstanding during the period, if
dilutive. Potentially dilutive securities have been excluded from the
computation of diluted net income (loss) per share if their inclusion is
antidilutive.
The following table sets forth the computation of net income (loss) per
share (in thousands, except share and per share data):
Year Ended December 31,2003
  
  2002
  
  2001Net income
  (loss)
  
  $
  868
  
  $
  (10,113
  )
  $
  (19,275
  )Weighted
  average shares used in caluculation of basic net income (loss) per share
  
  
  16,006,565
  
  
  15,641,849
  
  
  11,777,415Effect of
  dilutive secruities:Employee
  stock options
  
  
  901,796
  
  
  
  
  
  Weighted-average
  diluted commnon share
  
  
  16,908,361
  
  
  15,641,849
  
  
  11,777,415Net income
  (loss) per common share- basic and diluted:
  
  $
  0.05
  
  $
  (0.65
  )
  $
  (1.64
  )If the Company
had reported net income in 2002 and 2001, the calculation of diluted earnings
per share would have included the shares used in the computation of basic net
loss per share as well as an additional 64,000 and 36,000 common equivalent
shares (computed using the treasury stock method) related to outstanding stock
options not included in the calculations above for the years ended
December 31, 2002 and 2001, respectively.
Recent Accounting
Pronouncements

In November 2002, the Emerging Issues Task Force reached a consensus on
Issue No. 00-21 (EITF 00-21), Revenue
Arrangements with Multiple Deliverables.EITF 00-21 provides
guidance on how to account for arrangements that involve the delivery or
performance of multiple products, services and/or rights to use assets. The
provisions of EITF 00-21 apply to revenue arrangements entered into in fiscal
periods beginning after June 15, 2003. The Company believes that its revenue
recognition policies conform to the requirements of EITF 00-21.

In December 2003, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 104 Revenue Recognition (SAB 104), which updates
and summarizes the Commissions views on the application of generally accepted
accounting principles to revenue recognition in financial statements. The
Company believes that its revenue recognition policies conform to the
requirements of SAB 104.
40

Notes to Financial
Statements  (continued)

Reclassifications
Certain revenue and cost of revenue items from prior years have been
reclassified to conform to the current presentation.
2.  Restructuring, Lease and Asset Impairment
Write Downs
In October 2003 the Company entered into a lease termination agreement
with its landlord to terminate the lease on its Oakland headquarters and
entered into a new lease agreement for a reduced amount of space in the same
building. The reduction in space is expected to reduce future lease payments by
$6.5 million (net of lease termination fees described below) through 2008.  Under the lease termination agreement the
Company paid an increased security deposit of $550,000 and lease termination
fees totaling $490,000 in 2003.  The
balance of the lease termination fees of $1.8 million will be paid over the
next 12 months.  A net credit adjustment
of $7,000 was charged to operations. 
The adjustment represented an addition to the restructuring reserve of
$350,000 for lease and asset impairment charges, offset by a reduction in
deferred rent of $357,000 to account for the reduction in space under the new
lease agreement.
The following table sets forth the restructuring activity during the
year ended December 31, 2003 
(dollar in thousands).

Accrued
  restructuring costs,
  December 31, 2002
  
  Restructuring
  charges
  
  Asset
  write-down
  
  Cash paid
  
  Accrued
  restructuring costs,
  December 31, 2003Lease
  obligation
  
  
  $
  3,005
  
  
  
  $
  154
  
  
  
  $
  
  
  
  
  $
  (1,386
  )
  
  
  $
  1,773Asset
  write-down
  
  
  
  
  
  
  
  
  196
  
  
  
  
  (196
  )
  
  
  
  
  
  
  
  
  Severance
  benefits
  
  
  
  509
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  (509
  )
  
  
  
  Total
  
  
  $
  3,514
  
  
  
  $
  350
  
  
  
  $
  (196
  )
  
  
  $
  (1,895
  )
  
  
  $
  1,773In 2002 the
Company recorded restructuring, lease and asset impairment charges of $3.4
million in operating expenses.  The
restructuring resulted in a workforce reduction of approximately 30 employees
and a total charge to operations for severance benefits of $1.1 million.  All affected employees had been terminated
or notified of their severance benefits by December 31, 2002.  Most of the employees affected by the
workforce reduction were located in the Companys Oakland office in the marketing and
customer service departments.
Due to continued weakness in the commercial real estate market in 2002
the Company recorded an additional charge for excess office space at the Companys
Oakland headquarters of $2.3 million. This charge reflected adjustments to the
assumptions on which the 2001 write down for excess office space had been made,
including assumptions about the time period that the excess office space would
be vacant and potential sublease terms. The Company calculated the estimated
costs for the additional facilities restructuring charge based on current
market information provided by a commercial real estate broker.  We estimated the $3.0 million accrued at
December 31, 2002 would be paid over the next two years.

The following table sets forth the restructuring activity during the
year ended December 31, 2002
(in thousands).
Accrued
  restructuring costs,
  December 31, 2001
  
  Restructuring
  Charges
  
  Cash paid
  
  Accrued restructuring costs,
  December 31, 2002Lease
  obligation
  
  
  $
  1,458
  
  
  
  $
  2,306
  
  
  
  $
  (759
  )
  
  
  $
  3,005Severance
  benefits
  
  
  
  82
  
  
  
  
  1,059
  
  
  
  
  (632
  )
  
  
  
  509Total
  
  
  $
  1,540
  
  
  
  $
  3,365
  
  
  
  $
  (1,391
  )
  
  
  $
  3,51441

Notes to Financial
Statements  (continued)

Prepaid Expenses and
Other Current Assets

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


December
  31,2003
  
  2002Prepaid
  expenses
  
  $
  781
  
  $
  1,070Deferred
  financing
  
  
  232
  
  
  Product
  inventory
  
  
  109
  
  
  223Other
  receivables
  
  
  12
  
  
  47$
  1,134
  
  $
  1,3404. Property and Equipment
Property and equipment consists of the following (in thousands):


December
  31,2003
  
  2002Computer
  equipment
  
  $
  3,978
  
  $
  4,233Office
  furniture and equipment
  
  
  1,403
  
  
  1,439Leasehold
  improvements
  
  
  432
  
  
  5775,813
  
  
  6,249Less
  accumulated depreciation
  
  
  (5,276
  )
  
  (5,051
  )$
  537
  
  $
  1,1985.  Notes Receivable from Current and Former
Officers
Notes receivable from current and former
officers was $3.1 million for each of the years ended December 31, 2003 and
2002.  The Notes are full
recourse loans secured by shares of the Companys Common Stock owned by the
current and former officers and bear interest at 4.94%.  Principal and interest are due December 31,
2005.  Accrued interest of $419,000 and
$265,000 at December 31, 2003 and 2002 respectively is recorded in other assets.

6.   Other Assets
Other assets consist of the following (in thousands):

December
  31,2003
  
  2002Software
  development cost
  
  $
  3,089
  
  $
  3,089Less
  accumulated amortization
  
  
  (2,379
  )
  
  (1,616
  )Software
  development costs, net
  
  
  710
  
  
  1,473Deferred
  financing cost, net
  
  
  
  
  
  1,447Other non
  current assets
  
  
  1,294
  
  
  591$
  2,004
  
  $
  3,51142

Notes to Financial
Statements  (continued)

7.  Accrued Liabilities

Accrued liabilities consist of the following (in thousands):


December
  31,2003
  
  2002Accrued
  restructuring costs
  
  $
  1,773
  
  $
  3,514Accrued
  vacation
  
  
  831
  
  
  684Accrued
  commissions and bonus
  
  
  930
  
  
  911Other
  accrued liabilities
  
  
  298
  
  
  302$
  3,832
  
  $
  5,4118.  Bank Line of Credit
In 2001, the Company entered into a revolving loan agreement with a
bank for an unsecured revolving credit facility in the amount of $15 million
expiring June 30, 2004.  In October
2003, the credit facility was reduced to $10 million, because the Company did
not believe that it needed the full amount of the facility during its remaining
term. 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 would have expired in March 2004. As of December 31, 2003, no
borrowings were outstanding under the line of credit.

In January 2004 the line was terminated and a new bank line of credit
was obtained. See Note 15.
In consideration of the original guarantee the Company granted a
security interest in substantially all of the Companys assets and issued WPV,
Inc. a fully vested and non-forfeitable warrant to purchase 1,375,000 shares of
common stock of the Company at an exercise price of $8.00.  The warrant will expire if unexercised by
March 9, 2008. The fair value of the warrant at the date of issuance was $3.6
million and this amount is being amortized as deferred financing costs by a
charge to interest expense through July 31, 2004.  WPV, Inc. will continue to provide a guarantee on the new line of
credit through July 2004.
9.  Income Taxes
The Company has made no provision for U.S. federal, U.S. state or
foreign income taxes for any periods as the Company has incurred tax 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
  31,2003
  
  2002Deferred tax
  assets:Net
  operating loss carryforwards
  
  $
  25,778
  
  $
  26,083Restructuring
  reserve
  
  
  710
  
  
  506Capitalized
  software and development costs
  
  
  698
  
  
  670Deferred
  revenue
  
  
  800
  
  
  860Research
  credits carryforwards
  
  
  811
  
  
  715Other
  
  
  941
  
  
  683Total
  deferred tax assets
  
  
  29,738
  
  
  29,517Valuation
  allowance
  
  
  (29,738
  )
  
  (29,517
  )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 $221,000 and increased by $3.5 million during the years ended
December 31, 2003 and 2002, respectively.
43


Notes to Financial Statements
- (continued)
As of December 31, 2003, the Company had net operating loss
carryforwards for federal income tax purposes of approximately $71 million,
which expire in the years 2011 through 2023 and federal research tax credits of
approximately $489,000, which expire in the years 2011 through 2023.  The Company also had net operating loss
carryforwards for state income tax purposes of approximately $27 million
expiring in the years 2004 through 2013 and state research tax credits of
approximately $322,000 which carryforward indefinitely.
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
Deficit
Common Stock
At December 31, 2003, the Company had reserved shares of common stock
for future issuance as follows:
Stock
  Options outstanding
  
  
  3,045,027Stock
  Options available for future grants
  
  
  652,197Employee
  stock purchase plan
  
  
  304,143Common stock
  warrants
  
  
  1,382,2225,383,589Stock
Options
The Companys employee 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 years.  Options under the
employee plans 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 a modification
charge to operations.

In May 1999, the Companys stockholders approved the 1999 Equity
Incentive Plan, which amended and restated the Companys previous stock option
plan.  3,292,666 shares of common stock
were authorized for issuance under the plan, including shares originally authorized
under predecessor plans and shares added to the plan in 2001.  In
May 2002, the Companys Board of Directors approved and in May 2003, the
shareholders subsequently approved, adding
1,350,000 shares to the 1999 Equity Incentive Plan.  The total number of shares authorized for issuance under the plan
is now 4,642,666.  The Board of
Directors also approved the 2002 CEO Stock Option Plan in May 2002, which was
subsequently approved by the shareholders in May 2003.  This plan reserved an aggregate of 470,588
shares for grants of stock options under the plan.
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. In May 2003, the
Companys stockholders approved an increase in the number of shares authorized
for issue under the plan from 75,000 shares to a total of 150,000 shares.
44

Notes to Financial Statements  (continued)
A summary of the Companys stock option activity under the plans is as follows:

Outstanding
  OptionsNumber of
  Shares
  
  Weighted-
  Average
  Exercise
  Price Per
  ShareOutstanding
  at December 31, 2000
  
  
  1,618,274
  
  $
  11.34Granted
  
  
  438,826
  
  
  3.62Exercised
  
  
  (7,395
  )
  
  3.91Canceled
  
  
  (396,539
  )
  
  10.73Outstanding
  at December 31, 2001
  
  
  1,653,166
  
  
  9.47Granted
  
  
  2,239,290
  
  
  1.36Exercised
  
  
  (274,471
  )
  
  1.15Canceled
  
  
  (628,681
  )
  
  9.35Outstanding
  at December 31, 2002
  
  
  2,989,304
  
  
  4.20Granted
  
  
  501,834
  
  
  3.08Exercised
  
  
  (207,445
  )
  
  1.27Canceled
  
  
  (238,666
  )
  
  9.85Outstanding
  at December 31, 2003
  
  
  3,045,027
  
  $
  3.76Vested and
  exercisable
  
  
  1,417,970The following
table summarizes information concerning outstanding and exercisable stock
options at December 31, 2003:
Outstanding
  
  Vested and
  ExercisablePrice Range
  
  Number of
  Shares
  
  Weighted-
  Average
  Exercise
  Price Per
  Share
  
  Weighted-
  Average
  Remaining
  Contractual
  Life (Years)
  
  Number of
  Shares
  
  Weighted
  Average
  Exercise
  Price Per
  Share$  0.2600
   $    1.3900
  
  
  1,517,564
  
  
  
  $
  1.37
  
  
  
  8.36
  
  
  
  424,313
  
  
  
  $
  1.34$  1.4000
   $    6.1250
  
  
  1,164,304
  
  
  
  $
  3.35
  
  
  
  7.89
  
  
  
  640,643
  
  
  
  $
  3.68$  6.2500
   $  39.8750
  
  
  363,149
  
  
  
  $
  15.11
  
  
  
  5.74
  
  
  
  353,014
  
  
  
  $
  15.233,045,027
  
  
  
  
  
  
  
  
  
  
  
  
  1,417,97045

Notes
to Financial Statements  (continued)

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 per share.  The warrant was
issued to WPV, Inc., an affiliate of a significant stockholder of the Company,
in connection with the guarantee of a line of credit to the Company.   The warrant is outstanding and will expire
if unexercised by March 9, 2008. The fair 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 interest
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 per
share.  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 expired unexercised in
January 2004.
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 initially reserved a total of 350,000 shares of common stock for
issuance under the plan.  In May 2002
the Companys shareholders approved an additional 350,000 shares for a total of
700,000 shares.  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 52,912 and 116,861 shares of common stock under the plan during the
years ended December 31, 2003 and 2002, respectively.   At December 31, 2003, 304,143 shares were available for issuance
under the Plan.
11.  Commitments
Leases

The Company leases its corporate office facility under a non-cancelable
operating lease with a term expiring in 2013. 
Future minimum payments under this lease as of December 31, 2003 are as
follows (in thousands):

2004
  
  $
  9402005
  
  
  9402006
  
  
  9402007
  
  
  9402008
  
  
  9402009 and
  thereafter
  
  
  5,407Total
  minimum lease payments
  
  $
  10,107Rent expense
under all operating leases net of sublease income was $1 million, $1.7 million
and $2.0 million for the years ended December 31, 2003, 2002 and 2001,
respectively.
46


Notes to Financial
Statements  (continued)
License Agreement
In September 1996, the Company entered into a license agreement with a
university for the use of the intellectual property underlying its most
significant current products. In exchange for the license, 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.
The agreement also provides for additional royalties and milestone
payments based upon revenues from products using the licensed technology.
Royalty and milestone expenses were $909,000, $723,000 and $635,000 for the
years ended December 31, 2003, 2002 and 2001, respectively, and are
included in cost of revenues.  All
milestone payments required under the license have now been paid.  Annual minimum guaranteed royalty payments
are $150,000.
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. 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.  Guarantees
The Company generally provides a warranty that its software products
substantially operate as described in the manuals and guides that accompany the
software for a period of 90 days.  The
warranty does not apply in the event of misuse, accident, and certain other
circumstances.  To date, the Company has
not incurred any material costs associated with these warranties and has no accrual for such items at December 31, 2003.
13.  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 presently match
contributions by plan participants.
14.  Related Party
Transaction

On September 30, 2003 the Company entered into an agreement with
Neuroscience Solutions Corporation (NSC) to provide NSC with exclusive rights
in the healthcare field to certain intellectual property, patents and software
owned or licensed by the Company, along with transfer of certain healthcare
research projects.  A co-founder,
substantial shareholder, and member of the Board of Directors of the Company is
a co-founder, officer, director and substantial shareholder of NSC.

The rights were acquired by NSC for a
combination of cash, stock and future royalties. NSC paid $500,000 cash, of
which $448,000 was recognized at December 31, 2003. The balance will be
recognized over the next nine months as services are provided to NSC. Amounts
received to date and any future receipts are being reported as other income as
the Company does not consider the sale of these rights to be part of its
recurring operations. Under the agreement, the Company will receive net
royalties between 2% to 4% on products sold by NSC that use the Companys
patents or software.  We did not record
a value for the 1.8 million shares of NSC received in the transaction, because
NSC is a private start-up venture the shares of which have no determinable value.
47

Notes to Financial
Statements  (continued)
15.  Subsequent
Events
On January 30, 2004 the Company entered into a revolving line of credit
agreement with Comerica Bank.  The line
totals $7.0 million through July 22, 2004; after that date, the maximum that
can be borrowed under the agreement is $5.0 million.   The line expires on January 14, 2005. Borrowing under the line
of credit bears interest at prime plus .5%, currently 4.5%.  The facility is partially secured by a
letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus
Ventures, a significant stockholder of the Company. The letter of credit is for
$4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July
30, 2004.  The nonguaranteed portion of
the line is subject to limitations based on the Companys accounts receivable
balance.  To further secure the line the
Company granted a security interest in granted Comerica a security interest in
all of our assets other than our intellectual property, and agreed not to
restrict our ability to grant a security interest in our intellectual property.
On January 15, 2004, the Company terminated its $10.0 million revolving
loan agreement with Fleet National Bank. This line of credit was also
guaranteed by WPV, Inc. The guarantee was due to expire in March 2004.

16.  Interim Financial
Information (unaudited)
Quarterly financial data (in thousands, except per share amounts)
2003Quarter
  ended,
  March 31
  
  Quarter
  ended,
  June 30
  
  Quarter
  ended,
  September 30
  
  Quarter
  ended,
  December 31 (1)
  
  TotalTotal
  revenues
  
  
  $
  6,377
  
  
  
  $
  7,357
  
  
  
  $
  8,018
  
  
  
  $
  6,944
  
  
  
  $
  28,696Gross profit
  
  
  
  4,994
  
  
  
  
  5,846
  
  
  
  
  6,373
  
  
  
  
  5,399
  
  
  
  
  22,612Net (loss)
  income
  
  
  
  (610
  )
  
  
  
  (56
  )
  
  
  
  1,289
  
  
  
  
  245
  
  
  
  
  868Net (loss)
  income per share:basic
  
  
  
  (.04
  )
  
  
  
  (.00
  )
  
  
  
  .08
  
  
  
  
  .02
  
  
  
  
  .05diluted
  
  
  $
  (.04
  )
  
  
  $
  (.00
  )
  
  
  $
  .08
  
  
  $
  
  .01
  
  
  
  $
  .05(1) Includes other income from
related party of $448,000.

2002Quarter
  ended,
  March 31
  
  Quarter
  ended,
  June 30
  
  Quarter
  ended,
  September 30
  
  Quarter
  ended,December 31
  
  TotalTotal revenues
  
  
  $
  3,184
  
  
  
  $
  4,449
  
  
  
  $
  6,396
  
  
  
  $
  6,257
  
  
  
  $
  20,286Gross profit
  
  
  
  2,511
  
  
  
  
  3,583
  
  
  
  
  5,374
  
  
  
  
  5,340
  
  
  
  
  16,808Net loss
  
  
  
  (3,862
  )
  
  
  
  (2,926
  )
  
  
  
  (450
  )
  
  
  
  (2,875
  )
  
  
  
  (10,113
  )Net loss per
  share(basic and diluted)
  
  
  $
  (.25
  )
  
  
  $
  (.19
  )
  
  
  $
  (.03
  )
  
  
  $
  (.18
  )
  
  
  $
  (.65
  )48


ITEM
9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None.
ITEM
9A.  CONTROLS AND PROCEDURES
Based on the evaluation required under Rule 13a-15(b) of the Exchange
Act, conducted by the Companys management, including the Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the Companys
disclosure controls and procedures, the Companys Chief Executive Officer and
Chief Financial Officer concluded that the Companys disclosure controls and
procedures were effective as of December 31, 2003.
Disclosure controls and procedures are designed to ensure that
information required to be disclosed in our reports filed under the Exchange
Act, such as this Annual Report on Form 10-K, is recorded, processed,
summarized and reported within the required time periods. These procedures are
also designed to ensure that such information is accumulated and communicated
to our management, including our Chief Executive Officer and Chief Financial
Officer, as appropriate to allow timely decisions regarding required
disclosure.
A control system, no matter how well designed and operated, can provide
only reasonable, not absolute, assurance that the objectives of the system will
be met.  In addition, the design of a
control system must reflect the fact that there are resource constraints, and
the benefits of controls must be considered relative to their costs.  As a result, there can be no assurance that
a control system will succeed in preventing all possible instances of error and
fraud.  The Companys disclosure
controls and procedures are designed to provide reasonable assurance of
achieving their objectives, and the Chief Executive Officer and Chief Financial
Officer have concluded that these controls and procedures are effective at the
reasonable assurance level.
49

Part III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

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

Information required by
this item respecting our directors, audit committee and code of ethics is set
forth under the caption Proposal 1: Election of Directors in our Proxy
Statement relating to our 2004 Annual Meeting of Stockholders (the Proxy
Statement) and is incorporated by reference into this Form 10-K Report.  The Proxy Statement will be filed with the
Securities and Exchange Commission in accordance with Rule 14a-6(c) promulgated
under the Securities Exchange Act of 1934, as amended (the Exchange
Act).  With the exception of the
foregoing information and other information specifically incorporated by
reference into this Form 10-K Report, the Proxy Statement is not being filed as
a part hereof.
Information with respect
to compliance with Section 16(a) of the Exchange Act is set forth under the
caption Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy
Statement and is incorporated by reference into this Form 10-K Report.
ITEM 11.  EXECUTIVE COMPENSATION
Information required by
this item concerning compensation of executive officers and directors is set
forth under the caption Executive Compensation in the Proxy Statement and is
incorporated by reference into this Form 10-K Report.
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
Information required by
this item concerning security ownership of certain beneficial owners and
management is set forth under the caption Security Ownership of Certain
Beneficial Owners and Management in the Proxy Statement and is incorporated by
reference into this Form 10-K Report.
Information required by
this item concerning shares authorized for issuance under equity compensation
plans approved by stockholders and not approved by stockholders is set forth
under the caption Equity Compensation Plan Information in the Proxy Statement
and is incorporated by reference into this Form 10-K Report.
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by
this item concerning certain relationships and related transactions is set
forth under the captions Employment Agreement and Certain Transactions in
the Proxy Statement and is incorporated by reference into this Form 10-K
Report.
ITEM 14.  PRINCIPAL ACCOUNTING FEES AND SERVICES
Information required by
this item concerning the independent auditor fees and services is set forth
under the caption Independent Auditors in the Proxy Statement and is
incorporated by reference into this Form 10-K Report.
50

PART IV
ITEM 15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)
  Documents filed as part of this report.(1)
  Financial StatementsIndependent Auditors ReportBalance Sheet  December 31, 2003 and 2002Statement of Operations  Years Ended December 31,
  2003, 2002 and 2001Statements of Stockholders (Deficit) Equity  Years
  Ended December 31, 2003, 2002 and 2001Statement of Cash Flows  Years Ended December 31,
  2003, 2002 and 2001Notes to the Financial Statements(2)
  Financial Statement SchedulesAs 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:Opening
  Balance
  
  Charges to
  Operating
  Expenses
  
  Charges to
  Allowance(1)
  
  Deductions
  
  Closing
  Balance2003
  
  
  $
  270
  
  
  
  $
  0
  
  
  
  $
  89
  
  
  
  $
  (220
  )
  
  
  $
  1392002
  
  
  $
  248
  
  
  
  $
  19
  
  
  
  $
  309
  
  
  
  $
  (306
  )
  
  
  $
  2702001
  
  
  $
  241
  
  
  
  $
  130
  
  
  
  $
  239
  
  
  
  $
  (362
  )
  
  
  $
  248(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.51

(3)  Exhibits
Exhibit No.
  
  Description of Document3.3(1)
  
  Restated Certificate of Incorporation.3.4 (20)
  
  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, 19984.5(9)
  
  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, 199810.1(1)*
  
  Form of Indemnity Agreement with each of our
  directors and executive officers.10.2(14)*
  
  1999 Equity Incentive Plan, as amended.10.3(14)*
  
  Forms of Stock Option Grant Notice, Stock Option
  Agreement and Stock Award Agreement under the Incentive Plan.10.4(14)*
  
  1999 Non-Employee Directors Stock Option Plan, as
  amended.10.5(14)*
  
  Forms of Nonstatutory Stock Option Agreements under
  the Non-Employee Directors Stock Option Plan10.6(14)*
  
  1999 Employee Stock Purchase Plan, as amended.10.8(14)*
  
  Form of 1999 Employee Stock Purchase Plan Offering
  under the Employee Stock Purchase Plan.10.9 (21)
  
  Loan and Security Agreement dated as of January 15,
  2004 by and between Scientific Learning Corporation and Comerica Bank10.10 (21)
  
  Reimbursement and Security Agreement dated as of
  January 15, 2004 by and between Scientific Learning Corporation and WPV, Inc.10.11 (21)
  
  Intercreditor Agreement dated as of January 15, 2004
  by and between Comerica Bank and WPV, Inc10.13(1)
  
  Exclusive License Agreement, dated September 27,
  1996, with the Regents of the University of California.10.14 (22)
  
  Amendment No. 3 to Exclusive License Agreement,
  dated September 27, 1996, with the Regents of the University of California,
  amending the agreement filed as Exhibit 10.13.10.15(1)
  
  Securities Purchase Agreement, dated September 24,
  1996, with Warburg, Pincus Ventures, L.P.10.16 (23)
  
  Lease, dated as of October 1, 2003, with Rotunda
  Partners II10.17 (24)
  
  Lease Termination Agreement, dated as of October 1,
  2003, with Rotunda Partners II10.18(4)
  
  Revolving Loan Agreement dated as of March 9, 2001
  by and between Scientific Learning Corporation and Fleet National Bank10.19(5)
  
  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(6)
  
  Warrant to Purchase 1,375,000 Shares of Common Stock
  of Scientific Learning Corporation10.21(7)*
  
  Loan agreements, promissory notes and pledge
  agreements with each of Sheryle Bolton, Frank Mattson, Steve Miller, and
  James Mills10.22(8)
  
  Stock Purchase Agreement dated November 9, 2001
  between Scientific Learning Corporation and Warburg Pincus Ventures, L.P.10.23(10)*
  
  Letter Agreement dated March 12, 2002 between the
  Company and Sheryle Bolton.10.24(10)
  
  First Amendment Agreement, dated March 26, 2002,
  between the Company and Fleet National Bank amending the agreement filed as
  Exhibit 10.18.10.25(10)*
  
  2002 Management Incentive Plan.10.26(11)*
  
  Employment Agreement dated as of May 31, 2002 by and
  between Scientific Learning Corporation and Robert C. Bowen10.27(12)*
  
  2002 CEO Option Plan10.29(13)*
  
  Milestone Equity Incentive Plan10.30(13)*
  
  2003 Management Incentive Plan52

10.31 (15)
  
  Second Amendment Agreement dated as of September 24,
  2003, by and between Scientific Learning Corporation and Fleet National Bank,
  amending the agreement filed as Exhibit 10.18, which was previously amended
  by the First Amendment Agreement filed as Exhibit 10.24.10.32(16)
  
  Technology Transfer Agreement dated as of September
  30, 2003 by and between the Company and Neuroscience Solutions Corporation
  (NSC).10.33(17)
  
  SLC License Agreement dated as of September 30, 2003
  by and between the Company and NSC.10.34(18)
  
  NSC License Agreement dated as of September 30, 2003
  by and between NSC and the Company.10.35(19)
  
  Services Agreement dated as of September 30, 2003 by
  and between the Company and NSC.23.1
  
  Consent of Ernst & Young, LLP, Independent
  Auditors31.1
  
  Certification of Chief Executive Officer (Section
  302)31.2
  
  Certification of Chief Financial Officer (Section
  302)32.1
  
  Certification of Chief Executive Officer (Section
  906)32.2
  
  Certification of Chief Financial Officer  (Section 906)(1)
  
  Incorporated by reference to the 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 Exhibit 99.1 previously
  filed with the Companys Form 8-K on March 12, 2001 (SEC File No. 000-24547).(5)
  
  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).(6)
  
  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).(7)
  
  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).(8)
  
  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).(9)
  
  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).(10)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-K for the year ended
  December 31, 2001 (SEC File No. 000-24547).(11)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on June 7, 2002 (SEC File No. 000-24547).(12)
  
  Incorporated by reference to Exhibit 99.2 previously
  filed with the Companys Form 8-K on June 7, 2002 (SEC File No. 000-24547).(13)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-K for the year ended
  December 31, 2002 (SEC File No. 000-24547).(14)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-Q for the quarter ended
  June 30, 2003 (SEC File No. 000-24547).(15)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on October 3, 2003 (SEC File No.
  000-24547).(16)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(17)
  
  Incorporated by reference to Exhibit 99.2 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(18)
  
  Incorporated by reference to Exhibit 99.3 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).53

(19)
  
  Incorporated by reference to Exhibit 99.4 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(20)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-Q for the quarter ended
  September 30, 2003 (SEC File No. 000-24547).(21)
  
  Incorporated by reference to Exhibits previously
  filed with the Companys Form 8-K on February 5, 2004 (SEC File No.
  000-24547).(22)
  
  Incorporated by reference to Exhibit 10.36
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547).(23)
  
  Incorporated by reference to Exhibit 10.37
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547).(24)
  
  Incorporated by reference to Exhibit 10.38
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547). Certain portions of
this exhibit have been omitted based upon confidential treatment granted by the
Securities and Exchange Commission for portions of the referenced exhibit.
*Management contract or
compensatory plan or arrangement.

(b) Reports on Form
8-K.
On October 1, 2003, the
  Company filed a Report on Form 8-K disclosing the closing under a technology
  transfer agreement with Neuroscience Solutions Corporation.On October 3, 2003, the
  Company filed a Report on Form 8-K disclosing its agreement to reduce the
  amount available for borrowing under its credit line.On October 30, 2003, the
  Company filed a Report on Form 8-K furnishing its press release announcing
  its financial results for the quarter ended September 30, 2003 and the
  transcript of its conference call discussing those earnings54

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/ Robert C. Bowen
  
  March 26, 2004Robert C. BowenChief Executive OfficerPursuant 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/ Robert C. BowenRobert C. Bowen
  Chairman, Chief Executive Officer
  March 26, 2004and Director (Principal ExecutiveOfficer)/s/ Jane A. FreemanJane A. Freeman
  Senior Vice President, Chief Financial Officer,
  March 26, 2004and Treasurer (Principal Financial andAccounting Officer)/s/ Dr. Michael M. MerzenichDr. Michael M. Merzenich
  Director
  March 26, 2004/s/ Dr. Paula A. TallalDr. Paula A. Tallal
  Director
  March 26, 2004/s/ Carleton A. HolstromCarleton A. Holstrom
  Director
  March 26, 2004/s/ Rodman W. Moorhead, IIIRodman W. Moorhead, III
  Director
  March 26, 2004/s/ Ajit DalviAjit Dalvi
  Director
  March 26, 2004/s/ Dr. Joseph MartinDr. Joseph Martin
  Director
  March 26, 2004/s/ Edward Vermont Blanchard,
  Jr.Edward Vermont Blanchard, Jr.
  Director
  March 26, 200455

INDEX TO EXHIBITS

Exhibit No.
  
  Description of Document3.3(1)
  
  Restated Certificate of Incorporation.3.4 (20)
  
  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, 19984.5(9)
  
  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, 199810.1(1)*
  
  Form of Indemnity Agreement with each of our
  directors and executive officers.10.2(14)*
  
  1999 Equity Incentive Plan, as amended.10.3(14)*
  
  Forms of Stock Option Grant Notice, Stock Option
  Agreement and Stock Award Agreement under the Incentive Plan.10.4(14)*
  
  1999 Non-Employee Directors Stock Option Plan, as
  amended.10.5(14)*
  
  Forms of Nonstatutory Stock Option Agreements under
  the Non-Employee Directors Stock Option Plan10.6(14)*
  
  1999 Employee Stock Purchase Plan, as amended.10.8(14)*
  
  Form of 1999 Employee Stock Purchase Plan Offering
  under the Employee Stock Purchase Plan.10.9 (21)
  
  Loan and Security Agreement dated as of January 15,
  2004 by and between Scientific Learning Corporation and Comerica Bank10.10 (21)
  
  Reimbursement and Security Agreement dated as of
  January 15, 2004 by and between Scientific Learning Corporation and WPV, Inc.10.11 (21)
  
  Intercreditor Agreement dated as of January 15, 2004
  by and between Comerica Bank and WPV, Inc10.13(1)
  
  Exclusive License Agreement, dated September 27,
  1996, with the Regents of the University of California.10.14 (22)
  
  Amendment No. 3 to Exclusive License Agreement,
  dated September 27, 1996, with the Regents of the University of California,
  amending the agreement filed as Exhibit 10.13.10.15(1)
  
  Securities Purchase Agreement, dated September 24,
  1996, with Warburg, Pincus Ventures, L.P.10.16 (23)
  
  Lease, dated as of October 1, 2003, with Rotunda
  Partners II10.17 (24)
  
  Lease Termination Agreement, dated as of October 1,
  2003, with Rotunda Partners II10.18(4)
  
  Revolving Loan Agreement dated as of March 9, 2001
  by and between Scientific Learning Corporation and Fleet National Bank10.19(5)
  
  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(6)
  
  Warrant to Purchase 1,375,000 Shares of Common Stock
  of Scientific Learning Corporation10.21(7)*
  
  Loan agreements, promissory notes and pledge
  agreements with each of Sheryle Bolton, Frank Mattson, Steve Miller, and
  James Mills10.22(8)
  
  Stock Purchase Agreement dated November 9, 2001
  between Scientific Learning Corporation and Warburg Pincus Ventures, L.P.10.23(10)*
  
  Letter Agreement dated March 12, 2002 between the
  Company and Sheryle Bolton.10.24(10)
  
  First Amendment Agreement, dated March 26, 2002,
  between the Company and Fleet National Bank amending the agreement filed as
  Exhibit 10.18.10.25(10)*
  
  2002 Management Incentive Plan.10.26(11)*
  
  Employment Agreement dated as of May 31, 2002 by and
  between Scientific Learning Corporation and Robert C. Bowen56

10.27(12)*
  
  2002 CEO Option Plan10.29(13)*
  
  Milestone Equity Incentive Plan10.30(13)*
  
  2003 Management Incentive Plan10.31 (15)
  
  Second Amendment Agreement dated as of September 24,
  2003, by and between Scientific Learning Corporation and Fleet National Bank,
  amending the agreement filed as Exhibit 10.18, which was previously amended
  by the First Amendment Agreement filed as Exhibit 10.24.10.32(16)
  
  Technology Transfer Agreement dated as of September
  30, 2003 by and between the Company and Neuroscience Solutions Corporation
  (NSC).10.33(17)
  
  SLC License Agreement dated as of September 30, 2003
  by and between the Company and NSC.10.34(18)
  
  NSC License Agreement dated as of September 30, 2003
  by and between NSC and the Company.10.35(19)
  
  Services Agreement dated as of September 30, 2003 by
  and between the Company and NSC.23.1
  
  Consent of Ernst & Young, LLP, Independent
  Auditors31.1
  
  Certification of Chief Executive Officer (Section
  302)31.2
  
  Certification of Chief Financial Officer (Section
  302)32.1
  
  Certification of Chief Executive Officer (Section
  906)32.2
  
  Certification of Chief Financial Officer  (Section 906)(1)
  
  Incorporated by reference to the 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 Exhibit 99.1 previously
  filed with the Companys Form 8-K on March 12, 2001 (SEC File No. 000-24547).(5)
  
  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).(6)
  
  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).(7)
  
  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).(8)
  
  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).(9)
  
  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).(10)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-K for the year ended
  December 31, 2001 (SEC File No. 000-24547).(11)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on June 7, 2002 (SEC File No. 000-24547).(12)
  
  Incorporated by reference to Exhibit 99.2 previously
  filed with the Companys Form 8-K on June 7, 2002 (SEC File No. 000-24547).(13)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-K for the year ended
  December 31, 2002 (SEC File No. 000-24547).(14)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-Q for the quarter ended
  June 30, 2003 (SEC File No. 000-24547).(15)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on October 3, 2003 (SEC File No.
  000-24547).57

(16)
  
  Incorporated by reference to Exhibit 99.1 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(17)
  
  Incorporated by reference to Exhibit 99.2 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(18)
  
  Incorporated by reference to Exhibit 99.3 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(19)
  
  Incorporated by reference to Exhibit 99.4 previously
  filed with the Companys Form 8-K on October 1, 2003 (SEC File No.
  000-24547).(20)
  
  Incorporated by reference to the same numbered
  exhibit previously filed with the Companys Form 10-Q for the quarter ended
  September 30, 2003 (SEC File No. 000-24547).(21)
  
  Incorporated by reference to Exhibits previously
  filed with the Companys Form 8-K on February 5, 2004 (SEC File No.
  000-24547).(22)
  
  Incorporated by reference to Exhibit 10.36
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547).(23)
  
  Incorporated by reference to Exhibit 10.37
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547).(24)
  
  Incorporated by reference to Exhibit 10.38
  previously filed with the Companys Form 10-Q for the quarter ended September
  30, 2003 (SEC File No. 000-24547). Certain portions
of this exhibit have been omitted based upon confidential treatment granted by
the Securities and Exchange Commission for portions of the referenced exhibit.
*Management contract or
compensatory plan or arrangement.

58