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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K þ Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934 For the fiscal year ended December 31, 2004 or o Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934 For the transition period from  to COMMISSION FILE NO. 000-24547 SCIENTIFIC LEARNING CORPORATION  DELAWARE
    
    94-3234458(State or other jurisdiction of
    
    (IRS Employer Identification Number)incorporation or organization)
 300 FRANK H. OGAWA PLAZA, SUITE 600
OAKLAND, CA 94612-2040
(Address of principal executive offices, including zip code) 510-444-3500
(Registrants telephone number, including area code) Securities registered pursuant to Section 12 (b) of the Act: 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: þ No: o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of the Registrants knowledge in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this form 10-K. o Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2). Yes: o No: þ 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, 2004 as reported on
the Nasdaq Small Cap Market was approximately $39,148,211. Shares of Common Stock held by each
executive officer and director and by certain persons who owned 5% or more of the Registrants
outstanding Common Stock on that date have been excluded in that such persons may be deemed to be
affiliates. This determination of affiliate status is not necessarily a conclusive determination
for other purposes. As of March 15, 2005 the Registrant had outstanding 16,669,199 shares of Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the Registrants 2005 Annual Meeting of Stockholders are
incorporated by reference in Part III.




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TABLE OF CONTENTS PAGE NO.PART IItem 1.
    
    Business
    
    
    3Item 2.
    
    Properties
    
    
    17Item 3.
    
    Legal Proceedings
    
    
    17Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    17PART IIItem 5.
    
    Market for
Registrants Common Equity and Related Stockholder Matters
    
    
    20Item 6.
    
    Selected Financial Data
    
    
    21Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22Item 7A.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    32Item 8.
    
    Financial Statements and Supplementary Data
    
    
    33Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    51Item 9A.
    
    Controls and Procedures
    
    
    51Item 9B.
    
    Other Information
    
    
    51PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    52Item 11.
    
    Executive Compensation
    
    
    52Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    52Item 13.
    
    Certain Relationships and Related Transactions
    
    
    52Item 14.
    
    Principal Accounting Fees and Services
    
    
    52PART IVItem 15.
    
    Exhibits, Financial Statement Schedules, and Reports on Form 8-K
    
    
    53SIGNATURES
    
    
    
    
    57EXHIBIT 10.4EXHIBIT 10.30EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
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PART I This report 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.
Forward-looking statements are not historical facts but rather are based on current expectations
about our business and industry, as well as our beliefs and assumptions. Words such as may,
will, should, expects, intends, plans, anticipates, believes, estimates,
predicts, potential, continues and variations and negatives of these words and similar
expressions are used to identify forward-looking statements. None of the forward-looking
statements, including but not limited to those identified with asterisks(*) in this report is a
guarantee of future performance or events, and all are subject to risks, uncertainties and other
factors, many of which are beyond our control and some of which we may not even be presently aware.
As a result, our future results and other future events or trends may differ materially from those
anticipated in our forward-looking statements. Specific factors that might cause such a difference
include, but are not limited to, the risks and uncertainties discussed in Item 1, Business, under
the caption Factors That May Affect Results of Operations or Stock Price and in Item 7,
Managements Discussion and Analysis. We also refer you to the risk factors that are or may be
discussed from time to time in our public announcements and our other filings with the SEC,
including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance
on forward-looking statements, which reflect our view only as of the date of this report. 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. BUSINESS We develop and distribute the Fast ForWord® family of reading intervention software.
Our patented 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, in 2003 37% of fourth graders
in the U.S. had below basic reading scores and 69% were unable to read proficiently at grade level.
According to the NAEP, between 1992 and 2003, there was no significant change in the average
reading score of fourth graders or in the proportion of fourth graders below the basic level,
despite a national focus on reading and significant and increased federal funding. Learning to read proficiently is a complex task involving multiple cognitive processes. In recent
years, scientists have come to a much better understanding of these processes. Our software
products are based on and incorporate learning from more than 30 years of research on the brain,
language, and reading. Extensive outcomes research by independent researchers, school districts,
our founding scientists, and our company demonstrates that the Fast ForWord products help students
attain fast, lasting gains in the skills critical for reading. To assist educators in monitoring their Fast ForWord implementations and tracking their students
progress, our major products include an optional web-based tool that provides detailed reports on
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 2004, approximately 3,200 schools had purchased at least $10,000 of our Fast ForWord
product licenses and services, and over 470,000 individuals had enrolled in one of our products. MARKETS K-12 MARKET Our primary market is K-12 schools in the United States. In 2004, the K-12 sector represented more
than 90% of our business. We began building our school sales force in late 1998, and since 2000
our annual growth rate for K-12 booked sales has averaged more than 30%. Our current long-term
target for future growth in K-12 booked sales is 20% to 30% per year.* Our ability to achieve this
growth depends on many factors, some of which are beyond our control, and we may not be able to
achieve this target. The K-12 market is large and is projected to grow.* The National Center for Education Statistics,
part of the U.S. Department of Education, estimates that in fall 2004 U.S. K-12 schools enrolled
more than 54 million students, and Page 3




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projects that K-12 enrollment will continue growing through 2013.* Market Data Retrieval, a
supplier of market information to the education industry, estimates that there are approximately
13,700 public school districts in the U.S., and approximately 114,000 public and private school
buildings, or sites. The K-12 instructional materials market can be divided along a variety of characteristics based on
type of instructional material (for example, basal, supplemental, reference, assessment), subject
matter (reading, math, etc.), and medium (for example, print, software, on-line content,
manipulatives). Using these categories, our products are best classified as supplemental software
for reading intervention. Simba Information, Inc., a marketing information company, estimates that
the K-12 market for electronic instructional materials of all types is approximately $1.7 billion,
and grew approximately 3.6% between 2003 and 2004. Eduventures, a strategic consulting firm in the
education industry, estimates that in 2003, K-12 schools spent $3.3 billion on supplemental content
for all subject matter areas, 4.5% more than in 2002. Eduventures forecasts that the supplemental
market will grow to $3.8 billion in 2005, 7% over its 2004 forecast.* Eduventures further
estimates that digital supplemental products currently capture less than 20% of the supplemental
market, but will grow to more than 25% of the market by 2007.* The supplemental market is highly
fragmented, with numerous suppliers. We believe that we presently have a small share of the
reading intervention supplemental market. FUNDING The general availability of funding for public schools fluctuates from time to time, and in recent
years state and local education funding has been negatively affected by reduced levels of tax
revenues due to the economic slowdown, and the education technology industry generally experienced
soft sales, typically attributed to tight funding. However, substantial federal funding resources
remain, and many of those resources are focused on reading improvement. Eduventures estimates that
total spending in the broad K-12 learning market increased by 4.8% during 2004. In governmental fiscal 2005, state revenue is generally improving, according to a recent survey by
the National Conference of State Legislatures.* According to the NCSL State Budget Update:
November 2004, revenues for the first few months of FY 2005 are at or above projections in almost
every state, budget overruns are less severe than in recent years, and only three states reported
budget gaps. While the state revenue outlook is improving, however, states face increasing demands
on their budgets, in particular for increased spending for health care and for education spending
to meet the mandates of No Child Left Behind.* The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level
proficiency, and accountability through assessment as important national priorities. NCLB also
emphasizes the need to use proven practices and products grounded in scientifically based research
to improve student performance. Our products align well with the emphases of NCLB. Fast ForWord
products improve reading performance by developing cognitive skills, helping bring struggling
students to grade level and assisting educators in meeting their accountability objectives. Our
products are based on more than 30 years of neuroscience and cognitive research. The results that
can be achieved through our products are established by research conducted by independent academic
researchers and school districts as well our founding scientists and our company. To date, more
than 600 publications have described the results that can be achieved through Fast ForWord products
and the academic research on which the products are based. We believe that our products alignment
with the important national priorities outlined in NCLB assists us in marketing and selling our
products. For fiscal year 2005, federal education appropriations totaled over $71 billion and included $12.7
billion for aid to economically disadvantaged students and their school districts (Title 1, Part
A); $1 billion for Reading First; $496 million for educational technology; $991 million for
21st Century Community Learning Centers; and $675 million for English Language
Acquisition programs. All of these sources of federal funding have been used by our customers to
purchase Fast ForWord licenses. IDEA, the Individuals with Disabilities Education Act, which provides special education grants to
states, was reauthorized in late 2004. In the reauthorization, school districts have been given
more flexibility to use special education funds for intervention for children who have not yet been
classified with special needs. Special education funding has been a significant source of funds
for purchases of Fast ForWord, and with the reauthorization, we expect that it may become even more
significant to us.* The 2005 federal appropriation for special education grants to states was
$10.6 billion. Page 4




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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
total amount of federal funding for education has increased each year since 1996. The current
federal budget deficit, however, may impact the availability of federal education funding. Each
fiscal year from 1996 through 2005, the total federal appropriation for education has increased.
For fiscal 2006, the Presidents budget request is slightly lower than the 2005 appropriation.
However, for the specific areas mentioned above, the Presidents 2006 budget requests are slightly
higher than the 2005 appropriations for those areas. OTHER MARKETS In addition to selling to K-12 schools, we also sell to and through private practice professionals,
learning centers, hospitals and clinics. These speech and language and other professionals
recommend the use of our products to appropriate clients and then supervise the use of the
software, often in connection with their other services. In 2004, over 600 non-school
professionals and entities used our products. Our business in this sector decreased each year from
1999 through 2003, both in absolute dollars and as a percentage of our business, as we focused our
sales and marketing efforts on the school market. In 2004, however, this trend reversed and our
sales to the private sector increased in absolute dollars, although they still declined as a
percentage of total booked sales. These professionals remain significant to us. Private practice
professionals were our first market, and many 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. We are also building a network of independent value-added resellers outside North America. Thus
far, sales outside the United States have not been significant. PRODUCTS Our Fast ForWord software products develop the 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 Basisbelow) has demonstrated that
fast, significant and enduring improvements in student achievement can be achieved through
use of our products. 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 the cognitive skills of memory, attention,
processing and sequencing, which we call Learning MAPsÔ. 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 and to discriminate their differences. Processing skills are
an essential prerequisite for phonemic awareness (the ability to distinguish among and
manipulate the smallest sounds in language that can change meaning) and reading. 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 LEARNINGÔ FORMULA Neuroscience and cognitive research has demonstrated the importance of frequency and intensity,
adaptivity, simultaneous development, and timely motivation for learning new tasks. The Fast
ForWord products use these principles to help students learn more rapidly. Page 5




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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, five days per week. During 2003 and 2004, we introduced protocols for each of our major products that require 48 to 50
minutes of use, five days a week, for a period of eight to 12 weeks. Our original protocols
required product use for 90 to 100 minutes per day, five days a week, for a period of four to eight
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. 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 special animations that signify milestones as students progress. PRODUCTS IN THE FAST FORWORD FAMILY During 2004, our Fast ForWord family of products accounted for 72% 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 Languagesoftware 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 Schoolsoftware 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. Page 6




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Fast ForWord Language to Readingsoftware 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 Learning 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. We presently have available the Fast
ForWord to Reading 1, 2, 3 and 4 products. In 2005, we plan to introduce the Fast ForWord Language Basicsproduct*, which is targeted to young
children, four to seven years of age, and uses fun activities to develop visual attention, sound
sequencing skills and auditory discrimination skills. It is designed to be used as a precursor to
Fast ForWord Language when appropriate. This product will replace our current Fast ForWord Basics
product*. We also plan to introduce Fast ForWord to Reading Prep (which correlates to kindergarten
standards) and Fast ForWord to Reading 5*. We cannot assure you, however, that these products will
be introduced on our schedule, that they will not have technical issues, or that they will achieve
market acceptance. Our major products, Fast ForWord Language, Language to Reading, Middle & High School and the Fast
ForWord to Reading series, include an optional remote progress tracking system, Fast ForWord
Progress Tracker. This easy-to-use web-based tool provides reports of detailed learning results
for individuals and 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. Progress Tracker also
provides correlations that align the Fast ForWord products to state learning standards and selected
core reading programs. We also sell Reading Edge, a reading assessment instrument for students from kindergarten to second
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 as a perpetual license
or for a limited term. The license package typically contains at least two of our major products
and varying quantities of our other products. Most customers also purchase implementation
services, which we believe are important to facilitating successful use of the products. Our
license package list prices range from $10,000 to $85,000 per site, depending on the number of
products, the number of workstations, the duration of the license and the volume purchased. Products licensed for administration by private practice professionals are generally purchased on a
per product per student basis. Our major products presently list for between $500 and $900 per
product per student. The private practice professional charges separately for his or her services.
Hospitals, clinics and learning centers purchase both per-product per-student licenses and site or
workstation licenses, depending on their size and needs. 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, in order to achieve successful implementations, mainstream customers
tend to require more implementation support than do early adopters. In 2004, services and support
accounted for 26% of revenue, compared to 18% in 2003 and 2002. Page 7




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At the end of 2004, our service and support organization included 33 employees, supplemented by 36
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
on-site product training, technical installation, implementation management, consulting, and
professional development services. 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,
best practices 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. We host a National User Conference, 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 For customers who purchase our support services, we provide software maintenance releases and
extensive remote support. Our technical, professional, and customer support can be accessed via
telephone, email, and web-based chat, in whatever combination works best for the customer. Our
Customer Connect Website offers extensive implementation and technical resources and Web-based
seminars. 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. WARRANTY We generally provide a warranty that our software products operate substantially as described in
the manuals and guides that accompany the software for a period of 90 days. The warranty excludes
damage from misuse, accident, and certain other circumstances. To date, we have not experienced
any significant warranty expense. 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, over 470,000 individuals have enrolled in Fast ForWord products, and we have accumulated
research outcomes on more than 35,000 individuals, including approximately 21,400 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. Page 8




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BRAIN IMAGING AND READING IMPROVEMENTS A Stanford University study of students aged eight 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 statistically 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. 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. 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 Sciencein 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. STRATEGY Our principal strategic objective is to become the leader in scientifically based reading
intervention products. In order to achieve that objective, we will need to significantly expand
our share of the mainstream U.S. reading intervention market. Critical elements of our strategy to
expand our mainstream reading intervention customer base are:  
    Expanding and enhancing our product line to provide a more
complete and easier-to-use solution, through internal development
and/or acquisitions.
    Further improving our implementation and service models so that
they are more systematic, better engage classroom teachers in the
products use, increase the percentage of content completed by
students, emphasize further the need for students to follow the
recommended protocol, and increase the number of student users per
school.
    Building and leveraging our brand awareness and brand equities. As a key part of our strategy, we emphasize the productivity of our K-12 field sales force. We
focus particularly on districts and geographic areas with a high need for our products and
sufficient funding to purchase. We emphasize district-level multi-site transactions, while
continuing to pursue smaller sales for seeding purposes. To focus on small school districts,
independent schools and renewals, we are expanding our direct marketing and telesales capability. We continue to build on our research heritage, supporting and conducting targeted new research,
assisting schools in analyzing and presenting their results, and using research to improve and
expand our product solutions. We actively support studies by independent researchers, primarily at
universities. Although we are pursuing our strategy vigorously, we cannot assure you that we will be able to
achieve our strategic objectives. Page 9




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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, 2004, we employed 32 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 market. 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 emphasize district-level multi-site transactions, while continuing to pursue smaller sales for
seeding purposes. In 2004, our largest transaction to date, with the School District of
Philadelphia, represented 16% of booked sales. Because Philadelphia has now purchased perpetual
license packages for many of our products for most of its school sites, we do not expect that
purchases from Philadelphia will continue at this level in 2005. We are continuing to promote our
products to other large urban districts with significant populations of students not performing at
standards, which have a particular need for our products. To market our products, we participate in industry conferences and trade shows and conduct our own
Executive Forums for educational decision makers. We are building a small telesales group to
handle smaller transactions and supplement our field sales force. In our marketing, we emphasize
our proven impact on student achievement and our neuroscience research basis. On our
scientificlearning.com website, we post results reports documenting the student gains our customers
have achieved at schools throughout the U.S. 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 are also building a network of independent value-added resellers outside North America. While
to date sales outside North America have not been significant, our goal is to build this
distribution channel as a base for future growth in the longer term.* 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, reputation, existing relationships with customers, completeness of the product
offering, ability to provide effective and efficient product implementation, and ability to
complement and supplement the school curriculum. We believe that generally we compete favorably on
the basis of these factors. 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. Page 10




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Our research and development expenses were approximately $3.6 million, $3.5 million, and $3.0
million for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004,
22 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 solution. 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. The Gateway Edition products are now functioning well, and we believe that these technical
issues are well behind us.* In 2003 we also launched the second product in our Fast ForWord to Reading series, Fast ForWord to
Reading 4. During 2004, we launched two additional products in the Fast ForWord to Reading series,
Fast ForWord to Reading 1 and 2. In 2005, we plan to introduce Fast ForWord Language Basics, Fast
ForWord to Reading Prep and Fast ForWord to Reading 5, as well as further enhancements to the
Progress Tracker system*. Fast ForWord Language Basics and Fast ForWord to Reading Prep are
currently in field test and are scheduled for customer availability at the end of the second
quarter*. Fast ForWord to Reading 5 is scheduled for field test in the second quarter and customer
availability at the end of the third quarter*. 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. 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 presently conducting a randomized controlled study on the
additive effects of using multiple Fast ForWord products. The study includes students at a wide
variety of skill levels, ranging from just below proficient to well below proficient. An advisory
board of reading research experts is monitoring the research design, methods and data analyses
procedures. We have provided a donation to the Haan Foundation to fund a portion of the study. In addition, researchers at Hong Kong Polytechnic University are conducting a controlled study of
the impact of the Fast ForWord Language products on Cantonese-speaking children. These researchers
are studying children who are poor readers in both English and Chinese relative to their peers. We
supported this study by providing complimentary product licenses. Page 11




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Product Enhancements and New Products The data that is uploaded to our database from participants who use our products is a unique and
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 and 2004, 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 have also released Progress Tracker
flags providing individualized intervention recommendations based on the students actual
performance and new, easier introductory levels for exercises in which students have tended to
experience difficulty when beginning the exercise. 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, 2004, we held 51 issued U.S. patents and five pending U.S. applications. We also
held four issued patents from other countries and had 11 applications pending abroad. We were the
exclusive licensee under 11 issued U.S. patents, three issued foreign patents, and two pending
foreign patent applications. The U.S. patents expire between 2014 and 2019. We also have 15 U.S. trademark registrations, including registrations for marks including Fast
ForWord, our most important trademark. The patents and applications that we license are owned by the Regents of the University of
California and Rutgers, the State University of New Jersey, and relate to the basic speech and
sound modification and adaptive technology developed at those institutions. In 2004, approximately
58% 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 2005 and each year thereafter, the
minimum royalty payment is $150,000. In 2004, 2003 and 2002, we had approximately $746,000,
$898,000, and $723,000, respectively in royalty expense under the license. The final milestone
payment under the license was paid in 2001. In September 2003, we transferred certain of our technology to Posit Science Corporation (PSC)
(formerly named Neuroscience Solutions Corporation) for use in the healthcare field. The
transaction included 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 PSC 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 PSC for a combination of cash, stock, and future royalties. The two
companies also have agreed to share certain additional technology as it is developed. PSC 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. PSC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 PSC. ADDITIONAL INFORMATION As of December 31, 2004, we had 160 full-time and six 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. In addition to our Customer Connect support website, we also maintain the scientificlearning.com
and brainconnection.com websites. Scientificlearning.com provides information about our company and
our products Page 12




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and services, including reports detailing our products impact on student achievement.
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 RESULTS OF OPERATIONS OR STOCK PRICE The following factors as well as other information contained in this report should be considered in
making any investment decision related to our common stock. If any of the following risks actually
occurs, our business, financial condition and results of operations could be materially and
adversely affected and the trading price of our common stock could decline. To grow our business, we need to increase acceptance of our products by mainstream K-12 education
purchasers. Failure to do so would materially and adversely impact our revenue, profitability and
growth prospects. We believe that to date most educators who have used Fast ForWord products are early adopters.
We believe that our ability to penetrate the mainstream market will depend largely on the critical
factors discussed below. Our Fast ForWord products differ from the approaches that schools have traditionally used to
address reading problems. In particular, our products are based on neuroscience research and focus
on the development of cognitive skills, both of which may not be familiar to educators. K-12
educational practices are slow to change, and it can be difficult to convince educators of the
value of a substantially different approach. If we are unable to do so, it will slow our growth. Using our products in schools requires educators to devote a substantial amount of time to Fast
ForWord use out of a limited and crowded school day. While our new protocols have greatly reduced
the daily time required to use our products, the product use protocol still requires a substantial
time commitment from students and educators. If the products are not used correctly, they may not
produce the expected student results, which may lead to customer dissatisfaction and decreased
sales. Our products are generally implemented in a computer lab with a lab coach or teacher rather than in
the classroom with the students regular classroom teachers. To better reach mainstream customers,
facilitate expansion sales and improve results, we need to better engage classroom teachers in the
products implementation, in an effective and efficient manner. Failing to do so may impede sales. We encourage our customers to purchase significant levels of field service because we believe that
these services enable more effective product use and lead to stronger student achievements gains.
If we are unable to continue to convince customers to purchase these levels of service, we may
experience pressures on our service margins or our customers may be dissatisfied with their
implementations. This may lead to decreased profitability or slower growth. It is difficult for us to predict our financial results accurately and our quarterly results have
fluctuated significantly because, among other factors, our business has a long sales cycle, we sell
a variety of license packages with different revenue recognition periods, the timing of a single
large sale can significantly impact a quarters results and our sales and implementations tend to
be seasonal. Inaccuracy in estimating future results may cause the price of our stock to decline. 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. In addition, the cost of some of our K-12 license packages requires multiple levels of approval in
a political environment, which results in a time-consuming sales cycle that can be difficult to
predict. When a district decides to finance its license purchase, the time required to obtain
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, Page 13




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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. Some of our sales are significantly larger than others, and our sales strategy emphasizes
district-level, multi-site transactions. The timing of a single large order or its implementation
can significantly impact the level of sales and revenue in a given quarter. To the extent that we
are successful in implementing our large transaction strategy, our results may become more
unpredictable and may fluctuate to a greater extent.* 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. In December 2004, we changed our pricing structure. Prior to this change, we recognized revenue
from sales of perpetual license packages that included our Internet reporting tools over the
longest service period included in the contract. As a result of the December 2004 change, we
generally recognize revenue from perpetual software licenses at the later of delivery or the
contract start date. See Managements Discussion and Analysis, Revenue Recognitionfor more detail
about our revenue recognition practices. Therefore, in 2005 we expect to recognize a greater
proportion of current sales into revenue than we did in 2004*. At the same time, we will also be
recognizing deferred revenue from earlier years perpetual license sales into current revenue*. We
expect that this will result in revenue in 2005 growing at a faster rate than revenue grew in 2004
and at a faster rate than we currently project for 2006.* Our expense levels are based on our expectations of future sales 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 sales shortfall. All of the above factors may cause our operating results in future quarters to fail to meet the
expectations of investors, which could cause an immediate and significant decline in the trading
price of our common stock. The restatement of our financial statements has had a material adverse impact on us, including
increased costs and the increased possibility of legal or administrative proceedings, and reflected
a material weakness in our internal controls and disclosure controls and procedures. In December 2004, as a result of a reconsideration of our revenue recognition practices, our
management and Audit Committee concluded that we should correct our revenue recognition practices
for most of the Companys K-12 school contracts. As a result, we have restated our financial
statements for the period from 2000 through June 30, 2004, as described in more detail in our
Report on Form 10-K/A for the year ended December 31, 2003, our Reports on Form 10-Q/A for the
quarters ended March 31, 2004 and June 30, 2004 and our Report on Form 10-Q for the quarter ended
September 30, 2004, all filed February 15, 2005. As a result of these events, we have become subject to the following risks:  
    We have incurred substantial unanticipated costs for accounting and legal fees.
    It is not uncommon for lawsuits claiming to be class actions to be brought against
companies and their directors and officers following restatements. If such actions were to
be brought, it is likely that we would incur substantial defense costs regardless of their
outcome. Likewise, such actions might cause a diversion of our managements time and
attention. Likewise, if such actions were brought and we did not prevail, we could be
required to pay substantial damages or settlement costs.
    It is also not uncommon for the Securities and Exchange Commission to investigate
companies that restate their historical financial statements. If any such investigation
were commenced, it would likely divert more of our managements time and attention and
cause us to incur substantial costs. Such investigations could also lead to fines or
injunctions or orders with respect to future activities.
    The restatement of our historical financial statements and the resulting delay in the
preparation of our financial statements resulted in events of default under our credit
agreement. Our lender has now waived these defaults, and has extended the time period for
delivery to them of our current financial statements. Page 14




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
    The restatement reflected a material weakness in our internal controls and disclosure
controls and procedures. We rely on studies of student results to demonstrate the effectiveness of our products; if these
studies are challenged, it might harm our reputation and impede our business. We rely heavily on statistical studies of student results to demonstrate that our Fast ForWord
products lead to improved student achievement. We believe that these studies accurately reflect the
performance of our products. However, these studies involve the following risks:  
    The results of studies depend on schools appropriately implementing the products and
adhering to the product protocol. If a school does not do so, the study may not show that
our products produce substantial student improvements.
    Some studies of our products have limited sample sizes and/or lack a randomly selected
control group. These study characteristics may lead to criticism of the studies.
    Schools studying the effectiveness of our products use the product with different types
of students and use different assessments, sometimes making it difficult to aggregate or
compare results.
    We facilitate the collection and analysis of data for some of these studies and
sometimes support academic studies of our products. Our sales and marketing efforts, as well as our reputation, could be adversely impacted if our
studies are seen to be insufficient. This adverse effect could be compounded to the extent that
scientifically-based studies of effectiveness become increasingly important because of the NCLB
legislation or for other reasons. Claims relating to data collection from our user base may subject us to liabilities and additional
expense. Schools and clinicians that use our products frequently use students names to register them in our
products and enter into our database academic, diagnostic and/or demographic information about the
students. In addition, student results on our products are uploaded to our database. We have
designed our system to safeguard this personally-identifiable information, but the protection of
such information is an area of increasing public concern and significant government regulation,
including but not limited to the Childrens Online Privacy Protection Act. If our privacy
protection measures were ineffective, we could be subject to liability claims for unauthorized
access to or misuses of personally-identifiable information stored in our database. We may also
face additional expenses to analyze and comply with increasing regulation in this area. We may experience difficulties in launching new products efficiently, without significant technical
issues, and on schedule. This could materially slow sales or decrease profitability. We are developing additional products in our Fast ForWord to Reading series as part of our strategy
to reach mainstream reading intervention customers. We expect to ship Fast ForWord to Reading
Prep, Fast ForWord to Reading 5 and Fast ForWord Language Basics in 2005.* 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 are 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. Any significant defect or deficiency in our products
could cause customers to cancel or delay orders, cause us to incur significant expenses remedying
the problem, and harm our reputation. During the second quarter of 2003, we launched the new Gateway Edition of our major products. 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 sales in the fourth
quarter of 2003. Sales of our products depend on the availability of government funding for public school reading
intervention purchases, which is variable and outside our control. If such funding becomes less
available, our public school customers may be unable to purchase our products and services on a
scale or at prices that we anticipate, which would materially and adversely impact our revenue and
profitability. Page 15




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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. In
addition, the current federal budget deficit may impact the availability of federal education
funding. A cutback in federal education funding, or failing to continue to qualify for major
sources of that funding, could slow our sales. State and local school funding can be significantly impacted by fluctuations in tax revenues due to
changing economic conditions. From 2002 to 2004, the education technology industry has generally
experienced soft sales, frequently attributed to tight funding as a
result of reduced levels of tax revenues and increased demands
for state funds. We expect that future levels of state and local school spending will be significantly affected by the economic conditions and
outlook. A downturn or continued softness in the economy might slow our sales. We compete for sales with companies that have longer histories and greater resources than we do.
We may not be able to compete effectively in the education market. The market in which we operate is very competitive. While our products are highly differentiated by
their neuroscience basis and their focus on the development of cognitive skills, we nevertheless
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 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. We have not been consistently profitable. We started operations in February 1996 and through 2002 incurred significant operating losses. We
first generated positive cash flow from operating activities in 2002 and continued to have positive
cash flow from operations in 2003 and 2004. We were profitable in 2003, but had a $700,000 net
loss in 2004. At December 31, 2004, we had an accumulated deficit of approximately $84 million
from inception. Increasing our cash flow will require us to achieve higher sales goals in a soft
K-12 market. Our ability to achieve these goals 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. We have not yet been required to comply with Sarbanes-Oxley Section 404. We are presently engaged
in a process of evaluating and documenting our internal controls looking towards compliance no
later than the end of 2006. The process is very costly and requires significant internal
resources. Failure to comply with Section 404 could have a material adverse effect. Under Sarbanes-Oxley Section 404, as implemented by the PCAOB, we will be required to provide a
management report and auditors attestation and report on our internal control over financial
reporting. We have not previously been subject to this requirement. Our deadline for compliance
will be no later than December 31, 2006, but depending on our stock price we could be required to
comply at our 2005 year end. Historically, we have understood the importance of internal control over financial reporting, and
on an on-going basis, we evaluate our controls, assess whether we should improve them and when
appropriate implement improvements. In connection with our restatement at the beginning of 2005,
we concluded that we had a material weakness in our internal controls relating to revenue
recognition and we are committed to implementing improvements in our controls and processes in this
area. In order to achieve compliance with Section 404 specifically, we are now also engaged in a
costly and challenging process to document and evaluate our internal control over financial
reporting. This is requiring us to dedicate internal resources and engage outside consultants to
(i) assess and document the adequacy of internal control over financial reporting, (ii) take steps
to improve control processes where appropriate, (iii) validate through testing that controls are
functioning as documented, and (iv) implement a continuous reporting and improvement process for
internal control. Despite our efforts, we can not assure you that we and our independent registered
public accounting firm will conclude that, as of the deadline, our internal control over financial
reporting will be effective under Section 404. If we and/or our independent registered public
accounting firm are not able to so conclude, the financial markets could lose confidence in the
reliability of our financial statements, which might materially and adversely affect our stock
price. Page 16




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If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may
not be able to achieve our business goals, which could materially and adversely affect our
financial results and share price. We depend on the performance of Robert Bowen, our Chairman and Chief Executive Officer, and on
other senior management, sales, marketing, development, research, educational, finance and other
administrative personnel with extensive experience in our industry and with our Company. The loss
of key personnel could harm our ability to execute our business strategy, which could adversely
affect our financial results and share price. In addition, we believe that our future success will
depend in large part on our continued ability to identify, hire, retain and motivate highly skilled
employees who are in great demand. We cannot assure you that we will be able to do so. If we are unable to adequately protect our intellectual property rights or if we infringe on the
rights of others, we could become subject to significant liabilities, need to seek licenses or lose
our rights to sell our products. Our ability to compete effectively depends in part on whether we are able to maintain the
proprietary aspects of our technology and to operate without infringing on the proprietary rights
of others. It is possible that our issued patents will not offer sufficient protection against
competitors with similar technology, that our trademarks will be challenged or infringed by
competitors, or that our pending patent applications will not result in the issuance of patents.
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. Our directors and executive officers and their affiliates effectively control the voting power of
our company. At December 31, 2004, Warburg, Pincus Ventures, our largest shareholder, owned approximately 46% of
the Companys outstanding stock and, in the aggregate, our directors and executive officers and
their affiliates held more than 60% 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. Our common stock is thinly traded and its price is volatile. Our common stock presently trades on the Nasdaq National Market, and our trading volume is low.
For example, during the fourth quarter of 2004, our average daily trading volume was approximately
11,400 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. 
 ITEM 2. PROPERTIES We 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 PROCEEDINGS None 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Page 17




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EXECUTIVE OFFICERS The following table sets forth various information concerning our executive officers, as of March
15, 2005: NAME
    
    AGE
    
    POSITIONRobert C. Bowen
    
    
    63
    
    
    Chairman and Chief Executive OfficerJames R. Bray
    
    
    60
    
    
    Vice President, Business Development and Government AffairsLinda L. Carloni
    
    
    51
    
    
    Vice President, General Counsel and SecretaryGlenn G. Chapin
    
    
    49
    
    
    Vice President, SalesJane A. Freeman
    
    
    51
    
    
    Sr. Vice President, Chief Financial Officer, and TreasurerDr. William M. Jenkins
    
    
    54
    
    
    Sr. Vice President, Product DevelopmentDr. Steven L. Miller
    
    
    41
    
    
    Sr. Vice President, Research and OutcomesGillian M. Rutter
    
    
    49
    
    
    Vice President, OperationsSherrelle J. Walker
    
    
    58
    
    
    Chief Education Officer
 Robert C. Bowenjoined 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. Brayjoined 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. 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. Carlonijoined the Company as General Counsel in October 1999, became our Secretary in
March 2000 and was elected Vice President in June 2000. Before joining us, Ms. Carloni was a
founder and Vice President of Alere Medical Incorporated, a healthcare services start-up. Earlier
in her career, Ms. Carloni worked in technology transfer for the University of California, was the
general counsel of Nellcor Incorporated, a medical device company, and an associate and a partner
at the Cooley Godward law firm. She received her bachelors degree in political science from Case
Western Reserve University and her law degree from Boalt Hall School of Law at the University of
California, Berkeley. Glenn G. Chapinjoined 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. Page 18




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##### Table of Contents



Jane A. Freemanjoined us as Vice President, Finance and Treasurer in August 1999 and was named
Chief Financial Officer in January 2000. She was appointed Senior Vice President in January 2004.
She also served as our Vice President Business Development from August 1999 until June 2000. Prior
to joining us, Ms. Freeman spent 20 years in the investment business. From 1988 through 1998, she
was employed by Rockefeller & Co., a global investment firm, where she led the global asset
allocation process, managed the US Small Cap equity product and 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. Jenkinswas 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. Millerwas 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. Walkerjoined 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. Before joining NCS, Ms. Walker was vice president curriculum products at
American Cybercasting Corporation, which provided on-line curriculum products for teachers and
students. Ms. Walker 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. Page 19




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##### Table of Contents



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 National
Market under the symbol SCIL. From December 31, 2003 until July 2004, our common stock was
traded on the Nasdaq Small Cap Market. From January 1, 2003 until December 30, 2003, our common
stock was traded on the OTC Bulletin Board. 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 Nasdaq Small Cap Market or the OTC Bulletin Board, as applicable. High
    
    
    Low2003First Quarter
    
    $
    3.10
    
    
    $
    1.40Second Quarter
    
    $
    4.50
    
    
    $
    2.30Third Quarter
    
    $
    5.15
    
    
    $
    4.10Fourth Quarter
    
    $
    5.00
    
    
    $
    4.152004First quarter
    
    $
    7.40
    
    
    $
    5.00Second quarter
    
    $
    6.49
    
    
    $
    4.96Third quarter
    
    $
    6.84
    
    
    $
    5.18Fourth quarter
    
    $
    6.00
    
    
    $
    4.71
 Holders. As of March 15, 2005, the approximate number of stockholders of record of our
common stock was 132. 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 Page 20




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ITEM 6. Selected Financial Data In thousands, except per share amounts Selected Financial Data Year ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Statement of Operations Data:Revenues:Products
    
    $
    22,802
    
    
    $
    24,491
    
    
    $
    17,879
    
    
    $
    11,702
    
    
    $
    10,983Services and support
    

    
    8,174
    
    
    
    5,425
    
    
    
    3,958
    
    
    
    3,023
    
    
    
    3,079Total revenues
    
    
    30,976
    
    
    
    29,916
    
    
    
    21,837
    
    
    
    14,725
    
    
    
    14,062Cost of revenues:Products
    
    
    1,775
    
    
    
    2,127
    
    
    
    2,109
    
    
    
    1,857
    
    
    
    1,800Services and support
    
    
    4,981
    
    
    
    3,872
    
    
    
    1,502
    
    
    
    2,402
    
    
    
    1,877Total cost of revenues
    
    
    6,756
    
    
    
    5,999
    
    
    
    3,611
    
    
    
    4,259
    
    
    
    3,677Gross profit
    
    
    24,220
    
    
    
    23,917
    
    
    
    18,226
    
    
    
    10,466
    
    
    
    10,385Operating expenses:Sale and marketing
    
    
    16,087
    
    
    
    12,961
    
    
    
    14,554
    
    
    
    19,701
    
    
    
    20,981Research and development
    
    
    3,555
    
    
    
    3,500
    
    
    
    2,985
    
    
    
    3,390
    
    
    
    5,680General and administrative
    
    
    5,313
    
    
    
    4,529
    
    
    
    4,776
    
    
    
    6,348
    
    
    
    5,746Restructuring, lease and asset
impairment write downs
    
    
    
    
    
    
    (7
    )
    
    
    3,365
    
    
    
    2,608
    
    
    
    492Total operating expenses
    
    
    24,955
    
    
    
    20,983
    
    
    
    25,680
    
    
    
    32,047
    
    
    
    32,899Operating income (loss)
    
    
    (735
    )
    
    
    2,934
    
    
    
    (7,454
    )
    
    
    (21,581
    )
    
    
    (22,514
    )Interest income (expense), net
    
    
    (100
    )
    
    
    (1,209
    )
    
    
    (1,332
    )
    
    
    (1,053
    )
    
    
    1,077Other income from related party
    
    
    99
    
    
    
    448
    
    
    
    
    
    
    
    
    
    
    
    Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    91
    
    
    
    21
    
    
    
    2Net income (loss) before income tax
    
    
    (736
    )
    
    
    2,173
    
    
    
    (8,695
    )
    
    
    (22,613
    )
    
    
    (21,435
    )Income tax (benefit) provision
    
    
    (43
    )
    
    
    43
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )
    
    $
    (22,613
    )
    
    $
    (21,435
    )Basic net income (loss) per share
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
    
    $
    (1.92
    )
    
    $
    (1.92
    )Shares used in computing basic net
income (loss) per share
    
    
    16,408
    
    
    
    16,007
    
    
    
    15,642
    
    
    
    11,777
    
    
    
    11,148Diluted net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
    
    $
    (1.92
    )
    
    $
    (1.92
    )Shares used in computing diluted
net income (loss) per share
    
    
    16,408
    
    
    
    16,908
    
    
    
    15,642
    
    
    
    11,777
    
    
    
    11,148Balance Sheet Data:Cash and cash equivalents
    
    $
    10,281
    
    
    $
    3,648
    
    
    $
    4,613
    
    
    $
    4,610
    
    
    $
    818Investments in government securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,169
    
    
    
    7,667Working capital
    
    
    916
    
    
    
    (11,331
    )
    
    
    (10,879
    )
    
    
    (1,010
    )
    
    
    6,609Total assets
    
    
    22,958
    
    
    
    15,597
    
    
    
    18,531
    
    
    
    23,228
    
    
    
    18,953Long-term debt, including current
portion
    
    
    
    
    
    
    
    
    
    
    5,000
    
    
    
    10,000
    
    
    
    Stockholders (deficit) equity (1)
    
    
    (8,111
    )
    
    
    (8,544
    )
    
    
    (11,363
    )
    
    
    (3,247
    )
    
    
    10,281
   (1)
    
    We have paid no cash dividends since our inception. Page 21




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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview 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 fast, lasting gains in the skills critical for reading. To
encourage best practices in 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 2004,
K-12 schools accounted for 92% of our booked sales. By the end of 2004, approximately 3,200
schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and over
470,000 individuals had enrolled in one of our products. Business Highlights Market Trends The education market is
growing.* Eduventures, a strategic consulting firm in the education
industry, has estimated that in 2003, K-12 schools spent $3.3 billion on supplemental content, 4.5%
more than in 2002, and projects that in 2005, K-12 schools will spend 7% more on supplemental
content than in 2004.* The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level
proficiency, and accountability through assessment as important national priorities. NCLB also
emphasizes the need to use proven practices and products grounded in scientifically based research
to improve student performance. Our products align well with the emphases of NCLB, and we believe
that this alignment assists us in marketing and selling our products. The general availability of funding for public schools fluctuates from time to time. In recent
years state and local education funding has been negatively affected by reduced levels of tax
revenues due to the economic slowdown, and the education technology industry has generally
experienced soft sales, typically attributed to tight funding. However, substantial federal funding
resources remain, and many of those resources are focused on reading improvement. Eduventures
estimates that total spending in the broad K-12 learning market increased by 4.8% during 2004. In
fiscal 2005, state revenue is generally improving, according to a recent survey by the National
Conference of State Legislatures although states also face increasing budget pressures.* Company Highlights Our 2004 total booked sales increased by 21% over 2003, and K-12 booked sales increased 23%. Our
results were stronger than typical industry results in the K-12 market and booked sales growth was
within our target range of 20% to 30%. (For more explanation on booked sales, see, Revenue,
below.) We attribute our strong sales in a difficult market to our emphasis on reading improvement
and measurable results, emphases which are shared by our K-12 customers and aligned with NCLB. 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.* During the 2004 second quarter, we
closed a major contract with the School District of Philadelphia, with a total contract price of
$10.4 million, of which $6.0 million was recorded as booked sales. The remainder of the contracts
price represents future years of service and support, and is scheduled to be booked over the next
four calendar years.* In 2004, we closed 66 transactions in excess of $100,000 compared to 59 in
2003. Our goal is to continue to increase this number in 2005.* Larger sales tend to have a
longer sales cycle and involve more political influences and can be more unpredictable. Increases
in the proportion of our business from these large sales may cause increased fluctuations and
unpredictability in the timing of our sales and revenue.* In 2004 our revenue grew 4%
over 2003 to reach $31.0 million. This revenue growth was lower than
sales growth in both 2004 and 2003, which were 21% and 8% respectively. This difference primarily
reflects sales which are recognized into revenue over multiple years,
which comprised a larger
portion of our sales in 2004 and 2003 than in Page 22




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prior years. Because of changes in our pricing structure and a resulting change in the timing of
revenue recognition from perpetual license sales, we expect that revenue will grow faster than
booked sales in 2005.* We reported a net loss of $0.7 million in 2004, compared to $2.1 million profit in 2003. This net
loss results from higher expenses driven by increased sales and the timing lag between the
completion of sales and recognition of revenue. In 2005, 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. We ended 2004 with no debt, the same as at year end 2003. During the year we borrowed and repaid
$3.0 million in debt. 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. Net
cash from operating and investing activities was $5.7 million. This was the third successive year
of positive and increased cash flow from operations. We expect to be cash flow positive from
operations in 2005.* While our goals for 2005 include increasing sales, revenue, profit and cash flow, we cannot assure
you that we will achieve these goals. See Unpredictabilitybelow and Business  Factors That May
Affect Results of Operations and Stock Priceabove. Results of Operations Revenue Year ended December 31,(dollars in thousands)
    
    2004
    
    
    Change
    
    
    2003
    
    
    Change
    
    
    2002Products
    
    $
    22,802
    
    
    
    -7
    %
    
    $
    24,491
    
    
    
    37
    %
    
    $
    17,879Service and support
    
    
    8,174
    
    
    
    51
    %
    
    
    5,425
    
    
    
    37
    %
    
    
    3,958Total revenues
    
    $
    30,976
    
    
    
    4
    %
    
    $
    29,916
    
    
    
    37
    %
    
    $
    21,837
 2004 revenue compared to 2003: The decline in 2004 product revenue compared to 2003 was largely
attributable to only modest growth in 2003 booked sales coupled with a shift in sales mix in 2004
towards multi year contracts with longer revenue recognition periods. The majority of 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 2003 license
sales affected product revenue in both 2004 and 2003. Product revenue in 2004 was also negatively
affected by more volume discounts due to an increasing proportion of large sales in 2004 and 2003.
Our December 2004 strategic pricing change (discussed in Future Revenue, below) had little impact
in 2004, because the software for many December perpetual licenses was not delivered until January
2005. Service and support revenues increased, primarily due to increased sales of on-site services. The
sale and delivery of on-site services to schools was a major focus for us in 2004 to enhance school
implementations. Service and support revenue also increased as a result of the increase in the
number of schools purchasing ongoing Progress Tracker access and support contracts. 2003 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 license sales. The
majority of 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 in 2003 compared to
2002, which had a positive impact on revenue because these sales were 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 sales of on-site services. The sale and
delivery of on-site services to schools was 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. Future revenue:In December 2004, we made a strategic change to our pricing structure, relating to
our on-line progress tracking tool, to encourage all customers to use this important capability.
Prior to this change, we recognized revenue from sales of perpetual license packages that included
our Internet reporting tools over the longest service period included in the contract. As a result
of the change, we are now generally recognizing revenue from perpetual software licenses at the
later of delivery or the contract start date. See Managements Discussion and
Analysis, Revenue Recognitionfor more detail about our revenue recognition practices. Therefore,
in 2005 we Page 23




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expect to recognize a greater proportion of current sales into revenue than we did in
2004.* At the same time, we will also be recognizing deferred revenue from earlier years
perpetual license sales into current revenue.* We expect that
this non-recurring impact from our transition to a different pricing
structure will result in revenue in 2005
growing at a faster rate than 2005 booked sales and at
a faster rate than we currently project for revenue growth in 2006. 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. We believe that revenue is the
GAAP measurement closest to booked sales. However, booked sales should not be considered in
isolation from, and is not intended to represent, a substitute measure of revenue or any other
performance measure calculated under GAAP. The following reconciliation table sets forth our booked sales, revenues and change in deferred
revenue for the years ended December 31, 2004, 2003 and 2002. Year ended December 31,(dollars in thousands)
    
    2004
    
    
    Change
    
    
    2003
    
    
    Change
    
    
    2002Booked sales
    
    $
    37,260
    
    
    
    21
    %
    
    $
    30,704
    
    
    
    8
    %
    
    $
    28,353Less revenue
    
    
    30,976
    
    
    
    4
    %
    
    
    29,916
    
    
    
    37
    %
    
    
    21,837Net increase in deferred revenue
    
    
    6,284
    
    
    
    
    
    
    
    788
    
    
    
    
    
    
    
    6,516Current and long-term deferred
revenue beginning of the period
    
    
    19,500
    
    
    
    
    
    
    
    18,712
    
    
    
    
    
    
    
    12,196Current and long-term deferred
revenue end of the period
    
    $
    25,784
    
    
    
    32
    %
    
    $
    19,500
    
    
    
    4
    %
    
    $
    18,712
 Booked sales in the K-12 sector, which accounted for 92% of sales in 2004, grew 23% to $34.3
million, compared to $27.9 million in 2003. The increases were achieved in a difficult K-12 market
with tight state funding. We sold 1,013 site license packages over $10,000 compared to 862 in the
same period in 2003. In 2004 we continued to focus our sales force on multi-site sales. The number of sales over
$100,000 increased to 66 in 2004 from 59 in 2003 and 48 in 2002. In 2004, we had our first $10
million sale, our largest sale to date, to the School District of Philadelphia (PA). Only $6
million of this transaction was recorded as booked sales in 2004. The remaining $4 million is
scheduled to be recorded as booked sales in the coming four years.* In 2003 K-12 sector booked sales increased by 12% to $27.9 million compared to $24.9 million in
2002. The K-12 sector represented 91% of booked sales in 2003, compared to 88% in 2001. This
growth reflects our strategy to expand in the K-12 market. Booked sales outside the K-12 market increased by 7% in 2004 to $3.0 million compared to $2.8
million in 2003 and declined 17% in 2003 from 2002. We believe these customers are affected by
economic conditions and the improvement in 2004 is partially related to a recovery in disposable
income. Our primary focus has been on the K-12 market and we believe this focus contributed to the
decline in 2003. We believe we have stabilized our sales to this market and expect to hold near
this level in 2005 and may even experience modest growth due to increased sales to international
customers and new product introductions.* Unpredictability:We believe that we are positioned to achieve continued growth in the K-12 market
during 2005, although federal, state and local budget pressures continue to present an uncertain
funding environment for our customers.* However, achieving 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 the
engagement of classroom teachers and administrators with product implementations.* For a
discussion of some of the other important factors that affect our results, see Factors that May
Affect Results of Operations or Stock Price.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 Page 24




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##### Table of Contents



of a sale can be reasonably 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)
    
    2004
    
    
    2003
    
    
    2002Gross profit on products
    
    $
    21,027
    
    
    $
    22,364
    
    
    $
    15,770Gross profit margin on products
    
    
    92
    %
    
    
    91
    %
    
    
    88
    %Gross profit on service and support
    
    
    3,193
    
    
    
    1,553
    
    
    
    2,456Gross profit margin on services and support
    
    
    39
    %
    
    
    29
    %
    
    
    62
    %Total gross profit
    
    $
    24,220
    
    
    $
    23,917
    
    
    $
    18,226Total gross profit margin
    
    
    78
    %
    
    
    80
    %
    
    
    83
    %
 The overall gross profit margin declined in 2004 compared to 2003, as margin improvements in both
products and services and support were more than offset by revenue mix changes. Service and
support, which have a lower margin than products, increased to 26% of revenue in 2004 compared to
18% in 2003.Product margins increased due to lower effective royalty rates and lower amortization
of capitalized software. Product costs consist of manufacturing, packaging and fulfillment costs,
amortization of capitalized software and royalties. Our margins in service and support increased from 2003 levels as higher revenue provided better
fixed cost coverage. In the first quarter of 2003, we reorganized our service and support business
to increase the number of employees 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
incurred additional service costs in the second half of 2003 and the first quarter of 2004
associated with our new Gateway Edition. Service and support costs consist primarily of the cost
of personnel, materials and travel. We do not expect to incur further expenses associated with
Gateway Editions initial technical problems.* In 2003, overall gross margin declined compared to 2002, due in large part to the reorganization of
our service and support business in the first quarter of 2003 to increase the number of employees
available to provide service and support to our customers. In 2002, we primarily used per diem
consultants rather than full time employees to provide training services. In 2003, the gross
margin on products increased due to slightly lower materials costs and amortization of capitalized
software cost. We expect that product margins will improve in 2005 due to lower amortization of capitalized
software and a lower average royalty rate.* We also expect that service and support margins will
improve due to better fixed cost coverage.* Consequently we expect overall gross margins to improve
in 2005.* Operating Expenses Year ended December 31,(dollars in thousands)
    
    2004
    
    
    Change
    
    
    2003
    
    
    Change
    
    
    2002Sales and marketing
    
    $
    16,087
    
    
    
    24
    %
    
    $
    12,961
    
    
    
    -11
    %
    
    $
    14,554Research and development
    
    
    3,555
    
    
    
    2
    %
    
    
    3,500
    
    
    
    17
    %
    
    
    2,985General and administrative
    
    
    5,313
    
    
    
    17
    %
    
    
    4,529
    
    
    
    -5
    %
    
    
    4,776Restructuring, lease and
asset impairment
write-down
    
    
    
    
    
    
    n/a
    
    
    
    (7
    )
    
    
    n/a
    
    
    
    3,365Total operating expenses
    
    $
    24,955
    
    
    
    19
    %
    
    $
    20,983
    
    
    
    -18
    %
    
    $
    25,680
 Sales and Marketing Expenses:In 2004, our sales and marketing expenses increased primarily due to
increased sales and marketing staff, more marketing activities and higher commissions reflecting
higher sales. 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, 2004, we had 32 quota-bearing sales personnel selling to public
schools. In 2003 sales and marketing expenses decreased compared to 2002, primarily due to the
reclassification of some personnel from sales to our expanded service and support team as well as
lower spending on conferences, trade shows and marketing materials. Page 25




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##### Table of Contents



During 2005, 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 2% in 2004 compared
to 2003, but were lower as a percentage of revenue. The increase in research and development
spending in 2003 compared to 2002 was primarily related to the introduction of Gateway Edition.
Some of these costs did not recur in 2004. 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. We expect research and development expenses to increase in 2005 as we continue to invest in
improving our current product suite, demonstrating product efficacy and introducing new products.*
Two new products in our Fast ForWord to Reading series and one new product in our Language series
are scheduled for launch in 2005.* General and Administrative Expenses:General and administrative expenses increased in 2004
primarily due to the expenses associated with the restatement of our financial results and to the
addition of staff. Accounting and legal fees associated with the restatement totaled approximately
$515,000. 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 2003 compared to 2002, primarily because of decreases in personnel and legal costs. Stock-based Compensation
Expense:We are required to implement SFAS 123R beginning
January 1, 2006. This will require us to record compensation expense for employee stock awards. We expect that the
implementation of SFAS 123R will significantly increase our operating expenses in the next few
years.* 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. Compared to
the prior lease, 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 was paid in 2004 and
all restructuring expenses have been paid as of December 31, 2004. 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. Page 26




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##### Table of Contents



The following table sets forth the restructuring activity for the years ended December 31, 2004,
2003 and 2002. Lease
    
    
    Asset
    
    
    Severance(dollars in thousands)
    
    obligation
    
    
    write-downs
    
    
    benefits
    
    
    TotalAccrued 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
    
    
    $
    
    
    
    $
    
    
    
    $
    1,773Cash paid in 2004
    
    
    (1,773
    )
    
    
    
    
    
    
    
    
    
    
    (1,773
    )Accrued restructuring costs, December 31, 2004
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 Other Income from Related Party During 2004 we recorded $99,000 as other income for royalties and services provided to Posit
Science Corporation (PSC), formerly Neuroscience Solutions Corporation. During 2003, we recorded
$448,000 from the sale and licensing of certain intellectual property, patents and software to
Posit Science Corporation. One of our co-founders, substantial shareholders, and board members is
also a co-founder, officer, director and substantial shareholder of PSC. See Transaction with
Posit Science 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 recurring operations. There was
no comparable transaction for the same period of 2002. Interest Expense, net Year ended December 31,(dollars in thousands)
    
    2004
    
    
    Change
    
    
    2003
    
    
    Change
    
    
    2002Interest expense, net
    
    $
    (100
    )
    
    
    -92
    %
    
    $
    (1,209
    )
    
    
    -9
    %
    
    $
    (1,332
    )
 Interest expense, net decreased in 2004, compared to 2003, and decreased in 2003 compared to 2002.
The decreases in both years are due to progressively lower borrowing and, in 2004, from lower
amortization of deferred financing costs. Deferred financing costs were fully amortized in the
quarter ended September 30, 2004. In 2005 we do not expect to pay any interest, as we do not
anticipate borrowing during 2005.* This will require us to achieve sales targets, which is
uncertain, however.* Deferred financing expense was $232,000 in 2004 compared to $1.2 million in
2003. In 2004, interest expense, net included $155,000 in interest income primarily from loans to
current and former officers. Provision for Income Taxes The Company recorded a tax benefit of $43,000 for the year ended December 31, 2004 relating to the
reversal of a provision for U.S. federal alternative minimum tax for the year ended December 31,
2003. The Company has made no provision for U.S. federal, U.S. state or foreign income taxes for
the years ended December 31, 2004, 2003 and 2002 as the Company has incurred tax losses in all
periods and for all jurisdictions. At December 31, 2004, we had net operating loss carryforwards
for federal income tax purposes of approximately $77 million. Unutilized net
operating loss carryforwards will expire in years 2011 through 2024. 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, 2004, we had approximately $31.0 million of
deferred tax assets, comprised primarily of net operating loss carryforwards. Page 27




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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 $10.3 million at December 31, 2004 compared to $3.6 million at
December 31, 2003 and $4.6 million at December 31, 2002. During 2004, 2003 and 2002 we generated
cash flow from operations. At December 31, 2004 there were no borrowings outstanding under our
credit 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 2005.* During 2005,
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 2004 was $6.7 million, compared to $4.6 million in
2003. Net cash provided by operating activities increased in 2004 and 2003 primarily because
booked sales increased at a faster rate than spending and our collection experience was good. A
$6.3 million increase in deferred revenue with an offsetting accounts receivable increase of only
$0.6 million was a key driver in 2004 operating cash flow. Accounts receivable at year end was $5.7
million in 2004 compared to $5.1 million in 2003. Net cash used in investing activities in 2004 was $1.0 million, consisting primarily of computer
hardware and software acquisition costs. In 2003, net cash used by investing activities was $1.0
million, consisting primarily of an increase in non-current assets for the deposit of $550,000 for
our lease restructuring. 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. Our
2004 capital expenditures of $646,000 were higher than in 2003 and 2002, approximately $256,000 and
$124,000, respectively. In 2005, we expect that our capital spending will be higher than in 2004
as we continue to upgrade computer equipment and purchase new software to improve operations.* Financing activities generated $0.9 million in 2004, from the sale of stock upon option exercises
and the employee stock purchase plan. 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. Because our sales tend to be
seasonal, we may have negative cash flows in particular quarters,
particularly the first quarter, when sales tend to be substantially lower than in other quarters.
We borrowed money for working capital purposes in the first quarter of 2004 and may borrow again
from time to time.* We have a line of credit with Comerica Bank totaling $5.0 million, which expires on July 14, 2005.
The facility initially totaled $7.0 million and was partially secured by a letter of credit
provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The
letter of credit was for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to
July 30, 2004. The WPV letter of credit expired on July 30, 2004. The line is subject to
limitations based on our accounts receivable balance. Borrowings under the line are subject to
various covenants, which may limit our financial and operating flexibility. There is no borrowing
currently outstanding under the line. After 2005, 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. Page 28




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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 contractual obligations at December 31, 2004 and the
effects such obligations are expected to have on our liquidity and cash flow in future periods. Less than(dollars in thousands)
    
    Total
    
    
    1 year
    
    
    2 - 3 years
    
    
    4 - 5 years
    
    
    Thereafter 1Non-cancelable operating leases
    
    $
    9,167
    
    
    $
    940
    
    
    $
    1,880
    
    
    $
    1,924
    
    
    $
    4,423Minimum royalty payments
    
    
    1,500
    
    
    
    150
    
    
    
    300
    
    
    
    300
    
    
    
    750Total
    
    $
    10,667
    
    
    $
    1,090
    
    
    $
    2,180
    
    
    $
    2,224
    
    
    $
    5,173
    Our purchase order commitments at December 31, 2004 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, 2004 and 2003 was $3.7
million and $3.5 million, respectively, and is reflected in Notes and interest receivable from
current and former officers. Principal and interest are due December 31, 2005. This receivable
was reclassified from a non-current asset to a current asset as of December 31, 2004. 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% per annum. Transaction with Posit Science Corporation, formerly Neuroscience Solutions Corporation In September 2003, we signed an agreement with Posit Science Corporation (PSC), transferring
technology to PSC 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 PSC 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. We also agreed with PSC 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 PSC certain technology
transfer, hosting and support services. PSC 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. PSC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 PSC. The terms of the transaction were determined through arms length negotiations between PSC 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 PSC that use the licensed technology. We were
also issued 1,772,727 shares of Series A Preferred Stock in PSC. Because PSC 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 PSC 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 Page 29




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believe that the estimates, assumptions and judgments upon which we rely are reasonable based
upon information available to us at the time. The estimates, assumptions and judgments that we make
can affect the reported amounts of assets and liabilities as of the date of the financial
statements, as well as the reported amounts of revenues and expenses during the periods presented.
To the extent there are material differences between these estimates and actual results, our
financial statements would be affected. We believe that the estimates, assumptions and judgments pertaining to revenue recognition,
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, as amended by Statement of Position 98-9 (SOP 97-2). 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. Sales to our school customers typically include multiple elements (e.g. Fast ForWord software
licenses, Progress Tracker, our Internet-based participant tracking service, support, training,
implementation management, and other services). The Company allocates revenue to each element of a
transaction based upon its fair value as determined in reliance on vendor specific objective
evidence (VSOE). VSOE of fair value for each element of an arrangement is based upon the normal
pricing and discounting practices for those products and services when sold separately and, for
support services, is also measured by the renewal price. The value of software licenses, services and support invoiced during a particular period is
recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as
discussed below. License revenue.
Revenue from the licensing of software is recognized as follows: Perpetual licenses  software licensed on a perpetual basis. Revenue is recognized at the
later of product delivery date or contract start date using the residual method. If VSOE does not
exist for all the undelivered elements, all revenue is deferred and recognized ratably over the
service period if the undelivered element is services or when all elements have been delivered. Term licenses  software licensed for a specific time period, generally three to twelve
months. Revenue is recognized ratably over the license term. Individual participant licenses  software licensed for a single participant. Revenue is
recognized over the average period of use, typically six weeks. Service and support revenue.
Service and support revenue is derived from a combination of training, implementation, technical
and professional services, online services and customer support. Training, technical and other
professional services are typically sold on a per day basis. If VSOE exists for all elements of an
arrangement or all elements except software licenses, services revenue is recognized as performed.
If VSOE does not exist for all the elements in an arrangement except software licenses, service
revenue is recognized over the longest contractual period in an arrangement. Revenue from services
sold alone or with support is recognized as performed. 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 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 Page 30




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the improvement in our experience. Our 2004 experience was consistent with the late 2002 and 2003
experience and we did not adjust our reserve policy in 2004. 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 costs 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 three 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, 2004 future revenues from sale of products
for which development costs remain on the balance sheet are anticipated to exceed the $392,000 of
unamortized development costs.* Impairment of Long-Lived Assets We regularly review the carrying value of capitalized software development costs and property and
equipment. We continually make estimates regarding 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 Financial Statements, which contain additional information regarding our
accounting policies and other disclosures required by GAAP. Recent Accounting Pronouncements SFAS 123(R), Share-Based Payment On December 16, 2004 the FASB issued SFAS 123 (revised 2004), Share-Based Payment,which is a
revision of SFAS 123, Accounting for Stock-Based Compensation.Statement 123(R) supercedes APB
25, Accounting for Stock Issued to Employees,and amends SFAS 95, Statement of Cash Flows.
Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However,
SFAS 123(R) requires all share-based payments to employees, including grants of employee stock
options and purchases under employee stock purchase plans, to be recognized in the statement of
operations based on their fair values. Pro forma disclosure of fair value recognition will no
longer be an alternative. SFAS 123(R) is effective for public companies for annual periods beginning after June
15, 2005, with earlier adoption permitted. We are required to adopt
this new standard in our fiscal year beginning January 1, 2006. SFAS 123(R) permits public
companies to adopt its requirements using one of two methods:  1.
    A modified prospective method in which compensation cost is recognized beginning with
the effective date (a) based on the requirements of SFAS 123(R) for all share-based
payments granted after the effective date and (b) based on the requirements of SFAS 123 for
all awards granted to employees prior to the effective date that remain unvested on the
effective date.2.
    A modified retrospective method which includes the requirements of the modified
prospective method described above but also permits restatement using amounts previously
disclosed under the pro forma provisions of SFAS 123 either for (a) all prior periods
presented or (b) prior interim periods of the year of adoption. We have not yet chosen a method of adoption for SFAS 123(R). Page 31




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##### Table of Contents



As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25s
intrinsic value method. As a consequence, we generally recognize no compensation cost for employee
stock options and purchases under our Employee Stock Purchase Plan. Although the adoption of SFAS
123(R)s fair value method will have no adverse impact on our balance sheet or net cash flows, it
will have a significant adverse impact on our net income and net income per share. The pro forma
effects on net income and earnings per share if we had applied the fair value recognition
provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note
1 under Stock-Based Incentive Programs.Although the pro forma effects of applying SFAS 123 may
be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ
in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous
factors including the valuation model we use to value future share-based payments to employees,
estimated forfeiture rates and the accounting policies we adopt concerning the method of
recognizing the fair value of awards over the requisite service period. 
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk Our exposure to market risk for changes in interest rates relates primarily to the rate of interest
we will pay on our revolving credit facility with 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, 2004 would not have a
material affect on our results of operations. Page 32




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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 
 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Stockholders
Scientific Learning Corporation We have audited the accompanying balance sheets of Scientific Learning Corporation as of
December 31, 2004 and 2003 and the related statements of operations, stockholders deficit, and
cash flows for each of the three years in the period ended December 31, 2004. Our audits also
included the financial statement schedule listed in the index at Item 15 (a). These financial
statements and schedule are the responsibility of Scientific Learning Corporations management. Our
responsibility is to express an opinion on these financial statements and schedule based on our
audits. We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. We were not engaged to perform an audit of the Companys internal control over
financial reporting. Our audit included consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the circumstances, but not for
the purpose of expressing an opinion on the effectiveness of the Companys internal control over
financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Scientific Learning Corporation as of December 31,
2004 and 2003, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2004, in conformity with U.S. generally accepted
accounting principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein. /s/ ERNST & YOUNG LLP Walnut Creek, California
April 11, 2005 Page 33




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Scientific Learning Corporation 
 Balance Sheet
  December 31,2004
    
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    10,281
    
    
    $
    3,648Accounts
receivable, net of allowance for doubtful accounts $121 and $139 at December 31, 2004 and 2003, respectively
    
    
    5,661
    
    
    
    5,117Notes and interest receivable from current and former officers
    
    
    3,688
    
    
    
    Prepaid expenses and other current assets
    
    
    1,306
    
    
    
    1,144Total current assets
    
    
    20,936
    
    
    
    9,909Property and equipment, net
    
    
    755
    
    
    
    537Notes and interest receivable from current and former officers
    
    
    
    
    
    
    3,533Other assets
    
    
    1,267
    
    
    
    1,618Total assets
    
    $
    22,958
    
    
    $
    15,597Liabilities and stockholders deficitCurrent liabilities:Accounts payable
    
    $
    603
    
    
    $
    481Accrued liabilities
    
    
    4,338
    
    
    
    3,875Deferred revenue
    
    
    15,079
    
    
    
    16,884Total current liabilities
    
    
    20,020
    
    
    
    21,240Deferred revenue, long-term
    
    
    10,705
    
    
    
    2,616Other liabilities
    
    
    344
    
    
    
    285Total liabilities
    
    
    31,069
    
    
    
    24,141Commitments 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,
16,657,589 and 16,150,551 shares issued and outstanding
at December 31, 2004 and 2003, respectively
    
    
    75,586
    
    
    
    74,460Accumulated deficit
    
    
    (83,697
    )
    
    
    (83,004
    )Stockholders deficit:
    
    
    (8,111
    )
    
    
    (8,544
    )Total liabilities and stockholders deficit
    
    $
    22,958
    
    
    $
    15,597
 See accompanying notes. Page 34




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##### Table of Contents



Scientific Learning Corporation 
 Statement of Operations
  Year ended December 31,2004
    
    
    2003
    
    
    2002Revenues:Products
    
    $
    22,802
    
    
    $
    24,491
    
    
    $
    17,879Service and support
    
    
    8,174
    
    
    
    5,425
    
    
    
    3,958Total revenues
    
    
    30,976
    
    
    
    29,916
    
    
    
    21,837Cost of revenues:Cost of products
    
    
    1,775
    
    
    
    2,127
    
    
    
    2,109Cost of service and support
    
    
    4,981
    
    
    
    3,872
    
    
    
    1,502Total cost of revenues
    
    
    6,756
    
    
    
    5,999
    
    
    
    3,611Gross profit
    
    
    24,220
    
    
    
    23,917
    
    
    
    18,226Operating expenses:Sales and marketing
    
    
    16,087
    
    
    
    12,961
    
    
    
    14,554Research and development
    
    
    3,555
    
    
    
    3,500
    
    
    
    2,985General and administrative
    
    
    5,313
    
    
    
    4,529
    
    
    
    4,776Restructuring
    
    
    
    
    
    
    (7
    )
    
    
    3,365Total operating expenses
    
    
    24,955
    
    
    
    20,983
    
    
    
    25,680Operating income (loss)
    
    
    (735
    )
    
    
    2,934
    
    
    
    (7,454
    )Other income from related party
    
    
    99
    
    
    
    448
    
    
    
    Interest expense, net
    
    
    (100
    )
    
    
    (1,209
    )
    
    
    (1,332
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    91Net income (loss) before income tax
    
    
    (736
    )
    
    
    2,173
    
    
    
    (8,695
    )Income tax (benefit) provision
    
    
    (43
    )
    
    
    43
    
    
    
    Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Basic net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Shares used in computing basic net income (loss)
    
    
    16,408,039
    
    
    
    16,006,565
    
    
    
    15,641,849Diluted net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Shares used in computing diluted net income (loss)
    
    
    16,408,039
    
    
    
    16,908,361
    
    
    
    15,641,849
 See accompanying notes. Page 35




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##### Table of Contents



Scientific Learning Corporation 
 Statements of Stockholders Deficit
(In thousands, except share amounts) TotalCommon Stock
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Deficit
    
    
    DeficitBalance December 31, 2001
    
    
    15,475,619
    
    
    $
    73,192
    
    
    $
    (76,439
    )
    
    $
    (3,247
    )Issuance 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
    
    
    
    
    
    
    
    
    
    
    (8,695
    )
    
    
    (8,695
    )Balance December 31, 2002
    
    
    15,879,083
    
    
    
    73,771
    
    
    
    (85,134
    )
    
    
    (11,363
    )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
    
    
    
    
    
    
    
    
    
    
    2,130
    
    
    
    2,130Balance December 31, 2003
    
    
    16,150,551
    
    
    
    74,460
    
    
    
    (83,004
    )
    
    
    (8,544
    )Issuance of common stock under stock option plan
    
    
    417,773
    
    
    
    645
    
    
    
    
    
    
    
    645Issuance of common stock under employee stock purchase plan
    
    
    78,468
    
    
    
    300
    
    
    
    
    
    
    
    300Compensation charge relating to granting of common stock options
    
    
    
    
    
    
    110
    
    
    
    
    
    
    
    110Stock issued in exchange for services
    
    
    10,797
    
    
    
    71
    
    
    
    
    
    
    
    71Net loss and comprehensive loss
    
    
    
    
    
    
    
    
    
    
    (693
    )
    
    
    (693
    )Balance December 31, 2004
    
    
    16,657,589
    
    
    $
    75,586
    
    
    $
    (83,697
    )
    
    $
    (8,111
    )
 See accompanying notes Page 36




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##### Table of Contents



Scientific Learning Corporation 
 Statement of Cash Flows
  Year ended December 31,2004
    
    
    2003
    
    
    2002Operating Activities:Net (loss) income
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Adjustments to reconcile net income (loss) to cash provided by operating activities:Depreciation
    
    
    428
    
    
    
    721
    
    
    
    1,082Amortization of software development costs
    
    
    351
    
    
    
    617
    
    
    
    718Amortization of deferred financing costs
    
    
    232
    
    
    
    1,215
    
    
    
    1,216Stock based compensation
    
    
    181
    
    
    
    245
    
    
    
    142Asset impairment write downs
    
    
    
    
    
    
    
    
    
    
    50Changes in operating assets and liabilities:Accounts receivable
    
    
    (544
    )
    
    
    (250
    )
    
    
    887Prepaid expenses and other current assets
    
    
    (162
    )
    
    
    428
    
    
    
    (52
    )Accounts payable
    
    
    122
    
    
    
    194
    
    
    
    (157
    )Accrued liabilities
    
    
    463
    
    
    
    (1,339
    )
    
    
    1,814Deferred revenue
    
    
    6,284
    
    
    
    788
    
    
    
    6,515Other liabilities
    
    
    59
    
    
    
    (199
    )
    
    
    197Net cash provided by operating activities
    
    
    6,721
    
    
    
    4,550
    
    
    
    3,717Investing Activities:Sale of government securities
    
    
    
    
    
    
    
    
    
    
    1,169Purchases of property and equipment, net
    
    
    (646
    )
    
    
    (256
    )
    
    
    (124
    )Increase in capitalized software development costs
    
    
    
    
    
    
    
    
    
    
    (116
    )Increase in other non-current assets
    
    
    (387
    )
    
    
    (703
    )
    
    
    (80
    )Net cash (used in) provided by investing activities
    
    
    (1,033
    )
    
    
    (959
    )
    
    
    849Financing Activities:Proceeds from issuance of common stock, net
    
    
    945
    
    
    
    444
    
    
    
    437Borrowings under bank line of credit
    
    
    3,000
    
    
    
    2,000
    
    
    
    4,000Repayments of borrowings under bank line of credit
    
    
    (3,000
    )
    
    
    (7,000
    )
    
    
    (9,000
    )Net cash provided by (used in) financing activities
    
    
    945
    
    
    
    (4,556
    )
    
    
    (4,563
    )Increase (decrease) in cash and cash equivalents
    
    
    6,633
    
    
    
    (965
    )
    
    
    3Cash and cash equivalents at beginning of year
    
    
    3,648
    
    
    
    4,613
    
    
    
    4,610Cash and cash equivalents at end of year
    
    $
    10,281
    
    
    $
    3,648
    
    
    $
    4,613Supplemental disclosureInterest paid
    
    $
    44
    
    
    $
    134
    
    
    $
    294
 See accompanying notes. Page 37




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##### Table of Contents



Notes to Financial Statements1. Summary of Significant Accounting Policies Description of Business Scientific Learning Corporation (the Company) provides 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 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, as amended by Statement of Position 98-9 (SOP 97-2). 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. Sales to our school customers typically include multiple elements (e.g. Fast ForWord software
licenses, Progress Tracker, our Internet-based participant tracking service, support, training,
implementation management, and other services). The Company allocates revenue to each element of a
transaction based upon its fair value as determined in reliance on vendor specific objective
evidence (VSOE). VSOE of fair value for each element of an arrangement is based upon the normal
pricing and discounting practices for those products and services when sold separately and, for
support services, is also measured by the renewal price. The value of software licenses, services and support invoiced during a particular period is
recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as
discussed below. License revenue
Revenue from the licensing of software is recognized as follows: Perpetual licenses  software licensed on a perpetual basis. Revenue is recognized at the
later of product delivery date or contract start date using the residual method. If VSOE does not
exist for all the undelivered elements, all revenue is deferred and recognized ratably over the
service period if the undelivered element is services or when all elements have been delivered. Term licenses  software licensed for a specific time period, generally three to twelve
months. Revenue is recognized ratably over the license term. Individual participant licenses  software licensed for a single participant. Revenue is
recognized over the average period of use, typically six weeks. Page 38




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##### Table of Contents



Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) Service and support revenue
Service and support revenue is derived from a combination of training, implementation, technical
and professional services, online services and customer support. Training, technical and other
professional services are typically sold on a per day basis. If VSOE exists for all elements of an
arrangement or all elements except software licenses, services revenue is recognized as performed.
If VSOE does not exist for all the elements in an arrangement except software licenses, service
revenue is recognized over the longest contractual period in an arrangement. Revenue from services
sold alone or with support is recognized as performed. Cash and Cash Equivalents Cash and cash equivalents consist of cash and highly liquid investments with maturities of three
months or less from the time of purchase. 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. Inventories Product inventories are stated at the lower of cost or market. Cost is determined using a weighted
average approach, which approximates the first-in first-out method. If inventory costs exceed
expected market value due to obsolescence or lack of demand, reserves are recorded for the
difference between the cost and the market value. 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. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist
principally of cash, cash equivalents and accounts receivable. Cash and cash equivalents are invested in major financial institutions in the United States. Such
deposits may be in excess of insured limits and are not insured in other jurisdictions.
Management believes that the financial institutions that hold the Companys investments are
financially sound and, accordingly, minimal credit risk exists with respect to these
investments. The accounts receivable of the Company are derived from sales to customers located primarily in
the United States. The Company performs ongoing credit evaluations of its customers. The
Company does not require collateral. An allowance for doubtful accounts is determined with respect to those accounts that the Company
has determined to be doubtful of collection. At December 31, 2004 and 2003, no customer
accounted for more than 10% of the Companys accounts receivable. The company has no off-balance sheet concentration of credit risk, such as foreign exchange
contracts, option contracts or other hedging arrangements. 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. Page 39




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##### Table of Contents



Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) 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 and 2004, 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 product revenues
over the estimated useful life of the software, which is three years. Amortization was
$351,000, $617,000 and $718,000 for the years ended December 31, 2004, 2003 and 2002,
respectively. Long-Lived Assets The Company regularly reviews the carrying value of long-lived assets. We continually make
estimates regarding 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. 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 and employee stock purchase plan stock using the fair value
method. The fair value of each option granted and employee stock
purchase plan stock issued is estimated on the date of grant using the Black
Scholes valuation model with the following assumptions: Year ended December 31,Employee & Director Stock Options
    

2004
    
    

2003
    
    

2002Weighted average expected life
of option (in years)
    
    
    5
    
    5
    
5Risk-free interest rate
    
    
    3.0
    %
    
    
    3.0
    %
    
    
    3.0
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    85
    %
    
    
    85
    %
    
    
    85
    %Weighted average fair value
    
    $
    4.00
    
    
    $
    2.05
    
    
    $
    0.90
 Year ended December 31,Employee Stock Purchase Plan
    
    2004
    
    
    2003
    
    
    2002Weighted
average expected life (in years)
    
    
    0.5 - 1.0
    
    
    
    0.5 - 1.0
    
    
    
    0.5 - 1.0Risk-free interest rate
    
    
    3.0
    %
    
    
    3.0
    %
    
    
    3.0
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    85
    %
    
    
    85
    %
    
    
    85
    %Weighted average fair value
    
    $
    2.06
    
    
    $
    1.56
    
    
    $
    1.08
 Page 40




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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) The 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. 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 pro forma net income (loss) and basic and diluted net income (loss)
per share would have been as follows (in thousands, except per share amounts): Year Ended December 31,2004
    
    
    2003
    
    
    2002Net income (loss), as reported
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all
awards
    
    
    (1,668
    )
    
    
    (1,465
    )
    
    
    (2,472
    )Pro forma net income (loss), per share
    
    $
    (2,361
    )
    
    $
    665
    
    
    $
    (11,167
    )Basic, as reported
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Diluted, as reported
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Basic, pro forma
    
    $
    (0.14
    )
    
    $
    0.04
    
    
    $
    (0.71
    )Diluted, pro forma
    
    $
    (0.14
    )
    
    $
    0.04
    
    
    $
    (0.71
    )
 The pro forma impact of options on the net income (loss) for the years ended December 31, 2004,
2003 and 2002, 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. Advertising Advertising costs are expensed as incurred. Advertising expense was $13,000, $1,000 and $4,000 for
the years ended December 31, 2004, 2003 and 2002, 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 (computed using the treasury stock method) 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 loss per share as their
inclusion is antidilutive. Page 41




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Notes to Financial Statements1. Summary of Significant Accounting Policies (continued) The following table sets forth the computation of net income (loss) per share (in thousands, except
share and per share data): Year Ended December 31,2004
    
    
    2003
    
    
    2002Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Weighted average shares used in calculation
of basic net income (loss) per share
    
    
    16,408,039
    
    
    
    16,006,565
    
    
    
    15,641,849Effect of dilutive securities:Employee stock options
    
    
    
    
    
    
    901,796
    
    
    
    Weighted-average diluted common share
    
    
    16,408,039
    
    
    
    16,908,361
    
    
    
    15,641,849Net income (loss) per common share- basic :
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Net income (loss) per common share- diluted:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
 If the Company had reported net income in 2004 or 2002, 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 1,101,352 and 64,000 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, 2004 and 2002, respectively. Recent Accounting Pronouncements SFAS 123(R), Share-Based Payment On December 16, 2004 the FASB issued SFAS 123 (revised 2004), Share-Based Payment,which is a
revision of SFAS 123, Accounting for Stock-Based Compensation.Statement 123(R) supercedes APB
25, Accounting for Stock Issued to Employees,and amends SFAS 95, Statement of Cash Flows.
Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However,
SFAS 123(R) requires all share-based payments to employees, including grants of employee stock
options and purchases under employee stock purchase plans, to be recognized in the statement of
operations based on their fair values. Pro forma disclosure of fair value recognition will no
longer be an alternative. SFAS 123(R) is effective for public companies for annual periods beginning after June
15, 2005, with earlier adoption permitted. We are required to adopt
this new standard in our fiscal year beginning January 1, 2006. SFAS 123(R) permits public
companies to adopt its requirements using one of two methods:  1.
    A modified prospective method in which compensation cost is recognized beginning with
the effective date (a) based on the requirements of SFAS 123(R) for all share-based
payments granted after the effective date and (b) based on the requirements of SFAS 123 for
all awards granted to employees prior to the effective date that remain unvested on the
effective date.2.
    A modified retrospective method which includes the requirements of the modified
prospective method described above but also permits restatement using amounts previously
disclosed under the pro forma provisions of SFAS 123 either for (a) all prior periods
presented or (b) prior interim periods of the year of adoption. We have not yet chosen a method of adoption for SFAS 123(R). Page 42




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##### Table of Contents



Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25s
intrinsic value method. As a consequence, we generally recognize no compensation cost for employee
stock options and purchases under our Employee Stock Purchase Plan. Although the adoption of SFAS
123(R)s fair value method will have no adverse impact on our balance sheet or net cash flows, it
will have a significant adverse impact on our net income and net income per share. The pro forma
effects on net income and earnings per share if we had applied the fair value recognition
provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note
1 under Stock-Based Incentive Programs.Although the pro forma effects of applying SFAS 123 may
be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ
in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous
factors including the valuation model we use to value future share-based payments to employees,
estimated forfeiture rates and the accounting policies we adopt concerning the method of
recognizing the fair value of awards over the requisite service period. Reclassifications Certain other asset items from prior years have been reclassified to conform to the
current presentation. 2. Restructuring, Lease and Asset Impairment Write Downs In 2004, the Company completed lease termination payments of $1.8 million. There were no other
restructuring activities during the year and no accrued restructuring costs as of December 31,
2004. 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. 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. In 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. Page 43




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##### Table of Contents



Notes to Financial Statements
2. Restructuring, Lease and Asset Impairment Write Downs (continued) The following table sets forth the restructuring activity during the three years ended December 31,
2004
(in thousands). Accrued
    
    
    
    
    
    
    
    
    
    
    Accrued
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Accrued
    
    
    
    
    
    
    Accruedrestructuring
    
    
    
    
    
    
    
    
    
    
    restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    restructuring
    
    
    
    
    
    
    restructuringcosts,
    
    
    
    
    
    
    
    
    
    
    costs,
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    costs,
    
    
    
    
    
    
    costs,December 31,
    
    
    Restructuring
    
    
    
    
    
    
    December 31,
    
    
    Restructuring
    
    
    Asset write-
    
    
    
    
    
    
    December 31,
    
    
    
    
    
    
    December 31,2001
    
    
    Charges
    
    
    Cash paid
    
    
    2002
    
    
    Charges
    
    
    down
    
    
    Cash paid
    
    
    2003
    
    
    Cash paid
    
    
    2004Lease
obligation
    
    $
    1,458
    
    
    $
    2,306
    
    
    $
    (759
    )
    
    $
    3,005
    
    
    $
    154
    
    
    
    
    
    
    $
    (1,386
    )
    
    $
    1,773
    
    
    $
    (1,773
    )
    
    $
    Asset
write-down
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    196
    
    
    
    (196
    )
    
    
    
    
    
    
    Severance
benefits
    
    
    82
    
    
    
    1,059
    
    
    
    (632
    )
    
    
    509
    
    
    
    
    
    
    
    
    
    
    
    (509
    )
    
    
    Total
    
    $
    1,540
    
    
    $
    3,365
    
    
    $
    (1,391
    )
    
    $
    3,514
    
    
    $
    350
    
    
    $
    (196
    )
    
    $
    (1,895
    )
    
    $
    1,773
    
    
    $
    (1,773
    )
    
    $
    
 3. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets consist of the following (in thousands): December 31,2004
    
    
    2003Prepaid expenses
    
    $
    1,025
    
    
    $
    791Deferred financing
    
    
    
    
    
    
    232Product inventory
    
    
    273
    
    
    
    109Other receivables
    
    
    8
    
    
    
    12$
    1,306
    
    
    $
    1,144
 4. Property and Equipment Property and equipment consists of the following (in thousands): December 31,2004
    
    
    2003Computer equipment
    
    $
    4,517
    
    
    $
    3,978Office furniture and equipment
    
    
    1,489
    
    
    
    1,403Leasehold improvements
    
    
    453
    
    
    
    4326,459
    
    
    
    5,813Less accumulated depreciation
    
    
    (5,704
    )
    
    
    (5,276
    )$
    755
    
    
    $
    537
 5. Notes Receivable from Current and Former Officers Notes receivable from current and former officers was $3.1 million of principal at December 31,
2004 and 2003. 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. Principal and accrued interest of $3.7 million and $3.5 million is recorded
in Notes and Interest Receivable from Current and Former Officers as of December 31, 2004 and
December 31, 2003 respectively. Page 44




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Notes to Financial Statements (continued) 6. Other Assets Other Assets consist of the following (in thousands): December 31,2004
    
    
    2003Software development cost
    
    $
    3,089
    
    
    $
    3,089Less accumulated amortization
    
    
    (2,697
    )
    
    
    (2,346
    )Software development costs, net
    
    
    392
    
    
    
    743Other non current assets
    
    
    875
    
    
    
    875$
    1,267
    
    
    $
    1,618
 7. Accrued Liabilities Accrued liabilities consist of the following (in thousands): December 31,2004
    
    
    2003Accrued restructuring costs
    
    $
    
    
    
    $
    1,773Accrued vacation
    
    
    1,036
    
    
    
    831Accrued commissions and bonus
    
    
    2,093
    
    
    
    930Accounts payable accruals
    
    
    671
    
    
    
    196Other accrued liabilities
    
    
    538
    
    
    
    145$
    4,338
    
    
    $
    3,875
 8. Bank Line of Credit On January 30, 2004 the Company entered into a revolving line of credit agreement with Comerica
Bank. The line totaled $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 July 14, 2005. Borrowing
under the line of credit bears interest at prime plus 0.5%, currently 5.75%. The facility was
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 was 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 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. Borrowings under the line are subject to various covenants.
There were no borrowings outstanding on the line of credit at December 31, 2004. 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; this amount was amortized as deferred financing costs by a charge to
interest expense through July 31, 2004. 9. Income Tax The Company recorded a tax benefit of $43,000 for the year ended December 31, 2004 relating to the
reversal of a provision for U.S. federal alternative minimum tax for the year ended December 31,
2003. The Company has made no provision for U.S. federal, U.S. state or foreign income taxes for
the years ended December 31, 2004, 2003 and 2002 as the Company has incurred tax losses in all
periods and for all jurisdictions. Page 45




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Notes to Financial Statements9. Income Tax (continued) Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts
of assets and liabilities for financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Companys deferred tax assets are as follows, (in
thousands): December 31,2004
    
    
    2003Deferred tax assets:Net operating loss carryforwards
    
    $
    27,637
    
    
    $
    26,272Restructuring reserve
    
    
    
    
    
    
    710Capitalized software and development costs
    
    
    389
    
    
    
    698Deferred revenue
    
    
    395
    
    
    
    1,008Research credit carryforwards
    
    
    1,195
    
    
    
    811Other
    
    
    1,360
    
    
    
    941Total deferred tax assets
    
    
    30,976
    
    
    
    30,440Valuation allowance
    
    
    (30,976
    )
    
    
    (30,440
    )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 decreased from December 31, 2002 to December 31, 2003
in the amount of $357,000. As of December 31, 2004, the Company had net operating loss carryforwards for federal income tax
purposes of approximately $77,286,000, which expire in the years 2011 through 2024 and federal
research tax credits of approximately $823,000, which expire in the years 2011 through 2024. The
Company also had net operating loss carryfowards for state income tax purposes of approximately
$30,315,000 expiring in the years 2006 through 2014 and state research tax credits of approximately
$372,000 which carry forward 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, 2004, the Company had reserved shares of common stock for future issuance as
follows: Stock Options outstanding
    
    
    3,103,102Stock Options available for future grants
    
    
    1,026,439Employee stock purchase plan
    
    
    225,675Common stock warrants
    
    
    1,375,0005,730,216
 Page 46




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Notes to Financial Statements10. Stockholders Deficit (continued) Stock Options The Companys employee stock option plans provide for the issuance of incentive stock options
(ISO), nonstatutory stock options (NSO) and stock awards 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 ten 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. In January 2004, the Companys Board of Directors approved and in June 2004, the
shareholders subsequently approved, adding an additional 850,000 shares to the 1999 Equity Plan.
The total number of shares authorized for issuance under the plan is now 5,492,666. 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. The Company has, on occasion, granted stock options and stock to non-employees and directors. A
compensation charge has been recorded in these instances. In 2004 10,797 shares were issued to
directors as payment for their services; an expense of $71,000 was recorded for the year ended
December 31, 2004. A summary of the Companys stock option activity under the plans is as follows: Outstanding OptionsWeighted-Average ExerciseNumber of Shares
    
    
    Price Per ShareOutstanding 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
    
    
    
    3.76Granted
    
    
    552,497
    
    
    
    5.71Exercised
    
    
    (417,773
    )
    
    
    1.54Canceled
    
    
    (76,739
    )
    
    
    7.88Outstanding at December 31, 2004
    
    
    3,103,012
    
    
    $
    4.33Vested and exercisable
    
    
    1,407,373
 Page 47




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Notes to Financial Statements10. Stockholders Deficit (continued) The following table summarizes information concerning outstanding and exercisable stock options at
December 31, 2004: Outstanding
    
    
    Vested and ExercisableWeighted-
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    AverageWeighted-
    
    
    Remaining
    
    
    
    
    
    
    ExerciseNumber of
    
    
    Average Exercise
    
    
    Contractual Life
    
    
    Number of
    
    
    Price PerPrice Range
    
    Shares
    
    
    Price Per Share
    
    
    (Years)
    
    
    Shares
    
    
    Share$0.2600
 $  1.3900
    
    
    1,141,600
    
    
    $
    1.37
    
    
    
    7.35
    
    
    
    185,349
    
    
    $
    1.30$1.4000
 $  6.1250
    
    
    1,539,098
    
    
    $
    4.03
    
    
    
    7.60
    
    
    
    846,464
    
    
    $
    3.70$6.2500  $39.8750
    
    
    422,314
    
    
    $
    13.42
    
    
    
    5.58
    
    
    
    375,560
    
    
    $
    14.293,103,012
    
    
    
    
    
    
    
    
    
    
    
    1,407,373
 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. 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 78,468 and 52,912 shares
of common stock under the plan during the years ended December 31, 2004 and 2003, respectively. At
December 31, 2004, 225,675 shares were available for issuance under the Plan. Page 48




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Notes to Financial Statements (continued) 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, 2004 are as follows
(in thousands): 2005
    
    $
    9402006
    
    
    9402007
    
    
    9402008
    
    
    9402009
    
    
    9842010 and thereafter
    
    
    4,423$
    9,167
 Rent expense under all operating leases net of sublease income was $1 million, $1 million and $1.7
million for the years ended December 31, 2004, 2003 and 2002, respectively. 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, which expires in 2014, the Company issued stock and paid a license-issue fee. The
agreement also provided for milestone payments, all of which have been made, and for royalties
based on sales of products using the licensed technology. Royalty expenses were $830,000, $898,000
and $723,000 for the years ended December 31, 2004, 2003 and 2002, respectively, and are included
in cost of revenues. 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. Warranties; Indemnification 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, 2004. From time to time, the Company enters into contracts that require the Company, upon the occurrence
of certain contingencies, to indemnify parties against third party claims. These contingent
obligations primarily relate to (i) claims against the Companys customers for violation of third
party intellectual property rights caused by the Companys products; (ii) claims resulting from
personal injury or property damage resulting from the Companys activities or products; (iii)
claims by the Companys office lessor arising out of the Companys use of the premises; and (iv)
agreements with the Companys officers and directors under which the Company may be required to
indemnify such persons for liabilities arising out of their activities on behalf of the Company.
Because the obligated amounts for these types of agreements usually are not explicitly stated, the
overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have
been recorded for these obligations on the Companys balance sheet as of December 31, 2004 or 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. Page 49




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##### Table of Contents



Notes to Financial Statements (continued) 14. Related Party Transaction On September 30, 2003 the Company entered into an agreement with Posit Science Corporation (PSC),
formerly Neuroscience Solutions Corporation, to provide PSC 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 PSC. The rights were acquired by PSC for a combination of cash, stock and future royalties. PSC 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 PSC. 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 PSC that use the Companys patents or software.
We did not record a value for the 1.8 million shares of PSC received in the transaction, because
PSC was a private start-up venture, the shares of which had no determinable value. 15. Interim Financial Information (unaudited) Quarterly financial data (in thousands, except per share amounts) 2004Quarter endedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 31
    
    
    TotalTotal revenues
    
    $
    7,036
    
    
    $
    7,497
    
    
    $
    8,290
    
    
    $
    8,153
    
    
    $
    30,976Gross profit
    
    
    5,477
    
    
    
    5,803
    
    
    
    6,512
    
    
    
    6,428
    
    
    
    24,220Net income (loss)
    
    
    (290
    )
    
    
    (52
    )
    
    
    667
    
    
    
    (1,018
    )
    
    
    (693
    )Net income (loss) per share:Basic
    
    
    (0.02
    )
    
    
    0.00
    
    
    
    0.04
    
    
    
    (0.06
    )
    
    
    (0.04
    )Diluted
    
    
    (0.02
    )
    
    
    0.00
    
    
    
    0.04
    
    
    
    (0.06
    )
    
    
    (0.04
    )
 2003Quarter endedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 31
    
    
    TotalTotal revenues
    
    $
    6,583
    
    
    $
    8,074
    
    
    $
    8,293
    
    
    $
    6,966
    
    
    $
    29,916Gross profit
    
    
    5,158
    
    
    
    6,630
    
    
    
    6,724
    
    
    
    5,405
    
    
    
    23,917Net income (loss)
    
    
    (454
    )
    
    
    745
    
    
    
    1,678
    
    
    
    161
    
    
    
    2,130Net income (loss) per share:Basic
    
    
    (0.03
    )
    
    
    0.05
    
    
    
    0.10
    
    
    
    0.01
    
    
    
    0.13Diluted
    
    
    (0.03
    )
    
    
    0.04
    
    
    
    0.10
    
    
    
    0.01
    
    
    
    0.13
 Page 50




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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 9A. CONTROLS AND PROCEDURES Disclosure controls and procedures are designed to ensure that information required to be disclosed
in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K, is recorded,
processed, summarized and reported within the required time periods. These procedures are also
designed to ensure that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure. In December 2004, the Companys management and the Audit Committee of the Companys Board of
Directors concluded that the Company should change its revenue recognition method for most of the
Companys K-12 school contracts. This issue surfaced in the course of the review of our financial
statements for the third quarter of 2004. As a result, the Company has restated its historical
financial statements for the period from 2000 through June 30, 2004. This change in the Companys revenue recognition treatment reflects a correction in the Companys
application of AICPA Statement of Position 97-2, Software Revenue Recognition (as amended by
Statement of Position 98-9) (Statement 97-2) to these historical transactions. Controls over the
application of accounting policies are within the scope of internal controls. Therefore,
management has concluded that there was a material weakness in the Companys internal controls, as
defined by the Public Company Accounting Oversight Board. As required under Rule 13a-15(b) of the Exchange Act, the Companys management, including the Chief
Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the
Companys disclosure controls and procedures as of the end of the period covered by this report.
Solely because of the revenue recognition issue discussed above, the Companys Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures
were not effective as of December 31, 2004. We are committed to implementing changes in our
internal controls over financial reporting with respect to revenue recognition and are in the
process of evaluating what changes should be made in these controls. Except for these changes,
during the year ended December 31, 2004, there were no changes in the Companys internal controls
over financial reporting that materially affected, or are reasonably likely to materially affect
the Companys internal control over financial reporting. It should be noted that a control system, no matter how well designed and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control system are met. As a
result, there can be no assurance that a control system will succeed in preventing all possible
instances of error and fraud. The Companys disclosure controls and procedures are designed to
provide reasonable assurance of achieving their objectives, and the conclusions of our Chief
Executive Officer and the Chief Financial Officer are made at the reasonable assurance level. 
 ITEM 9B. OTHER INFORMATION Not Applicable. Page 51




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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 2005 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 ACCOUNTANT FEES AND SERVICES Information required by this item concerning the independent auditors fees and services is set
forth under the caption Ratification of Selection of Independent Registered Public Accounting Firm in the Proxy Statement and
is incorporated by reference into this Form 10-K Report. Page 52




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##### Table of Contents



PART IV 
 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report:  (1) Financial Statements Independent Registered Public Accounting Firms ReportRestated Balance Sheet  December 31, 2004 and 2003Restated Statement of Operations  Years Ended December 31, 2004, 2003 and 2002Restated Statements of Stockholders (Deficit) Equity  Years Ended December 31, 2004, 2003 and 2002Restated Statement of Cash Flows  Years Ended December 31, 2004, 2003 and 20021Notes 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 Charges to
    
    
    
    
    
    
    AdditionsOpening
    
    
    Operating
    
    
    Charges to
    
    
    (deductions) to
    
    
    ClosingBalance
    
    
    Expenses
    
    
    Allowance
    
    
    Allowance
    
    
    Balance2004
    
    $
    139
    
    
    $
    (3
    )
    
    $
    (100
    )
    
    $
    85
    
    
    $
    1212003
    
    
    270
    
    
    
    
    
    
    
    89
    
    
    
    (220
    )
    
    
    1392002
    
    
    248
    
    
    
    19
    
    
    
    309
    
    
    
    (306
    )
    
    
    270
 Page 53




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##### Table of Contents



(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, 1998.4.5(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, 1998.10.1(1)*
    
    Form of Indemnity Agreement with each of our directors and executive officers.10.2(13)*
    
    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*
    
    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 Plan.10.6(14)*
    
    1999 Employee Stock Purchase Plan, as amended.10.7 (25)*
    
    Summary of base salary and bonuses payable to Named Executive Officers10.8(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 Bank.10.10(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 II.10.17(24)
    
    Lease Termination Agreement, dated as of October 1, 2003, with
Rotunda Partners II.10.18(4)
    
    Revolving Loan Agreement dated as of March 9, 2001 by and between Scientific
Learning Corporation and Fleet National Bank.10.19(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
Corporation.10.21(7)*
    
    Loan agreements, promissory notes and pledge agreements with each of Sheryle
Bolton, Frank Mattson, Steve Miller, and James Mills.10.22(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(25)*
    
    2005 Management Incentive Plan10.26(11)*
    
    Employment Agreement dated as of May 31, 2002 by and between Scientific
Learning Corporation and Robert C. Bowen.10.27(12)*
    
    2002 CEO Option Plan.
 Page 54




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##### Table of Contents



Exhibit No.
    
    Description of Document10.28(13)*
    
    Letter Agreement dated January 2004 by and between the Company and Robert C.
Bowen amending the Employment Agreement listed as Exhibit 10.26.10.29(13)*
    
    Milestone Equity Incentive Plan.10.30
    
    First Amendment to Loan and Security Agreement, dated as of September 29,
2004, by and between Comerica Bank and the Company, amending the Loan and Security
Agreement filed as Exhibit 10.9.10.31(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 (now renamed Posit Science
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.10.36(13)*
    
    2004 Management Incentive Plan10.37(26)*
    
    Independent Contractor Agreement dated April l7, 2003 between the Company and
Paula A. Tallal and Project Assignment thereunder dated December 17, 2004.23.1
    
    Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm.31.1
    
    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-Q for the quarter ended March 31, 2004 (SEC File No.
000-24547).
 Page 55




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##### Table of Contents



Exhibit No.
    
    Description of Document(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).(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).(25)
    
    Incorporated by reference to exhibits previously filed with the Companys
Form 8-K filed on March 25, 2005.(26)
    
    Incorporated by reference to Exhibit 99.1 previously filed with the
Companys Form 8-K filed on December 20, 2004.
      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 25, 2004, the Company filed a Report on Form 8-K announcing that it had issued a
press release announcing that it had delayed the release of its third quarter financial
results and had conducted a publicly available conference call discussing the delay.On November 17, 2004, the Company filed a Report on Form 8-K announcing that it had received
a Staff Determination notice from the Nasdaq Stock Market stating that the Company was not
in compliance with Nasdaqs rules because the Company had not then filed its 10-Q Report for
the third quarter and that the Companys securities were therefore subject to delisting.On December 20, 2004, the Company filed a Report on Form 8-K announcing its intention to
restate certain of its historical financial statements to correct an error in the revenue
recognition of certain transactions and that, accordingly, those financial statements should
not be relied upon.On December 20, 2004, the Company filed a Report on Form 8-K announcing that it had amended
its Independent Contractor Agreement with one of its directors by entering into a new
Project Assignment for work over the period from 2005 through 2009. Page 56




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. SCIENTIFIC LEARNING CORPORATION By
    
    /s/ Robert C. Bowen
    
    
    

April 13, 2005Robert C. BowenChief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons on behalf of the registrant and in the capacities and on the dates
indicated. SIGNATURES
    
    TITLE
    
    DATE/s/ Robert C. Bowen

Robert C. Bowen
    
    Chairman, Chief Executive Officer
and Director (Principal Executive
Officer)
    
    April 13, 2005/s/ Jane A. Freeman

Jane A. Freeman
    
    Senior Vice President, Chief Financial Officer,
and Treasurer (Principal Financial and
Accounting Officer)
    
    April 13, 2005/s/ Dr. Michael M. Merzenich

Dr. Michael M. Merzenich
    
    Director
    
    April 13, 2005/s/ Dr. Paula A. Tallal

Dr. Paula A. Tallal
    
    Director
    
    April 13, 2005/s/ Carleton A. Holstrom

Carleton A. Holstrom
    
    Director
    
    April 13, 2005/s/ Rodman W. Moorhead, III

Rodman W. Moorhead, III
    
    Director
    
    April 13, 2005/s/ Ajit Dalvi

Ajit Dalvi
    
    Director
    
    April 13, 2005/s/ Dr. Joseph Martin

Dr. Joseph Martin
    
    Director
    
    April 13, 2005/s/ Edward Vermont Blanchard, Jr.

Edward Vermont Blanchard, Jr.
    
    Director
    
    April 13, 2005/s/ David W. Smith

David W. Smith
    
    Director
    
    April 13, 2005




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##### Table of Contents

\

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, 1998.4.5(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, 1998.10.1(1)*
    
    Form of Indemnity Agreement with each of our directors and executive officers.10.2(13)*
    
    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*
    
    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 Plan.10.6(14)*
    
    1999 Employee Stock Purchase Plan, as amended.10.7 (25)*
    
    Summary of base salary and bonuses payable to Named Executive Officers10.8(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 Bank.10.10(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 II.10.17(24)
    
    Lease Termination Agreement, dated as of October 1, 2003, with
Rotunda Partners II.10.18(4)
    
    Revolving Loan Agreement dated as of March 9, 2001 by and between Scientific
Learning Corporation and Fleet National Bank.10.19(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
Corporation.10.21(7)*
    
    Loan agreements, promissory notes and pledge agreements with each of Sheryle
Bolton, Frank Mattson, Steve Miller, and James Mills.10.22(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(25)*
    
    2005 Management Incentive Plan10.26(11)*
    
    Employment Agreement dated as of May 31, 2002 by and between Scientific
Learning Corporation and Robert C. Bowen.




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##### Table of Contents



Exhibit No.
    
    Description of Document10.27(12)*
    
    2002 CEO Option Plan.10.28(13)*
    
    Letter Agreement dated January 2004 by and between the Company and Robert C.
Bowen amending the Employment Agreement listed as Exhibit 10.26.10.29(13)*
    
    Milestone Equity Incentive Plan.10.30
    
    First Amendment to Loan and Security Agreement, dated as of September 29,
2004, by and between Comerica Bank and the Company, amending the Loan and Security
Agreement filed as Exhibit 10.9.10.31(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 (now renamed Posit Science
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.10.36(13)*
    
    2004 Management Incentive Plan10.37(26)*
    
    Independent Contractor Agreement dated April l7, 2003 between the
Company and Paula A. Tallal and Project Assignment thereunder dated December 17,
2004.23.1
    
    Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm.31.1
    
    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).




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##### Table of Contents



Exhibit No.
    
    Description of Document(13)
    
    Incorporated by reference to the same numbered exhibit previously filed
with the Companys Form 10-Q for the quarter ended March 31, 2004 (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).(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).(25)
    
    Incorporated by reference to exhibits previously filed with the Companys
Form 8-K filed on March 25, 2005.(26)
    
    Incorporated by reference to Exhibit 99.1 previously filed with the
Companys Form 8-K filed on December 20, 2004.
      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.