UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-K





x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2010





or





o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____  TO  _____ .





COMMISSION FILE NO. 000-24547





SCIENTIFIC LEARNING CORPORATION


(Exact name of registrant as specified in its charter)





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


300 Frank H. Ogawa Plaza, Suite 600


Oakland, CA 94612


510-444-3500


(Address of Registrant’s principal executive offices, including zip code, and telephone number, including area code)





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





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


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





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





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





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes: x No: o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes: xNo: 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 a large accelerated filer, an accelerated filer a non-accelerated filer, or a smaller reporting company. (See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).(Check one):





Large accelerated filer o  Accelerated filer o  Non-accelerated filer o  Smaller reporting company x





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes: o No: x





The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on June 30, 2010 as reported on the Nasdaq Global Market was approximately 59,431,062. Shares of Common Stock held by each director and executive officer and 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 February 28, 2011 the Registrant had outstanding 18,712,184 shares of Common Stock.




DOCUMENTS INCORPORATED BY REFERENCE
 
 Portions of the Proxy Statement for the Registrant's 2011 Annual Meeting of Stockholders are incorporated by reference in Part III.










TABLEOF CONTENTS





PART I

PAGE NO.Item 1.
Business
1Item 1A.
Risk Factors
8Item 1B.
Unresolved Staff Comments
12Item 2.
Properties
12Item 3.
Legal Proceedings
12Item 4.
Removed and Reserved
12PART IIItem 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
14Item 6.
Selected Financial Data
16Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
17Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
26Item 8.
Financial Statements and Supplementary Data
27Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
48Item 9A.
Controls and Procedures
48Item 9B.
Other Information
49PART IIIItem 10.
Directors and Executive Officers and Corporate Governance
50Item 11.
Executive Compensation
50Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
50Item 13.
Certain Relationships and Related Transactions, and Director Independence
50Item 14.
Principal Accountant Fees and Services
50PART IVItem 15.
Exhibits and Financial Statement Schedules
51SIGNATURES
52


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Forward Looking Statements





Some of the statements contained in this Annual Report on Form 10-K are forward-looking statements that involve risk and uncertainties. The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “intends,” “estimates,” “predicts,” “potential,” or “continue” or the negative of these terms or other comparable terminology. These statements are subject to known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. Important factors that may cause actual results to differ from expectations include those discussed in this Annual Report on Form 10-K in Item 1A – “Risk Factors”. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us on the date thereof, and we assume no obligation to update any such forward-looking statements.





PARTI





ITEM 1. BUSINESS





Overview





We create educational software that accelerates learning by applying proven research on how the brain learns. Our results, demonstrated in approximately 250 research studies, show that learners who use our products can realize achievement gains of 1 - 2 years in as little as 8 - 12 weeks and maintain an accelerated rate of learning even after product use ends. Learners have used our software products, which apply “Brain Fitness” principles to the areas of reading and learning nearly 3 million times.  We provide our offerings primarily to U.S. K-12 schools and also to parents and learning centers, and in more than 40 countries around the world.





We are highly differentiated because of our foundation in and continuous incorporation of research-based learning approaches. The fact that the learning brain can improve through exercise - the concept of brain fitness - led us to create a novel approach to learning.Our focus on results continues in our emphasis on generating rigorous proof that our products produce substantial improvements for different types of readers in a variety of settings. At December 31, 2010, approximately 250 efficacy studies, including randomized controlled trials and longitudinal studies representing results from approximately 95,000 aggregate participants, demonstrated the academic gains achieved through our products. These studies show gains for students at all K-12 grade levels, for at-risk students, special education students, English language learners, Title One (low income, under achieving) students, and a variety of other demographic groups. Gains have been demonstrated throughout the United States and in ten other countries. Studies show that these gains endure over time.





Our technology leverages a scalable approach to effectively and consistently deliver individualized training to a large number of students simultaneously.Our Fast ForWord educational software products are now available on our browser-based SciLEARN Enterprisesoftware platform. The SciLEARN Enterprise platform meets the needs of institution and district-wide installations by providing scalability, remote access, centralized database, and ease of administration and support for multiple campuses.





Markets





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





United States K-12 Market





Our sales are concentrated in K-12 schools in the United States, which in 2010 were estimated to total nearly 117,000 schools serving approximately 54 million students in over 14,000 school districts. Purchasing decisions for our products are made primarily by district level administrators. In each of the last three fiscal years, the U.S. K-12 sector has represented approximately 90% of our sales.





We market our products primarily as a learning acceleration solution, to be used as a technology supplement to existing curriculum materials, at both the elementary and secondary school levels to improve reading and learning. Despite a national focus on reading and increased school district accountability, independent evaluations of student performance have demonstrated little improvement in reading results. According to the U.S. Department of Education (USDE), in 2009, 67% of fourth graders in the United States were not “proficient” in reading and 33% performed below the” basic” level. Between 2007 and 2009, there was no change in average 4th grade reading scores.


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United States K-12 public schools are funded primarily through state and local tax revenues, but also receive funding from the federal government through a variety of programs, many of which target children who are poor and/or are struggling academically. The funding for a substantial portion of our K-12 sales has historically come from federal sources, in particular IDEA (special education) and Title One funding.  The federal law governing these programs is scheduled for reauthorization, and there is much discussion about potential changes.  While the American Recovery and Reinvestment Act provided for substantial temporary increases in federal programs, those increases are expiring in 2011.  State and local school funding for schools continues to be significantly impacted by decreases in tax revenues due to the recent recession. While education spending remains an important priority for states, many states have reduced their funding to schools, resulting in teacher layoffs and program restrictions.





According to Simba’s Publishing for the Pre K – 12 Market 2010 – 2011 the educational materials market declined in 2009 by 5.5% driven primarily by an over 20% decrease in spending on new textbooks. This same report forecasts a slow recovery driven by demand for technology based solutions that cost-effectively scale and improve performance for all learners.





Other Markets





In addition to selling to K-12 schools, we also sell to and through private practice professionals and learning centers. These speech and language and other professionals recommend the use of our products to appropriate clients and then supervise the use of the software, often in connection with their other services. In 2010, over 400 non-school professionals and entities in the United States and Canada (North America) offered our products.





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





Sales to countries other than the United States and Canada are a small but growing part of our business, which we serve though a network of value-added representatives to serve these markets. During 2010, products were marketed to customers in 45 countries. As of December 31, 2010, we were represented by 24 value-added representatives.





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





Historically, the majority of our sales have been large transactions from U.S. K-12 school districts.  In the recent economic downturn, it has been more challenging to close large transactions as district leaders feel pressure to fund only basic infrastructure needs.  Our current technology development activities are focused on building a robust and scalable  technology platform that will support on-demand access and allow us to rapidly add new types of student exercises.  We believe that this new platform will allow us to better address both the U.S. K-12 market and the international, consumer and virtual school markets.  As our model becomes more diversified, we expect to become less big deal dependent and to significantly increase our subscription base with more predictable transactions and recurring revenue.





Products





Our products unify proven curriculum with brain fitness exercises, thereby accelerating the learning process and resulting in enduring gains. We build learning capacity by systematically and rigorously exercising the brain to develop the cognitive and reading skills required for lifelong learning success.  Our products apply learning principles that have been established though neuroscience and cognitive research as critical to learning new tasks:  frequency and intensity of exercises, adaptivity to the students’ individual performance, timely motivation and simultaneous development of multiple skills.




Fast ForWord products





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


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The Fast ForWord Language and Literacy Series





The Fast ForWord Language series for elementary learners and the Literacy series for adolescent learners build foundational reading and language skills to help districts move below grade level learners to be successful learners in the general classroom.  The products in this series are Fast ForWordLanguage v2, Fast ForWordLanguage to Reading v2,Fast ForWordLiteracyand Fast ForWordLiteracy Advanced.





The exercises in the Fast ForWordLanguage v2 product specifically focus on oral language comprehension and listening, including phonological awareness, listening accuracy and comprehension, working memory, and familiarity with language structures.  The content and exercises of the Literacy product are similar to those of Language v2, but have been adapted to maximize impact for adolescents and English language learners.  These products use acoustically modified speech, which stretches and emphasizes particular sounds in an adaptive manner, to help children learn to quickly isolate and recognize individual speech sounds, an underlying skill critical to reading. The Fast ForWordLanguage to Reading v2 product helps students make the link between spoken and written language, using exercises that focus on listening comprehension, sound letter recognition, phonological awareness, beginning word recognition and English language conventions.TheLiteracy Advanced software includes content and exercises similar to those in the Fast ForWordLanguage to Reading with a user interface is designed to appeal to adolescents, emphasizing phonemic awareness, decoding, word recognition, sequential and inferential comprehension and the ability to sequence multi-step instructions.





The FastForWord Reading Series





The Fast ForWord Reading series of products builds learning capacity through developing cognitive skills using exercises focused on critical “reading to learn” abilities. The Reading Series exercises focus on phonemic awareness, phonics and decoding, spelling, vocabulary, fluency and comprehension.   The Fast ForWord Reading series begins withReading Readiness, which prepares the student for reading, focusing on phonemic identification, categorization and blending, letter names, sound and letter correspondence, rapid letter/word recognition, and oral vocabulary.  The series continues with levels 1 through 5, which focus on reading skills and tasks of increasing complexity.  The exercises in the Reading 5 product carry a significant working memory load, as they build vocabulary, improve critical thinking and abstract reasoning, improve composition skills, and focus on accuracy, fluency and comprehension.





Reading Assistant products





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





Progress Tracker and Reading Progress Indicator products





Progress Tracker, our Internet-based data analysis and reporting tool, analyzes student learning results to provide diagnostic and prescriptive intervention information and allows educators to track and report their students’ learning progress. Progress Tracker provides detailed reports at the student, classroom, school, and district level, and can be reported by subgroup, providing a tool for educators to analyze student progress towards required goals. Customers can configure the system to send automatic emails to parents, teachers, administrators or others to provide easy periodic updates. Progress Tracker also provides the ability to collect behavioral survey data from teachers and parents prior to and after product use.





Reading Progress Indicator is a reliable and valid assessment of a student’s reading skills. It is designed to be quick and convenient to administer before and after product use, to rapidly demonstrate the effectiveness of our products.





BrainSpark products and BrainPro services





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





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


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





Implementation





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





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





License Terms





We license our products in a variety of configurations to meet the customer’s needs. Schools typically purchase site or workstation licenses, which are available either as a perpetual license or for a limited term. Most customers also purchase implementation services, which we believe are important to encourage successful use of the products.





Products licensed for administration by private practice professionals and parents are generally purchased on a per product per student basis.  Products licensed by International VARs are generally purchased on a per student, per month subscription basis.





Services and Support





We believe that the training and implementation support provided by our service personnel is important to achieving appropriate product use in schools, where a limited school day and competing priorities makes it challenging for educators to devote the time and resources needed for a solid implementation. The Fast ForWord products employ neuroscience and research unfamiliar to many educators, and understanding these principles is critical to successful and sustained implementations.





As of December 31, 2010, our service and support organization included 51 employees supplemented by 21 independent contractors who provide on-site customer training, consulting and technical services. The Customer Success team coordinates our service and support contacts with customers, providing one dedicated point of contact to work closely with our customers, helping them be successful at every stage of the product lifecycle.





Services





To facilitate effective implementation, we offer on-site product training, technical installation, implementation management, consulting, and Web-based synchronous and asynchronous professional development services. We also offer a Leadership and Accountability service focused at the district level, which provides administrators a detailed overview of the implementation at each of their schools, consulting on data analysis and interpretation, intervention and motivation strategies, connecting with classroom teachers and other topics of interest to the customer.





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





Support





For customers who purchase our support services, we provide progress monitoring, software technical update releases, and extensive telephone, email, chat and web-based support. Our progress monitoring services provide customers proactive on-going remote monitoring of their students’ progress by our staff, with periodic out-bound contact tailored to the customer’s level of implementation success. Our Customer Connect Website provides extensive implementation and technical resources, together with Web-based seminars.


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Warranty





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





Sales and Marketing





We sell to our principal market, K-12 school districts throughout the United States, primarily using a direct sales force. Our field sales personnel typically are experienced professionals with backgrounds in selling technology based curriculum products to the K-12 market. Most bring strong relationships with educators built over many years. To maximize our coverage of the K-12 market, we also employ an inside sales team to reach smaller and rural school districts and private schools. We also sell to K-12 schools in Canada using our inside sales team.





We emphasize our highly differentiated message of “accelerating learning using brain fitness” through web-based marketing efforts to reach more educators quickly while targeting specific audiences with research results and success stories most relevant to their areas of responsibility and expertise.





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





We sell to clinical professionals and learning centers principally through direct marketing (mail, web and telesales) and conferences (both industry conferences and an annual forum we conduct ourselves). In 2009, we began selling directly to parents online with our e-learning offering, BrainSparkTM, and our remote tutoring service, BrainProTM.





We also maintain a network of independent value-added representatives outside North America. As of December 31, 2010, we had relationships with 24 value-added representatives. To date, booked sales outside North America have not been significant. We are building this channel in response to the growing demand for English fluency around the world. We believe that Fast ForWord and Reading Assistantproducts offer unique value in quickly “rewiring” the brain for English. We also believe the international market has significant potential growth opportunities, and we are positioning to take advantage of these in the future.





Competition





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





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





Our patented products are highly differentiated by their proven results and focus on the development of learning capacity through improving brain fitness. 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 us, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to language and reading are fundamentally different from the approach we take; the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.


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Product Development; New Products





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





Our research and development expenses were approximately $7.9 million, $6.4 million and $7.0 million for the years ended December 31, 2010, 2009 and 2008, respectively. Additionally, we capitalize certain software development costs incurred subsequent to the establishment of technological feasibility and amortize those costs over the estimated lives of the related products. In 2010 and 2009, we capitalized $0.1 million and $1.0 million of costs, respectively, relating to new products that had reached technological feasibility. In 2008 costs incurred subsequent to the establishment of technological feasibility for new projects were not significant, and were charged to research and development expense. In 2010, we established a wholly-owned foreign subsidiary in Shanghai, China to provide research and development services to us, initially focused on Reading Assistant.   As of December 31, 2010, 33 of our employees were engaged in research and development activities, which include product development, product management, and outcomes research.





Development Strategy





Over the past several years, our development efforts have focused on broadening our product solution and making our products more effective and easier to use in the school environment. Recently, our focus has been transitioning our products to a web-based platform. The first milestone in this effort was achieved in 2010 with the release of SciLEARN Enterprise, a browser-based platform hosted by the school district or learning institution. We plan to roll out a hosted offering that expands our per student licensing option to the broader U.S. K-12 market and that we believe will more effectively address newer markets outside U.S. K-12.





Major Product Introductions


Product
Launch YearFast ForWord Language
1997Fast ForWord Language to Reading
1998Away We Go! product family (predecessors to Fast ForWord Language Basics and Fast ForWord to Reading Prep)
1999Fast ForWord Middle and High School (predecessor to Fast ForWord to Literacy)
1999Fast ForWord Reading 3 (originally Fast ForWord Reading)
2000Progress Tracker
2001Fast ForWord Gateway Edition (new architecture of our major products that improved ease of use, added additional student content and provided additional Internet based capabilities)
2003Fast ForWord Reading 4
2003Fast ForWord Reading 1
2004Fast ForWord Reading 2
2004Fast ForWord Language Basics
2005Fast ForWord Reading Readiness (originally Fast ForWord Reading Prep)
2005Fast ForWord Reading 5
2005Fast ForWord Literacy
2006Fast ForWord Literacy Advanced
2006Reading Progress Indicator addition to Progress Tracker
2007Fast ForWord Language v2
2008Fast ForWord Language to Reading v2
2008Scientific Learning Reading Assistantv4.1.2
2008BrainSpark
2009BrainPro
2009Scientific Learning Reading Assistant Expanded Edition
2009SciLEARN Enterprise
2010





Intellectual Property





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





At December 31, 2010, we held the rights to 82 issued patents and 21 pending applications. These include 58 issued U.S. patents and 14 pending U.S. applications that we own or co-own. We also held six issued patents from other countries and had seven applications pending abroad. We were the exclusive licensee under 11 issued U.S. patents, seven issued foreign patents.


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Our U.S. patents relating to the Fast ForWord products expire between 2014 and 2026; the Reading Assistant patents expire in 2024.





The 18 patents and applications that we license are owned by the Regents of the University of California, (“the Regents”), and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2010, approximately 60% of our product booked sales was derived from selling products that use the licensed inventions. This license is exclusive and extends for the life of the University patents, which expire in 2014, subject to the right of the Regents to terminate in case of default and our right to terminate at any time upon 60 days written notice. If we were to lose our rights under this license, it would materially harm our business. This license requires payment of royalties based upon cumulative net booked sales of our products, subject to certain minimum royalty amounts. For the remainder of the license term, the minimum royalty payment is $150,000. In fiscal 2010, 2009 and 2008, we had approximately $0.5 million, $0.8 million and $0.8 million, respectively in royalty expense under the license.





We also have 12 U.S. trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark.





Posit Science Corporation





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





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





Seasonality





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





Backlog





Our deferred revenue was approximately $21.9 million as of December 31, 2010, and $22.2 million as of December 31, 2009. These deferred revenues are primarily composed of the portion of multi-year sales, term-based sales, support and Progress Tracker sales not yet recognized as revenue, and professional development and technical services that have not yet been performed. Approximately $16.4 million of our deferred revenue as of December 31, 2010 is expected to be recognized within the next 12 months.





Employees





As of December 31, 2010 we had 212 full-time equivalent employees, compared to 201 at December 31, 2009. None of our employees are represented by a union or subject to collective bargaining agreements.





General





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


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Item 1A. Risk Factors





RISK FACTORS





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





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





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





The funding for a substantial portion of our K-12 sales typically comes from federal sources, in particular IDEA (special education) and Title One funding.  The amount of this funding varies from time to time, as do the rules governing the use of this funding.  The Elementary and Secondary Education Act is scheduled for reauthorization in 2011, and there is much discussion about potential changes to some controversial provisions in the No Child Left Behind Act of 2001.  While the American Recovery and Reinvestment Act (ARRA) provided for substantial temporary increases in federal programs, that funding is scheduled to expire in September 2011.  In addition, the federal budget deficit and competing federal priorities could adversely impact the ongoing level of federal education funding. A cutback in federal education funding or a change in the funding rules to allow general rather than restricted uses of the funding could have a materially adverse impact on our revenue.





State and local school funding continues to be significantly impacted by decreases in tax revenues due to the recent recession. According to the Center on Budget and Policy Priorities, to balance their fiscal 2011 budgets, states faced fiscal year 2011 (generally, July 2010 through June 2011) gaps totaling $130 billion, or 20 percent of budgets in 46 states.  The Center forecasts continuing state budget difficulties in fiscal year 2012 and beyond, because federal stimulus assistance is expiring, unemployment remains high and tax revenues typically lag economic growth.  While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for the unemployed and homeowners, and rising healthcare costs. Many states have reduced their funding to schools, resulting in teacher layoffs and program restrictions. A continued reduction in state tax revenues could have a materially adverse impact on our revenue.





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





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





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





Our revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. In 2010, we had a net loss of $9.7 million, which included a non-cash impairment charge of $3.9 million; in 2009, we had net income of $4.8 million; in 2008, we had a net loss of approximately $3.3 million. Our sales strategy has primarily emphasized district-level, multi-site transactions. The receipt or implementation of a single large order, or conversely its loss or delay, can significantly impact the level of sales booked and revenue recognized in a given quarter. This uncertainty is compounded by the fact that our various license and service packages have substantially differing revenue recognition periods. Even when the amount and timing of a transaction can be accurately projected, it may be difficult to predict which license package a customer will purchase.





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


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





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





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





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





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





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





If we determine that any of our intangible assets, including technology purchased in acquisitions, or goodwill are impaired, we would be required to take a charge to earnings, which could have a material adverse effect on our results of operations.





We recorded a significant amount of goodwill and other intangible assets, such as core technology, related to our acquisition of the Soliloquy product line in January 2008.  We periodically evaluate goodwill and all significant intangible assets for impairment.  Because of our decision to migrate the core technology associated with the Reading Assistant product acquired from Soliloquy to a web-enabled delivery platform, we determined it was necessary to assess the recoverability of the asset group associated with generating Reading Assistant cash flows. Based on our impairment analysis, we incurred non-cash charges of $3.9 million related to the write-down of the Soliloquy core technology asset group in the fourth quarter of 2010.





At December 31, 2010, after we recorded this impairment charge, we had $4.6 million of goodwill and $1.0 million of intangible assets.  Significant judgments are required to estimate the fair value of our goodwill and intangible assets, including estimating future cash flows, projecting future sales, forecasting industry trends and market conditions, and making other assumptions. Changes in these estimates and assumptions could materially affect our impairment determinations, which could result in non-cash charges that would adversely affect our results of operations.





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





We rely heavily on statistical studies of student results on assessments to demonstrate that our products lead to improved student achievement, which involves certain risks. For example, a school may fail to appropriately implement the products or adhere to the product protocol, resulting in a study that does not produce substantial student improvements. In addition, some studies on which we rely may be challenged because the studies use a limited sample size, lack a randomly selected control group, include assistance or participation from us or our scientists, or have other design characteristics that are not optimal. These challengers may assert that these studies are not sufficiently rigorous or free from bias, and may lead to criticism of the validity of the studies and the conclusions that we draw from them. Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient.





We may not be able to develop new and improved products and services as needed to address changing market trends or emerging technologies in a timely and cost effective manner.





We need to design, develop and introduce new and improved products and services on a cost effective basis and on a timeline that keeps pace with changing market trends and emerging technology developments.  We have recently expanded our product development and product management groups, and we are planning important product improvements and new product launches in 2011.  We may encounter unexpected difficulties developing new products and improvements that could delay our introduction of new products and services or cause their development to be more costly than planned.  Additionally, our product changes may not receive the market acceptance we anticipate.  If we fail to develop products and services cost effectively that respond to technology and market developments, we may lose market share and revenue, and our business could materially suffer.


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We may not be successful in executing our transition to a new business model.





We are completing the development of the technology platform for our on-demand offering, which we expect will allow us to better address both the international, consumer and virtual school markets, as well as the U.S. K-12 market we now principally serve.  We expect this transition will make us less dependent on large US K-12 transactions, and will significantly increase the number of smaller, more predictable transactions and recurring revenue. In order to accomplish this, we will need to complete our product development in a timely manner and achieve acceptance with new types of customers.  We may find our marketing and sales efforts in this market less effective or more expensive than we have planned.  If we fail to achieve the level of new market acceptance that we expect, we may be unable to achieve our planned level of sales and revenue from these markets.


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





Providing our products and services and conducting our general business operations both substantially rely on computer and network systems.  Over the past several years, our computer and network systems became outdated, and we have experienced disruptions in both our customer and internal network services due to hardware failures.  We have now modernized much of our hardware infrastructure, and are in the midst of a major upgrade to our business software platforms. In addition, our disaster recovery capability, while improved, does not permit us to recover immediately from certain sorts of disasters. We believe that our business is becoming increasingly dependent on our hardware and software infrastructure, and as a result, the reliability of our systems has become increasingly important.  If our customer systems are disrupted, we may be required to issue credits, customers may elect not to renew their contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability. If our internal systems are disrupted, we may lose productivity and incur delays in product development, sales operations or other functions.


If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims.
 
 Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. We expect that, as we have experienced in the past, despite our testing, errors will be found in new products and product enhancements in the future. We plan to launch important products and product improvements in 2011.


Many of our products and services rely on the World Wide Web in order to function. Unanticipated problems affecting our network systems, third party facilities, telecommunications or electricity supply could cause interruptions or delays in the delivery of that product. We have experienced problems due to power loss in the past, and we will continue to be exposed to the risk of access failure in the future.


If there are significant errors in our products or problems with customer access to our Web-delivered products and services, we could be required to issue credits or we could experience delays in or loss of market acceptance of our products, diversion of our resources, decreases in expansions or renewals, injury to our reputation, increased service expenses or payment of damages.





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





We believe that cash flow from operations, together with our current cash and short-term investment balances, will be our primary source of funding for our operations during the next several years. During 2010, we used $4.2 million cash in operations, while in 2009 we generated $14.5 million in cash from operations and in 2008, used $3.7 million used in operating activities.





Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.





We maintain a credit line with Comerica Bank, with a limit of $7.5 million, expiring December 31, 2011. At December 31, 2010, no borrowing was outstanding under our credit line with Comerica, and we were in compliance with the covenants of the line. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica and financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth. If we do not comply with the covenants, we risk being unable to borrow under the credit line.





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


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Our new product development office in China exposes us to new risks, including those associated with currency exchange rates, Chinese government regulations and business practices, and intellectual property.
 
 We established a wholly-owned subsidiary in Shanghai, China during the second quarter of 2010. The new entity provides us with product development services.   To date, substantially all of our operations have been located in the United States, and our sales outside the United States and Canada have been made in U.S. Dollars to local distributors. Because our new Shanghai subsidiary will conduct its operations in Chinese RMB, we will now have the risk of unexpected and possibly sudden increases in expenses caused by shifts in currency exchange rates. In addition, Chinese government regulations and business practices are quite different from those in the United States, and operating under those regulations and challenges may pose unexpected costs, delays or difficulties. Further, intellectual property protection is not as strong in China as in the U.S., and operating a product development group in China may increase our risk of infringement or misappropriation of our intellectual property by others.





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





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





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





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





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





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





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





Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. These licensed patents expire in 2014.  In 2010, we generated approximately 60% of our booked sales from products that use this licensed technology. We also have incorporated technology and content licensed from other third parties as part of our products and services. If we were to lose our rights under these licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.





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 be found invalid or will not offer sufficient protection against competitors, that our trademarks will be challenged or infringed, or that our pending patent applications will not result in the issuance of patents. If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our sales. The Company historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright.


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





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





Our common stock presently trades on the Nasdaq Global Market, and our trading volume is generally low. For example during 2010, our average daily trading volume was approximately 26,000 shares. As a result, the ability of holders of our common stock to sell such common stock and thereby monetize their investment may be limited. In addition, the market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.





The ownership of our common stock is concentrated.





At December 31, 2010, Trigran Investments owned approximately 28% of our outstanding stock, and our officers and directors held approximately 11% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of the Company.





ITEM 1B. UNRESOLVED STAFF COMMENTS





Not applicable





ITEM 2. PROPERTIES





We currently have the following leased properties:





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





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





3.
A lease for approximately 6,000 square feet in Waltham, Massachusetts that expires in September 2011.  Following the closure of the Waltham office in December 2009, we have subleased this property through the end of the lease.





4.
A lease for an office in Shanghai, China for 2,500 square feet that expires in May 2012 to be used for research and development.





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.





ITEM4.





Removed and reserved.


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EXECUTIVE OFFICERS





The following table sets forth information concerning our executive officers:




Name

Age

TitleD. Andrew Myers

39

President and Chief Executive OfficerLinda L. Carloni

57

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

42

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

60

Senior Vice President and Chief Scientific OfficerJessica Lindl

37

Senior Vice President, Marketing and Product ManagementDavid C. Myers

45

Senior Vice President, Sales and ServiceRonald Park

44

Vice President, Product Development





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





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





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





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





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





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


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Mr. Park holds a BS in Computer Science and Engineering from the University of California, Los Angeles, and an MBA from The Wharton School at the University of Pennsylvania.





There are no family relationships among our officers or directors.





PARTII





ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES





(a)
Market Information. Our common stock currently is, and since March 29, 2010 has been, traded on the Nasdaq Global Market under the symbol "SCIL”.  Prior to March 29, 2010, our common stock traded on the Nasdaq Capital Market under the symbol “SCIL”.





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





High


LowFiscal year ending December 31, 2010First quarter

$
5.73


$
4.71Second quarter

$
5.47


$
4.65Third quarter

$
5.49


$
4.59Fourth quarter

$
4.52


$
3.00Fiscal year ending December 31, 2009First quarter

$
2.35


$
1.50Second quarter

$
2.35


$
1.85Third quarter

$
3.60


$
2.03Fourth quarter

$
5.88


$
3.40





Stockholders





As of February 28, 2011, the approximate number of stockholders of record of our common stock was 94.





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.


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Securities Authorized for Issuance under Equity Compensation Plans




For information regarding securities authorized for issuance under equity compensation plans, see Item 12.




Performance Measurement Comparison




The following chart compares the cumulative total stockholder return of Scientific Learning Common Stock for the five years ended December 31, 2010 with the cumulative total return during the same period of (i) the NASDAQ Composite Market Index and (ii) a Scientific Learning constructed peer group index. The companies in the peer group index were selected on the basis of similarity in the nature of their business. At December 31, 2010, the peer group included Renaissance Learning Inc., Scholastic Corporation, K12 Inc, Archipelago Learning and Princeton Review. Over the last five years we have changed companies in the peer group because of acquisitions, changes in business, new companies entering the market and other changes affecting peer group companies. This table shows these changes:





Members of Peer Group
Tenure in Peer GroupExcelligence
Removed from peer group after September 30, 2006 after it stopped trading.K12 Inc
Added to peer group in 2008 after going public in December 2007.Archipelago Learning
Added to peer group in 2010 after going public in November 2009.Plato Learning Inc.
Removed from peer group in May 2010 after it was acquired.




The comparison assumes $100 was invested on December 31, 2005 in Scientific Learning Common Stock and in each of the foregoing indices. It also assumes reinvestment of dividends. The performance shown in the graph below should not be considered an indication of future performance.











Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities





Not applicable





(b) Not applicable





(c) Not applicable


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ITEM 6.  SELECTED FINANCIALDATA





In thousands, except per share amounts





Year Ended December 31,2010


2009


2008


2007


2006Statement of Operations Data:Revenues:Products

$
22,506


$
35,863


$
28,301


$
31,023


$
29,966Service and support


20,878



19,425



19,453



15,030



11,032Total revenues


43,384



55,288



47,754



46,053



40,998Cost of revenues:Cost of products


2,092



2,679



2,178



1,680



1,638Cost of service and support


9,348



8,895



9,721



8,539



7,897Total cost of revenues


11,440



11,574



11,899



10,219



9,535Gross profit


31,944



43,714



35,855



35,834



31,463Operating expenses:Sales and marketing


21,498



24,042



23,587



24,868



21,073Research and development


7,933



6,418



7,016



4,500



4,129General and administrative


8,129



8,135



7,883



7,660



6,643Impairment charge


3,890



-



-



-



-Total operating expenses


41,450



38,595



38,486



37,028



31,845Operating income (loss)


(9,506
)


5,119



(2,631
)


(1,194
)


(382
)Interest and other income (expense), net


(41
)


110



564



1,266



793Income (loss) before income tax


(9,547
)


5,229



(2,067
)


72



411Provision for income taxes (income tax benefit)


143



429



1,248



(1,082
)


203Net income (loss)

$
(9,690
)

$
4,800


$
(3,315
)

$
1,154


$
208Basic net income (loss) per share

$
(0.52
)

$
0.27


$
(0.19
)

$
0.07


$
0.01Shares used in computing basic net income (loss) per share


18,498



18,039



17,488



17,161



16,846Diluted net income (loss) per share

$
(0.52
)

$
0.26


$
(0.19
)

$
0.06


$
0.01Shares used in computing diluted net income (loss) per share


18,498



18,690



17,488



18,297



17,740Balance Sheet Data:Cash and cash equivalents

$
5,415


$
20,679


$
7,550


$
21,179


$
16,364Short-term investments


9,631



-



-



-



-Working capital


1,176



5,178



(3,551
)


7862



3,951Total assets


31,803



43,128



30,260



33,803



26,283Stockholders’ equity (1)


4,334



11,929



5,045



5,820



1,017





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


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ITEM 7.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS





Overview




We develop, distribute and license technology that accelerates learning by applying proven research on how the brain learns.  Based on more than thirty years of neuroscience and cognitive research, our family of products improves brain fitness with technology-based exercises that build the cognitive skills required to read and learn effectively. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the U.S., to whom we sell through a direct sales force.  To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support.  Since our inception, learners have used our products nearly three million times and over 7,000 schools have purchased at least $10,000 of our product licenses and services.  As of December 31, 2010, we had 212 full-time equivalent employees, compared to 201 at December 31, 2009.





Business Highlights





We market our Fast ForWord and Reading Assistant products primarily as a reading intervention solution for struggling and special education students and English Language Learners.  According to the U.S. Department of Education (USDE), in 2009, 67% of fourth graders in the United States were not “proficient” in reading and 33% performed below the” basic” level. Between 2007 and 2009, there was no change in average 4th grade reading scores. While our installed base is growing, the over 7,000 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 117,000 K-12 schools in the U.S.





States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products.  Additionally, federal education funds are a critical resource in helping school districts address the needs of the most challenged learners.  We believe that a significant proportion of our sales are funded by federal sources, particularly Title I and IDEA (special education) grants.





During 2010, school districts focused more attention on balancing operating budgets than on investing in tools to improve student achievement.  We experienced a substantial decline in booked sales in 2010 compared to 2009, which we believe resulted from state budget pressures, uncertainty about future education policies, and an increasing trend toward using federal funds wherever possible to save teacher jobs and core programs rather than on supplemental programs focused on struggling learners. In February 2010, the Center on Budget and Policy Priorities estimated that for the current fiscal year, which began July 2010, 46 states had budget shortfalls totaling $130 billion, or 20% of budgets in those states.  The fact that schools have until September 2011 to spend remaining ARRA funds gives them the flexibility to wait for news regarding additional federal funding to save teacher jobs and developing education policies.  As a result, we believe that many school districts have delayed their purchasing decisions.





Despite the recent attention school districts have paid to balancing their budgets, we believe our solutions will remain well-positioned for federal Title I, IDEA and competitive funding opportunities such as Race to the Top and School Improvement Grants, due to the continued emphasis on national achievement mandates and education reform.





Company Highlights





Our total revenue decreased by 22% during 2010 as compared to 2009.  Our total booked sales decreased by 30% during 2010 as compared to 2009.  (Booked sales is a non-GAAP financial measure.  For more explanation on booked sales, see Revenues below). K-12 booked sales decreased by 32% during 2010 as compared to 2009. In 2010, we closed five transactions in excess of $500,000 totaling $3.7 million compared to 20 such transactions totaling $22.2 million in 2009.  The $18.5 million decline in transactions approximates the decline in our K-12 business. In 2011, we expect that large deals will continue to drive our business with an expected significant contribution from SciLEARN Enterprise, a new browser-based platform hosted by the school district or learning institution. We expect that our new platform enables us to expand our per student licensing option to the broader U.S. K-12 market, and we anticipate that in 2012 and later we will become less dependent on large deals. We believe our new platform will enable us to significantly increase the number of smaller, more predictable transactions and recurring revenue.  Non-school sales, including private practice, international, direct to consumer, virtual schools and OEM customers, increased by 10% during 2010 as compared to 2009.





Operating expenses increased by 7% during 2010 as compared to 2009, and included a non-cash impairment charge of $3.9 million.


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Results of Operations





Revenues





The following table sets forth information relating to our revenues (dollar amounts in thousands):





Year ended December 31,


2009-2010


2008-20092010


2009


2008


% Change


% ChangeProducts

$
22,506


$
35,863


$
28,301



(37.2
)%


26.7
%Service and support


20,878



19,425



19,453



7.5
%


(0.1
)%Total revenues

$
43,384


$
55,288


$
47,754



(21.5
)%


15.8
%





2010 versus 2009: Product revenues decreased by $13.4 million in 2010 compared to 2009. The decrease in 2010 from 2009 was primarily due to lower U.S. K-12 booked product sales as school districts continued to struggle with current and anticipated budget shortfalls.





Our service and support revenue increased by $1.5 million in 2010 compared to 2009 due to a higher renewal rate as we continue to focus on increasing product effectiveness and customer success. For 2010, our renewal rate increased to 88% from 80% in 2009. Renewal rate is determined by dividing the number of school sites that renewed annual support and maintenance contracts by the total number of sites whose contracts were expiring in the period.





2009 versus 2008: Product revenues increased by $7.6 million in 2009 compared to 2008. The increase in 2009 was primarily due to higher U.S. K-12 booked sales, which reflected the increased federal funding made available to schools by ARRA. Booked sales included one transaction for $6.9 million for which we recognized product revenue of $3.2 million in 2009.





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





We believe that recurring revenue is an important measure of our operating performance. In 2010, the recurring portion of our revenue stream increased 11% to $12.3 million. The following table sets forth information relating to our recurring revenues (dollar amounts in thousands):





Year Ended December 31,2010


2009


2008


2007


2006Products:Recurring 1

$
1,476


$
629


$
169


$
-


$
-Non-recurring


21,030



35,234



28,132



31,023



29,966Total products


22,506



35,863



28,301



31,023



29,966Service and support:Recurring 1


10,832



10,421



10,048



7,452



5,660Non-recurring


10,046



9,004



9,405



7,578



5,372Total service and support


20,878



19,425



19,453



15,030



11,032Total revenues

$
43,384


$
55,288


$
47,754


$
46,053


$
40,998Recurring revenue as a % of total revenue


28.4
%


20.0
%


21.4
%


16.2
%


13.8
%Non-recurring revenue as a % of total revenue


71.6
%


80.0
%


78.6
%


83.8
%


86.2
%





1We derive recurring product revenue from subscription fees paid by U.S. and international customers to access our applications. Recurring service and support revenue consists of support and maintenance for our software products and fees paid to access our web-delivered reporting tools, Progress Tracker and Reading Progress Indicator.


18
 Table of Contents


Booked sales





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





The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue (dollar amounts in thousands):





Year ended December 31,


2009-2010


2008-20092010


2009


2008


% Change


% ChangeBooked sales

$
41,838


$
59,701


$
45,084



(29.9
)%


32.4
%Less: revenue recognized


43,384



55,288



47,754



(21.5
)%


15.8
%Other adjustments


1,187



(2,135
)


(333
)

NA


NANet increase/(decrease) in deferred revenue


(359
)


2,278



(3,003
)


(115.8
)%

NATotal deferred revenue end of period

$
21,871


$
22,230


$
19,952



(1.6
)%


11.4
%





2010 versus 2009: Booked sales in the K-12 sector decreased by 32% to $37.9 million in 2010 compared to $56.2 million in 2009. As described above, state budget pressures caused many school districts to delay purchases during 2010. Booked sales to the K-12 sector for 2010 and 2009 were 91% and 94%, respectively, of total booked sales.  “Other adjustments” in 2010 consists primarily of the recognition of deferred revenue and the related receivable for 2009 booked sales with Free-On-Board (“FOB”) destination delivery terms that were not delivered until 2010.





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





We believe large booked sales, which we define as transactions totaling more than $500,000, are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. In 2010, we closed five transactions in excess of $500,000 compared to 20 in 2009 and 10 in 2008. In 2010, school districts struggled with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. In 2009, we benefited from the increased federal funding made available to schools by ARRA.  For the years ended December 31, 2010, 2009 and 2008, 9%, 37% and 19%, respectively, of our booked sales arose from transactions over $500,000. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate. Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting. We cannot predict the size and number of large transactions in the future.





Booked sales to non-school customers increased by 10% to $3.9 million in 2010 as compared to 2009.  This increase reflects higher sales to private practice clinicians, international VARs, consumers and virtual schools.  Booked sales to non-school customers decreased by 31% in 2009 as compared to 2008 as a result of adverse economic conditions. In addition, in 2008 we recorded OEM booked sales of approximately $1.0 million from the operations we purchased in our acquisition of JTT Holdings Inc. d/b/a Soliloquy Learning (“Soliloquy”) in January 2008, compared with $110,000 in 2009.





Although the current economic and financial conditions, the temporary nature of federal stimulus funding, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 and non-school markets.  However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.  Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding.  While federal funding for education has grown steadily over the last few decades, the current level of federal spending and the federal deficit are likely to put pressure on all areas in the federal budget.  In addition, school district spending based on federal education stimulus funding is expected to decline after 2011. States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets.  These conditions may continue to impact state education spending.


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In addition, the revenue recognized from our booked sales can be unpredictable.  Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected.  In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time.





Gross Profit and Cost of Revenues





The following table sets forth information relating to our gross profits (dollar amounts in thousands):





Year ended December 31,2010


2009


2008Gross profit on products

$
20,414


$
33,184


$
26,123Gross profit margin on products


91
%


93
%


92
%Gross profit on service and support


11,530



10,530



9,732Gross profit margin on services and support


55
%


54
%


50
%Total gross profit

$
31,944


$
43,714


$
35,855Total gross profit margin


74
%


79
%


75
%





2010 versus 2009: The overall gross profit margin decreased by 5% in 2010 compared to 2009 due to declines in the proportion of higher margin product revenue. Product revenues made up 52% of total revenues in 2010, compared to 65% in 2009. Product margins decreased by 2% in 2010 over 2009, mainly due to lower revenues over which fixed costs could be allocated. Service and support margins increased by 1% in 2010 compared to 2009, reflecting higher delivery of services in 2010.




2009 versus 2008: The overall gross profit margin increased by 4% in 2009 compared to 2008, mainly due to an increase in the proportion of higher margin product revenue.  Product revenues made up 65% of total revenues in 2009, compared to 59% in 2008. Product margins in 2009 increased 1% over 2008, as proportionately lower royalty costs were partially offset by increased amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant. Service and support margins improved in 2009 compared to 2008 principally due to year over year price increases and cost savings resulting from more efficient delivery of services.





Operating Expenses





The following table sets forth information relating to our expenses (dollar amounts in thousands):





Year ended December 31,


2009-2010


2008-20092010


2009


2008


% Change


% ChangeSales and marketing

$
21,498


$
24,042


$
23,587



(10.6
)%


1.9
%Research and development


7,933



6,418



7,016



23.6
%


(8.5
)%General and administrative


8,129



8,135



7,883



(0.1
)%


3.2
%Impairment charge


3,890



-



-



100.0
%


-Total operating expenses

$
41,450


$
38,595


$
38,486



7.4
%


0.3
%





Sales and Marketing:Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. The $2.5 million decrease in sales and marketing expenses in 2010 compared to 2009 was due to lower commission and bonus expense as we did not meet our sales quotas for 2010. The $0.5 million increase in 2009 from 2008 is mostly due to higher commission expense of approximately $1.4 million as a result of the strong sales performance, partially offset by lower salary and benefit costs as a result of restructuring actions taken in January 2009.  At December 31, 2010, we had 41 quota-bearing sales personnel compared to 49 and 50 at December 31, 2009 and 2008, respectively.





Research and Development: Research and development expenses principally consist of compensation paid to employees and consultants engaged in research, product development and product management activities and product testing, together with software and equipment costs. Research and development expenses increased by $1.5 million in 2010 compared to 2009. During 2010, we continued to make critical investments in product development which resulted in increased headcount and consulting expenses.  We also incurred start up expenses for our new development office in Shanghai, China.  The $0.6 million decrease in 2009 from 2008 is primarily due to the capitalization of approximately $1.0 million of development costs relating to our Reading Assistant Expanded Edition product, partially offset by increased bonus expense of approximately $0.4 million. No development costs were capitalized in 2008.


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 Table of Contents


General and Administrative: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. General and administrative expenses remained unchanged for 2010 as compared to 2009 as a result of lower bonus expense offset by increased legal and consulting expenses related to our exploration of strategic alternatives in the area of mergers and acquisitions, which are presently not being pursued. The $0.2 million increase in 2009 compared to 2008 is primarily due to increases in bonus expenses of approximately $1.0 million, partially offset by a decrease in bad debt expense of $0.6 million.





Impairment Charge: Impairment charge is attributable to the impairment of the long lived asset group associated with the Reading Assistant product line acquired through the purchase of Soliloquy in 2008. We acquired Soliloquy for its Reading Assistant product line that uses speech recognition technology to improve reading fluency. We have seen success in both the US K-12 and the international markets, as our partners successfully developed an effective English language learning curriculum around the product. Because of this success, we are making additional investments in Reading Assistant to replace the core technology and enable compatibility with our new web-based platform. Due to this investment, we assessed whether the intangible asset group acquired from Soliloquy, including some capitalized software development costs post acquisition, was impaired in accordance with the required accounting rules.




We used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group associated with Reading Assistant exceeded the carrying values of those assets. As a result of this assessment, the carrying value of the asset group exceeded the undiscounted cash flows. We then applied a fair-value-based test.  The fair value of the asset group was estimated using the expected present value of future cash flows which rely on estimates, judgments and assumptions.  These estimates, judgments and assumptions include the discount rate, expected remaining useful life of the asset group and cash flows generated during the remaining useful life. This analysis resulted in a non-cash impairment charge of $3.9 million in 2010, which includes $0.5 million related to capitalized software development costs.





Income Tax Provision





2010: During 2010, we recorded an income tax provision of approximately $0.1 million, and our valuation allowance increased by approximately $3.1 million.





Our effective tax rate decreased to (1.5)% for fiscal 2010 compared to 8.2% for the same period a year ago. The decrease was primarily due to U.S. losses not benefitted in the current year.





As of December 31, 2010, we had U.S. federal and state net operating loss carryforwards of approximately $56.6 million and $42.8 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2030 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2012 through 2030.





As of December 31, 2010, we had U.S. federal and state tax credit carryforwards of approximately $1.5 million and $1.5 million, respectively.  The federal credit will expire at various dates beginning in 2011 through 2029, if not utilized. California state research and development credits can be carried forward indefinitely.





2009:During 2009, we recorded an income tax provision of approximately $0.4 million, and our valuation allowance decreased by approximately $2.4 million.





Our effective tax rate increased to 8.2% for fiscal 2009 compared to (60.5)% for the same period a year ago. The increase was due to pre-tax income in 2009.





2008:During 2008, we recorded an income tax provision of $1.2 million. This provision primarily consisted of a $1.2 million increase in the valuation allowance against our deferred tax assets. As a result of the establishment of the valuation allowance, our effective tax rate was (60.5)%.  This valuation allowance increase was the result of recording a valuation allowance against our deferred tax assets. After considering all available positive and negative evidence, including our past operating results and our forecast of future taxable income, we concluded that we could no longer support a deferred tax asset balance. We intend to maintain the valuation allowance until sufficient positive evidence exists to support the realizability of the deferred tax assets.





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





Liquidity and Capital Resources





Our cash, cash equivalents and short-term investments were $15.0 million at December 31, 2010, compared to $20.7 million at December 31, 2009.


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 Table of Contents


We expect that during at least the next twelve months our cash flow from operations together with our current cash balances will be our primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures.  Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.We expect that this pattern will continue, that we will use cash in operations during the first half of 2011 and that our current cash balances will be sufficient to fund our operating requirements during that period. Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.





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





Net cash used in operating activities for 2010 was $4.2 million versus cash generated of $14.5 million during 2009.The decrease was mainly the result of lower revenue resulting from a decrease in our booked sales.





Net cash used in investing activities in 2010 was $11.7 million, of which $9.6 million was used for the purchase of short-term investments (net of sales and maturities of $6.7 million) and $2.0 million was used for capital spending primarily related to investments in research and development and new systems for back-office operations.  Net cash used in investing activities in 2009 was $2.1 million, of which $1.1 million was used for purchase of property and equipment and $1.0 million was used in development of our Reading Assistant product.





Financing activities generated $0.6 million in 2010 resulting from proceeds from the exercise of stock options.  Financing activities for 2009 included the $2.5 million borrowing offset by the $2.5 million repayment on our line of credit as well and proceeds of $0.7 million from the exercise of stock options.





Off-Balance Sheet Arrangements





We have no off-balance sheet arrangements.





Contractual Obligations and Commitments





We have a non-cancelable lease agreement for our corporate office facilities in Oakland, California. The minimum lease payment was approximately $78,000 per month through 2008. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013. We also have a lease agreement for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month. In early 2008, we entered into a lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet at an average monthly rent of approximately $12,000 that expires in September 2011. Following the closure of the Waltham office in December 2009, we have sublet this property through the end of the lease at a monthly rent of approximately $5,000.  In June 2010, we signed a lease for an office in Shanghai, China for 2,500 square feet at a rate of approximately $4,000 per month through May 2012 to be used for research and development.





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


22
 Table of Contents


The following table summarizes our obligations at December 31, 2010 and the effects such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):





2011


2012


2013


2014


2015 and thereafter


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

$
1,219


$
1,274


$
1,242


$
-


$
-


$
3,735Minimum royalty obligations


150



150



150



150



-



600Total

$
1,369


$
1,424


$
1,392


$
150


$
-


$
4,335





Our purchase order commitments at December 31, 2010 are not material.





Application of Critical Accounting Policies





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





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





Revenue Recognition





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





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





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





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


23
 Table of Contents


Product revenue




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




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




·
Subscription and term licenses – software licensed for a specific time period, generally month to month or a term of 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, implementation, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.





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





Income Taxes




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





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





Stock-Based Compensation





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





The estimated expected stock price volatility increased from 55% in 2008 to 58% in 2009 and increased again to 62% in 2010. Our expected stock price volatility over the expected life of the options is based upon our historical experience over the expected life of the options.





Our estimate of the forfeiture rate has also changed from 6.2% in 2008 to 8.3% in 2009 to 7.7% in 2010, based on our experience of actual forfeiture rates. Stock compensation expense may be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.


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 Table of Contents


The requirement to expense stock-based awards will continue to materially reduce our reported results of operations. As of December 31, 2010, we had an aggregate of $2.2 million of stock compensation remaining to be amortized to expense over the remaining requisite service period of the underlying awards. We currently expect this stock compensation balance to be amortized as follows: $0.8 million during 2011; $0.7 million during 2012; $0.5 million during 2013; and $0.2 million during 2014. These amounts reflect only outstanding stock awards as of December 31, 2010. We expect to continue to issue share-based awards to our employees in future periods.





Capitalization of software development costs and website development costs





As discussed in Note 1 – Summary of Significant Accounting Policies to the Financial Statements, in 2010 and 2009 we capitalized certain software development costs incurred subsequent to the establishment of technological feasibility and will amortize the costs over the estimated lives of the related products. In 2010 and 2009, the Company capitalized $0.1 million and $1.0 million of costs, respectively, relating to new products that had reached technological feasibility. In 2008, costs incurred subsequent to the establishment of technological feasibility for new projects were not significant and were charged to research and development expense. The rules that govern how development costs are accounted for can have a major impact on our reported financial results. Significant judgment is required in assessing whether and when products have reached technological feasibility. We are also required to use judgment to estimate the net realizable value of the asset by projecting future revenues and cash flows expected to be generated by the products, in order to determine whether the unamortized cost exceed the net realizable value. Moreover, any future changes to our software product offerings could result in write-offs of previously capitalized costs and have a significant impact on our financial results.





We also capitalize costs related to internal use software and web site application, infrastructure development and content development.  In each case, the software or website is for internal needs, and we do not plan to market the software externally. For the year ended December 31, 2010, we capitalized approximately $1.2 million of software and web site development costs. For the years ended December 31, 2009 and 2008, we capitalized approximately $0.4 million and $0.1 million of software and web site development costs, respectively.





The Company evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets.  If indicators of impairment are present, estimates of future cash flows are used to test the recoverability of the asset. If the carrying amount of the asset exceeds its fair value, an impairment charge is recognized. In 2010, we determined that capitalized software development costs relating to the Reading Assistant asset group was impaired.  See Long-livedassets below for further discussion. In late 2009, we determined that we needed to completely redesign our BrainSpark website and accordingly we recorded an impairment charge of $0.4 million. Significant judgment is required in evaluating which costs are eligible for capitalization and whether any impairment exists.





Long-lived assets





Long-lived assets, such as property and equipment and purchased intangible assets subject to amortization are reviewed for impairment annually and whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of an asset is measured by a comparison of the carrying amount of an asset to its estimated undiscounted future cash flows. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset.





In December 2010, we identified an impairment indicator related to the core technology intangible asset acquired as a result of the purchase of Soliloquy in 2008.   In 2010, we decided to make additional investments in the Reading Assistant product line to replace the core technology and enable compatibility with our new web-based platform. As a result, we determined it was necessary to assess the recoverability of the asset group associated with generating Reading Assistant cash flows, which includes some capitalized software development costs post acquisition.




We used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group exceeded the carrying values of those assets. As a result of this assessment, the carrying value of the asset group exceeded the undiscounted future cash flows. We then performed an analysis to determine the fair value of the asset group, which was determined using the expected present value of future cash flows which are based on estimates, assumptions and management’s judgments.  These include the forecast of future cash flows related to the asset group, the discount rate used in discounting those cash flows, and the expected remaining useful life of the asset group. This analysis resulted in a non-cash impairment charge of $3.9 million in 2010, which includes $0.5 million related to capitalized software development costs. The impairment charge was allocated on a pro-rata basis using the relative carrying amounts of the asset group.





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ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK





Market risk represents the risk of loss that may result from the change in value of a financial instrument due to fluctuations in its market price.  Our exposure to market risk is related to our short-term investments in federal agency and corporate bonds at December 31, 2010.  We had no investments subject to market risk at December 31, 2009.





Interest Rate Risk





The primary objectives of our investment activities are to preserve principal, provide liquidity and maximize income without significantly increasing risk. By policy, we do not enter into investments for trading or speculative purposes. Some of the securities we invest in are subject to market risk. This means that a change in prevailing interest rates may cause the fair value of the investment to fluctuate. To minimize this risk, we invest in a variety of securities, which primarily consist of money market funds, commercial paper, municipal securities and other debt securities of domestic corporations. Due to the nature of these investments and relatively short duration of the underlying securities, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future interest income. During the year ended December 31, 2010, a 10% appreciation or depreciation in overall interest rates would not have had a material impact on our interest income or the fair value of our marketable securities.




Foreign currency exchange risk




Our sales contracts are primarily denominated in U.S. dollars and, therefore, the majority of our revenues are not subject to foreign currency risk. We are directly exposed to changes in foreign exchange rates to the extent such changes affect our expenses related to our foreign assets and liabilities. Our only exposure in regard to our foreign assets and liabilities is with our Chinese subsidiary whose functional currency is the Chinese Renminbi.


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ITEM 8. FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA





Report of Independent Registered Public Accounting Firm





The Board of Directors and Stockholders of Scientific Learning Corporation





We have audited the accompanying consolidated balance sheets of Scientific Learning Corporation as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.





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





In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scientific Learning Corporation at December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.











/s/Ernst & Young LLP




San Jose, California


March 4, 2011


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SCIENTIFIC LEARNING CORPORATION


CONSOLIDATED BALANCE SHEETS


(In thousands, except share and per share data)




December 31,2010


2009AssetsCurrent assets:Cash and cash equivalents

$
5,415


$
20,679Short-term investments


9,631



-Accounts receivable, net of allowance for doubtful accounts of $76 and $97, respectively


5,053



6,390Prepaid expenses and other current assets


2,206



2,142Total current assets


22,305



29,211Property and equipment, net


2,497



1,780Goodwill


4,568



4,568Other intangible assets, net


1,034



5,476Other assets


1,399



2,093Total assets

$
31,803


$
43,128Liabilities and stockholders' equityCurrent liabilities:Accounts payable

$
543


$
812Accrued liabilities


4,198



7,362Deferred revenue


16,388



15,859Total current liabilities


21,129



24,033Deferred revenue, long-term


5,483



6,371Other liabilities


857



795Total liabilities


27,469



31,199Commitments and contingencies (See Note 15 to the consolidated financial statements)Stockholders' equity :Common stock, $0.01 par value: 40,000,000 authorized, 18,702,044 and 18,294,808 shares issued and outstanding, respectively, and additional paid in capital


89,277



87,182Accumulated deficit


(84,943
)


(75,253
)Total stockholders' equity


4,334



11,929Total liabilities and stockholders' equity

$
31,803


$
43,128





See accompanying notes.


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SCIENTIFIC LEARNING CORPORATION


CONSOLIDATED STATEMENTS OF OPERATIONS


(In thousands, except per share amounts)





Year Ended December 31,2010


2009


2008Revenues:Products

$
22,506


$
35,863


$
28,301Service and support


20,878



19,425



19,453Total revenues


43,384



55,288



47,754Cost of revenues:Cost of products


2,092



2,679



2,178Cost of service and support


9,348



8,895



9,721Total cost of revenues


11,440



11,574



11,899Gross profit


31,944



43,714



35,855Operating expenses:Sales and marketing


21,498



24,042



23,587Research and development


7,933



6,418



7,016General and administrative


8,129



8,135



7,883Impairment charge


3,890



-



-Total operating expenses


41,450



38,595



38,486Operating income (loss)


(9,506
)


5,119



(2,631
)Interest and other income (expense), net


(41
)


110



564Income (loss) before income tax


(9,547
)


5,229



(2,067
)Provision for income taxes


143



429



1,248Net income (loss)

$
(9,690
)

$
4,800


$
(3,315
)Basic net income (loss) per share

$
(0.52
)

$
0.27


$
(0.19
)Shares used in computing basic net income (loss) per share


18,498



18,039



17,488Diluted net income (loss) per share

$
(0.52
)

$
0.26


$
(0.19
)Shares used in computing diluted net income (loss) per share


18,498



18,690



17,488





See accompanying notes.


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SCIENTIFIC LEARNING CORPORATION


CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)





Year ended December 31,2010


2009


2008Operating Activities:Net income (loss)

$
(9,690
)

$
4,800


$
(3,315
)Adjustments to reconcile net income (loss) to cash provided by (used in) operating activitiesDepreciation and amortization


2,532



1,895



1,266Impairment charge


3,890



-



-Stock-based compensation


1,496



1,389



1,997Increase in deferred tax asset valuation allowance


-



-



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


1,337



1,327



(1,293
)Prepaid expenses and other current assets


(64
)


(801
)


(29
)Other assets


32



(90
)


(399
)Accounts payable


(268
)


138



(317
)Accrued liabilities


(3,164
)


3,398



(5
)Deferred revenue


(359
)


2,278



(3,003
)Other liabilities


62



170



172Net cash provided by (used in) operating activities


(4,196
)


14,504



(3,735
)Investing Activities:Purchases of property and equipment, net


(2,036
)


(2,070
)


(304
)Purchases of short-term investments


(16,355
)


-



-Sales and maturies of short-term investments


6,724



-



-Purchase of Soliloquy


-



-



(10,133
)Net cash used in investing activities


(11,667
)


(2,070
)


(10,437
)Financing Activities:Borrowings under bank line of credit


-



2,500



-Repayment of borrowings


-



(2,500
)


-Proceeds from issuance of common stock, net


599



695



543Net cash provided by financing activities


599



695



543Increase (decrease) in cash and cash equivalents


(15,264
)


13,129



(13,629
)Cash and cash equivalents at beginning of period


20,679



7,550



21,179Cash and cash equivalents at end of period

$
5,415


$
20,679


$
7,550Supplemental disclosure of cash flow informationCash paid during the year for income taxes

$
242


$
301


$
66Cash paid during the year for interest

$
-


$
56


$
-


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SCIENTIFIC LEARNING CORPORATION


CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


(In thousands, except share amounts)





Common Stock and Additional Paid-In Capital


Accumulated


Total Stockholders’Shares


Amount


Deficit


EquityBalance at December 31, 2007


17,315,886


$
82,558


$
(76,738
)

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


124,765



395



-



395Issuance of common stock under employee stock purchase plan


79,406



148



-



148Stock-based compensation


-



1,997



-



1,997Vesting of restricted stock units


155,503



-



-



-Net loss and comprehensive loss


-



-



(3,315
)


(3,315
)Balance at December 31, 2008


17,675,560


$
85,098


$
(80,053
)

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


251,816



492



-



492Issuance of common stock under employee stock purchase plan


114,142



203



-



203Stock-based compensation


-



1,389



-



1,389Vesting of restricted stock units


253,290



-



-



-Net income and comprehensive income


-



-



4,800



4,800Balance at December 31, 2009


18,294,808


$
87,182


$
(75,253
)

$
11,929Issuance of common stock under stock option plan


100,398



239



-



239Issuance of common stock under employee stock purchase plan


163,457



360



-



360Stock-based compensation


-



1,496



-



1,496Vesting of restricted stock units


143,381



-



-



-Net loss and comprehensive loss


-



-



(9,690
)


(9,690
)Balance at December 31, 2010


18,702,044


$
89,277


$
(84,943
)

$
4,334





See accompanying notes


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Notes to Consolidated Financial Statements





1. Summary of Significant Accounting Policies





Description of Business





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





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





All of the Company’s activities are in one operating segment.





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.  To the extent that there are material differences between these estimates and actual results, the Company’s financial statements could be affected.





Principles of Consolidation





The consolidated financial statements include the accounts of the Company and its wholly owned China subsidiary Shanghai Zhiyong Information Technology Co., Ltd.  All significant intercompany balances and transactions have been eliminated in consolidation.





Revenue Recognition





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




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





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





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


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Product revenue





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





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





·
Subscription and term licenses – software licensed for a specific time period, generally month to month or a term of 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, implementation, technical and other professional services are typically sold on a per day basis. If VSOE of fair value exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE of fair value does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.





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





Cash and Cash Equivalents





The Company considers all highly liquid investments purchased with an original maturity of three months or less from the date of purchase to be cash equivalents. Cash and cash equivalents, which primarily consist of cash on deposit with banks and money market accounts, are stated at cost, which approximates fair value.





Short-term Investments





The Company determines the appropriate classification of short-term investments at the time of purchase and reevaluates such determination at each balance sheet date. Short-term investments are classified as available for sale and are carried at fair value.  Fair value is determined based on quoted market rates when observable or utilizing data points that are observable, such as quoted prices, interest rates and yield curves.  Unrealized gains and losses on short-term investments are included in accumulated other comprehensive income.  Declines in fair value judged to be other-than-temporary on securities available for sale are included as a component of other income. The cost of securities sold is based on the specific-identification method. Interest on securities classified as available for sale is also included as a component of other income. In order to determine whether a decline in value is other-than-temporary, the Company evaluates, among other factors: the duration and extent to which the fair value has been less than the carrying value, the Company’s financial condition and business outlook, including key operational and cash flow metrics, current market conditions and the Company’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair market value.





Accounts Receivable





The Company conducts business primarily with public school districts and speech and language professionals in the United States. The Company maintains an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. The allowance is adjusted periodically based on historical experience of bad debt write-offs.





Inventories





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


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Deferred Charges





The Company defers royalty charges as incurred and recognizes the expense over the term of the related license agreements or service periods. These deferred charges are included in “Prepaid expenses and other current assets” and in “Other assets” in the consolidated balance sheets.





Property and Equipment





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





Software and Web Site Development Costs





The Company capitalizes certain software development costs incurred subsequent to the establishment of technological feasibility and amortizes costs over the estimated lives of the related products. The annual amortization is the greater of the amount computed using (a) the ratio of current year to date gross revenues for the product to the aggregate of total anticipated revenues for the product or (b) the straight-line method over the remaining estimated economic life of the product. Technological feasibility is established upon completion of a working model. In 2010 and 2009, the Company capitalized $0.1 million and $1.0 million of costs, respectively, relating to new products that had reached technological feasibility. In 2008 costs incurred subsequent to the establishment of technological feasibility for new projects were not significant, and were charged to research and development expense. Software costs are amortized to cost of product revenues over the estimated useful life of the software, which is three years. For the years ended December 31, 2010, 2009 and 2008 amortization costs were $0.3 million, $0.1 million and zero, respectively.





The Company also capitalizes costs related to internal use software and web site application, infrastructure development and content development costs.  The capitalized costs are included in “Property and equipment” in the consolidated balance sheets. In each case the software or website is for internal needs, and the Company does not plan to market the software externally. For the year ended December 31, 2010, the Company capitalized approximately $1.2 million of software and web site development costs. For the years ended December 31, 2009 and 2008, the Company capitalized approximately $0.4 million and $0.1 million of software and web site development costs, respectively.





The Company evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets.  If indicators of impairment are present, estimates of future cash flows are used to test the recoverability of the asset. If the carrying amount of the asset exceeds its fair value, an impairment charge is recognized. In 2010, the Company determined that capitalized software development costs relating to the Reading Assistant asset group was impaired.  See Note 6 –Intangible Assetsfor further discussion.In late 2009 it was determined that BrainSpark website needed to be completely redesigned and accordingly the Company recorded an impairment charge of $0.4 million and capitalized development costs of $21,000 for the new website. These costs will amortize over a period corresponding to the estimated life of the related products when the web site is ready for use.





Goodwill





Goodwill and purchased intangible assets were recorded when the Company acquired the assets of Soliloquy in 2008. The cost of the acquisition was allocated to the assets and liabilities acquired, including purchased intangible assets, and the remaining amount was classified as goodwill. Goodwill arising from purchase transactions is not amortized to expense, but rather periodically assessed for impairment. The allocation of the acquisition cost to purchased intangible assets and goodwill, therefore, has a significant impact on operating results. The allocation process involves an extensive use of estimates and assumptions, including estimates of future cash flows to be generated by the acquired assets.





Goodwill is required to be tested annually for impairment or between annual impairment test if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. The Company selected the fourth quarter to perform its annual goodwill impairment testing.The guidance requires a two-step impairment test be performed on goodwill. The Company performed the two steps as follows:


Step 1 – The Company compares the fair value of the reporting unit to its carrying value. The Company has one reporting unit, and therefore the fair value assessment is at an enterprise level. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is considered not impaired and the Company is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the implied fair value of the reporting unit, the Company must perform the second step of the impairment test in order to determine the implied fair value and record an impairment loss equal to the difference.


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Step 2 –The Company assigns the fair value of a reporting unit to all of the assets and liabilities of that unit. The excess of the fair value over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. The implied fair value is compared to the carrying amount of goodwill, if the carrying amount of the goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess.





During 2010, the Company determined that the carrying value of goodwill had not been impaired, and no impairment charge was recorded. The Company will continue to assess goodwill for impairment on an interim basis when indicators events or circumstances change. Conditions that indicate that goodwill may be impaired include market capitalization declining below net book value or a sustained decline in stock price. A significant impairment could have a material adverse effect on the Company’s consolidated balance sheets and results of operations.





Long-Lived Assets





Long-lived assets, such as property and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of an asset is measured by a comparison of the carrying amount of an asset to its estimated undiscounted future cash flows. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. In 2010, the Company determined that the carrying amount of the intangible assets and certain other long-lived assets were not recoverable and was impaired.  See Note 6 – Intangible Assets for further discussion.





Fair Value of Financial Instruments





The carrying amounts of cash equivalents, short-term investments, accounts receivable, and accounts payable approximate fair value as they are short-term in nature or have relatively short maturities.





Concentration of Risk





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





Cash and cash equivalents are primarily invested in a major financial institution in the United States. Such deposits may be in excess of insured limits and are not insured in other jurisdictions. The Company 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.





Accounts receivable are primarily from booked sales to customers located primarily in the United States. The Company performs ongoing credit evaluations of customers. The Company does not require collateral.





An allowance for doubtful accounts is determined with respect to those accounts that have been determined to be doubtful of collection. At December 31, 2008 one customer accounted for more than 10% of accounts receivable. No customers accounted for more than 10% of accounts receivable at December 31, 2010 and 2009.  No customers accounted for more than 10% of revenue in 2010, 2009 or 2008.





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





Concentration of royalty arrangements potentially exposes the Company to risk. If the Company were to lose rights under these arrangements, this could materially impact booked sales, revenue and net income. The patents and applications that are licensed 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 2010, approximately 60% of product booked sales was derived from selling products that use the licensed inventions.





Accounting for Stock-Based Compensation





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





Advertising





Advertising costs are expensed as incurred. Advertising expenses were $0.3 million, $0.2 million and, $0.1 million for the years ended December 31, 2010, 2009 and 2008, respectively.


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Income Taxes





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





Net Income (Loss) 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.





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





Year Ended December 31,2010


2009


2008Net income (loss)

$
(9,690
)

$
4,800


$
(3,315
)Weighted average shares used in calculation of basic net income (loss) per share


18,498



18,039



17,488Effect of dilutive securities:Employee stock options and awards


-



651



-Weighted-average diluted common shares


18,498



18,690



17,488Basic net income (loss) per share

$
(0.52
)

$
0.27


$
(0.19
)Diluted net income (loss) per share

$
(0.52
)

$
0.26


$
(0.19
)





For the year ended December 31, 2010, 2009 and 2008, 1,012,220, 1,510,281 and 3,150,180 options, respectively, were excluded from the calculation of diluted net income per share because their effect is anti-dilutive.





Foreign Currency Translation





The functional currency of the Company’s foreign subsidiary is the local currency, Chinese RMB. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are recorded as part of a separate component of stockholders’ equity. Foreign currency transaction gains and losses are included in Other income (expense). All assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the exchange rate as of the balance sheet date. Revenues and expenses are translated at the average exchange rate during the period. Equity transactions are translated using historical exchange rates.





Recent Accounting Pronouncements





In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurements” which amends Subtopic 820-10 to require new disclosures and update existing disclosures.  This update is intended to provide a greater level of information and more robust disclosures about valuation techniques and inputs to fair value measurements.  ASU 2010-06 became effective beginning with the Company’s first quarter of 2010 and did not have a material impact on the Company’s balance sheets or results of operations.





2. Restructuring





On January 7, 2009, the Company announced a series of changes intended to better align costs and organization structure with the current economic environment and improve profitability. These changes included a reduction in work force of approximately 14% during the first quarter of 2009. Employees were notified in December 2008 and January 2009, and severance costs were approximately $104,000 in the year ended December 31, 2008 and $287,000 year ended December 31, 2009.





On September 1, 2009, the Company announced a plan to consolidate its product development and product management functions in the Company’s Oakland, California headquarters.  Under this plan, the Company closed its Waltham, Massachusetts office, and most Waltham employees left the Company by the end of 2009.  The Company notified the employees affected by the workforce reduction on September 1, 2009.  The Company’s lease on the Waltham office expires on September 30, 2011.  In January 2010, the Company signed an agreement to sublease the property through October 2010 and in September 2010 an addendum was signed to extend the sublease through September 2011.


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 Table of Contents


These restructuring costs were mainly recorded under Research and development in the consolidated statement of operations.  The Company paid all employee costs by December 31, 2010 and expects to pay the facility costs through September 2011.  Accrued costs are shown in the following table (in thousands):





Employee costs


Facility costs


TotalAccrued at December 31, 2009

$
19


$
226


$
245Adjustments


-



(48
)


(48
)Cash paid


(19
)


(93
)


(112
)Accrued at December 31, 2010

$
-


$
85


$
85





3. Prepaid Expenses and Other Current Assets





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





December 31,2010


2009Prepaid expenses

$
1,730


$
1,557Product inventory


297



495Other receivables


179



90Total prepaid expenses and other current assets

$
2,206


$
2,142





4. Property and Equipment





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





December 31,2010


2009Computer equipment and software

$
4,306


$
3,327Office furniture and equipment


1,370



1,043Leasehold improvements


606



598Total property and equipment


6,282



4,968Less: accumulated depreciation


(3,785
)


(3,188
)Total property and equipment - net

$
2,497


$
1,780





Depreciation expense for the years ended December 31, 2010, 2009 and 2008 was $1.2 million, $0.9 million and $0.5 million, respectively.





5. Fair Value Measurements of Financial Instruments





The Company generally invests its excess cash in investment grade short-term fixed income securities and money market funds.  The portion in cash and cash equivalents represents highly liquid instruments with insignificant interest rate risk and original maturities of three months or less. Short-term investments are classified as available for sale and are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component stockholders’ equity. There were no unrealized gains and losses for the three-years ended December 31, 2010, 2009 and 2008.


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 Table of Contents


The Company has established a three-tier fair value hierarchy, categorizing the inputs used to measure fair value.  The hierarchy can be described as follows: Level 1- observable inputs such as quoted prices in active markets; Level 2- inputs other than the quoted prices in active markets that are observable either directly or indirectly; and Level 3- unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.





Cash equivalents consist of money market instruments and commercial paper that have original maturities of 90 days or less.  These instruments are classified in Level 1 of the fair value hierarchy.  The Company also invests in federal agency and corporate bonds with an original maturity date of greater than 90 days that are classified as short-term investments.  These instruments are classified within Level 2 of the fair value hierarchy.  The Company has no Level 3 financial assets.





The Company’s valuation techniques used to measure the fair values of money market accounts that were classified as Level 1 in the table below were derived from quoted market prices.  The Company’s valuation techniques used to measure the fair values of the Company’s U.S. Treasury, U.S. government and U.S. government agency debt securities, corporate bonds and commercial paper that are classified as Level 2 in the table below, generally all of which mature within two years and the counterparties to which have high credit ratings, were derived from non-binding market consensus prices that are corroborated by observable market data or quoted market prices for similar instruments.





The following is a summary of the fair value of the major categories of financial instruments held by the Company (in thousands):





December 31,2010


2009Assets:Money market accounts

$
3,500


$
20,177Commercial paper


500



-Agency bonds


8,629



-Other fixed income securities


502



-Total

$
13,131


$
20,177





The following is a summary of the Company’sfinancial assets that are accounted for at fair value on a recurring basis by level in accordance with the fair value hierarchy described above (in thousands):





December 31, 2010Fair Value MeasurementLevel 1

Level 2

Level 3

TotalAssets:Money market accounts

$
3,500


$
-


$
-


$
3,500Commercial paper


-



500



-



500Agency bonds


-



8,629



-



8,629Other fixed income securities


-



502



-



502Total

$
3,500


$
9,631


$
-


$
13,131





There were no unrealized gains and losses at December 31, 2010.





As of December 31, 2009, the Company’s financial assets of approximately $20.2 million were entirely comprised of money market accounts which were classified as Level 1 in the fair value hierarchy.  The Company had no Level 2 or Level 3 financial assets.





The fair value of short-term investments with contractual maturities is as follows at December 31, 2010(in thousands):





Due in less than one year

$
8,099Due in more than one year


1,532Total

$
9,631





The Company has the ability, if necessary, to liquidate any of its investments in the next 12 months.  Accordingly, those investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheet.


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 Table of Contents


6. Intangible Assets





Purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  Intangible assets are accounted for at fair value on a recurring basis as level 3 assets in accordance with the fair value hierarchy.





In December 2010, the Company identified an impairment indicator related to the core technology intangible asset acquired as a result of the purchase of JTT Holdings Inc. d/b/a Soliloquy Learning (“JTT”), pursuant to which the Company agreed to acquire from JTT the Soliloquy Reading Assistant product line and substantially all of the other assets of the Soliloquy Learning business.  In 2010, the Company determined it would make additional investments in Reading Assistant to replace the core technology and enable compatibility with the Company’s new web-based platform.  As a result, the Company determined it was necessary to assess the recoverability of the asset group associated with generating Reading Assistant cash flows.  The asset group consists of intangible assets and capitalized software.




The Company used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group exceeded the carrying values of those assets. As a result of this assessment, the carrying value of the asset group exceeded the undiscounted cash flows. The Company then performed an analysis to determine the fair value of the asset group, which was determined using the expected present value of future cash flows which are based on estimates, assumptions and management’s judgments.  These include the forecast of future cash flows related to the asset group, the discount rate used in discounting those cash flows, and the expected remaining useful life of the asset group. This analysis resulted in a non-cash impairment charge of $3.9 million in 2010, which includes $0.5 million related to capitalized software development costs. The impairment charge was allocated on a pro-rata basis using the relative carrying amounts of the asset group.





Intangible assets at December 31, 2010 are as follows (dollar amounts in thousands):





Gross carrying amount


Accumulated amortization


Impairment


Net carrying amount at December 31, 2010


Remaining amortization period (years)Core technology

$
5,800


$
1,816


$
3,062


$
922



2OEM contracts


560



372



145



43



2Customer list


220



212



6



2



2Non compete agreement


610



324



219



67



2Total other intangible assets

$
7,190


$
2,724


$
3,432


$
1,034





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





Fiscal year

Amortization2011

$
5172012


517$
1,034





7. Other Assets





Other assets consist of the following (in thousands):





December 31,2010


2009Long-term lease deposits

$
883


$
953Capitalized software, net


232



895Other non current assets


284



245Total other assets

$
1,399


$
2,093





Capitalized software amortization of $0.3 million and $0.1 million was charged to expense in 2010 and 2009, respectively. Additionally, a non-cash impairment charge related to capitalized software was recorded in 2010 for approximately $0.5 million.  See Note 6 –Intangible Assetsfor further discussion.


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 Table of Contents


8. Stock-Based Compensation





Stock-Based Compensation Plans





On December 31, 2010, the Company had four active share-based compensation plans, which are described below.





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





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




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





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





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. At December 31, 2010, 143,528 shares were available for issuance under this plan.




Stock Based Compensation Expense




Compensation expense is recognized for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.





Forfeitures are required to be estimated at the time of grant. The estimates are revised in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and records share-based compensation expense only for those awards that are expected to vest. The following table summarizes the impact of share-based compensation in the years ended December 31, 2010, 2009 and 2008 (in thousands):





Year Ended December 31,2010


2009


2008Cost of service and support revenues

$
97


$
151


$
200Sales and marketing


450



490



685Research and development


276



285



434General and administrative


673



463



678Total stock-based compensation expense

$
1,496


$
1,389


$
1,997





Valuation of Stock Option Awards





The fair value of each option award is estimated on the date of grant using a Black-Scholes Merton option pricing model with subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures noted in the table below:





Expected volatility – Based on the historical prices of common stock over the expected life of each option.





Expected life – Based on the history of option exercise and cancellation activity of the options





Risk-free interest rate – Based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options.





Dividend yield – As the Company has not paid, nor does it currently plan to pay, dividends in the future, the assumed dividend yield is zero.


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 Table of Contents


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





Year Ended December 31,2010


2009


2008Expected life (in years)


5.5



5.5



5.1Risk-free interest rate


2.3
%


1.9
%


2.0
%Dividend yield


0.0
%


0.0
%


0.0
%Expected volatility


62
%


58
%


55
%





Summary of Stock Options




The following table summarizes all stock option activity under the Company’s share-based compensation plans for the year ended December 31, 2010:





Number of Options


Weighted-Average Exercise Price Per Share


Weighted-Average Remaining Contractual Term (Years)


Aggregate Intrinsic ValueOutstanding at December 31, 2009


2,889,347


$
3.48



4.02


$
6,264,503Granted


413,250



4.65Exercised


(100,398
)


2.48Cancelled (includes forfeited and expired)


(309,225
)


7.67Outstanding at December 31, 2010


2,892,974



3.22



4.04



2,430,991Vested and expected to vest at December 31, 2010


2,833,877


$
3.21



3.95


$
2,416,966Exercisable at December 31, 2010


2,226,494


$
3.14



2.71


$
2,129,882





The aggregate intrinsic value of options outstanding at December 31, 2010 is calculated as the difference between the exercise price of the underlying options and the market price of the Company’s common stock for 1.7 million shares that had exercise prices that were lower than the $3.07 market price of the Company’s common stock at December 31, 2010 (“in the money options”). The total intrinsic value of options exercised during the years ended December 31, 2010, 2009 and 2008 was $0.2 million, $0.2 million and $0.1 million, respectively. The fair value of options vested during the years ended December 31, 2010, 2009 and 2008 was $0.4 million, $0.4 million and $0.8 million, respectively. The weighted average grant date fair value of options granted during the years ended December 31, 2010, 2009 and 2008 was $2.62, $1.09 and $1.13, respectively.





As of December 31, 2010, total unrecognized compensation cost related to stock options granted under the Company’s various plans was $1.1 million. The Company expects that cost to be recognized over a weighted-average period 2.7 years.


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 Table of Contents


Summary of Restricted Stock Units and Restricted Stock Awards





The following table summarizes all restricted stock unit activity under the Company’s share-based compensation plans for the year ending December 31, 2010:





Number of Shares


Weighted-Average Grant Date Fair Value


Weighted-Average Remaining Contractual Term (Years)


Aggregate Intrinsic ValueOutstanding at December 31, 2009


248,936


$
5.00Awarded


263,939



4.73Released (Vested)


(143,381
)


5.29Forfeited or expired


(26,742
)


4.44Outstanding at December 31, 2010


342,752



4.71



1.35


$
1,025,973Vested and expected to vest at December 31, 2010


304,575


$
4.73



1.32


$
935,016





Restricted stock units were granted for the first time in 2006 under the 1999 Equity Incentive Plan. The fair value of these grants was calculated based upon the fair market value of the Company’s stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during fiscal years 2010, 2009 and 2008 was $4.73, $1.96 and $4.64, respectively, and the fair value of stock units that vested during fiscal years 2010, 2009 and 2008 was $0.9 million, $0.9 million and $1.1 million, respectively. As of December 31, 2010, total unrecognized compensation cost related to restricted stock units was $1.1 million. The Company expects that cost to be recognized over a weighted-average period 2.6 years.





Employee Stock Purchase Plan (“ESPP”)




ESPP awards were valued using the Black-Scholes model using the following assumptions:





Year Ended December 31,2010


2009


2008Expected life (in years)


0.5 - 1.0



0.5 - 1.0



0.5 - 1.0Risk-free interest rate


0.4
%


1.1
%


3.3
%Dividend yield


0
%


0
%


0
%Expected volatility


58
%


85
%


58
%





Disclosures Pertaining to All Share-Based Compensation Plans




Cash received under all share-based payment arrangements for the years ended December 31, 2010, 2009 and 2008 was $0.6 million, $0.7 million and $0.5 million, respectively, related to the exercise of stock options and the purchase of ESPP shares. The weighted-average grant-date fair value of options, restricted stock units and restricted stock awards granted in the years ended December 31, 2010, 2009 and 2008 was $3.42, $1.18 and $3.89 per share, respectively.





9. Accrued Liabilities





Accrued liabilities consist of the following (in thousands):





December 31,2010


2009Accrued vacation

$
1,114


$
953Accrued commissions and bonus


1,147



4,192Other accrued liabilities


1,692



2,032Accounts payable accruals


245



185Total accrued liabilities

$
4,198


$
7,362


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 Table of Contents


10. Deferred Revenue




Deferred revenue consists of the following (in thousands):





December 31,2010


2009Current:Products

$
3,662


$
2,322Service and support


12,726



13,537Total deferred revenue, current

$
16,388


$
15,859Long term:Products

$
111


$
232Service and support


5,372



6,139Total deferred revenue, long-term

$
5,483


$
6,371





11. Warranties and Indemnification





The Company generally provides a warranty that the Company’s 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, 2010.





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 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 as of December 31, 2010.





12. Bank Line of Credit





On February 28, 2010, the Company amended its existing revolving line of credit agreement with Comerica Bank.  The maximum that can be borrowed under the agreement is $7.5 million.  The line expires on December 31, 2011.





Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate”.  Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring the Company to maintain a minimum adjusted quick ratio of 1.15 and positive net worth.  The agreement includes a letter of credit sublimit not to exceed $1.0 million.  At December 31, 2010, the Company had an outstanding letter of credit for $206,000.  There were no borrowings outstanding on the line of credit at December 31, 2010, and the Company was in compliance with all its covenants.


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 Table of Contents


13. Provision for Income Taxes





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





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





Year Ended December 31,Current:

2010


2009


2008Federal

$
(8
)

$
50


$
(101
)State


28



265



41Foreign


5



-



1Total current

$
25


$
315


$
(59
)Deferred:Federal

$
104


$
104


$
1,157State


14



10



150Foreign


-



-



-Total deferred


118



114



1,307Total provision for income taxes

$
143


$
429


$
1,248





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





Year Ended December 31,2010


2009


2008Computed tax at statutory rate of 34%

$
(3,246
)

$
1,777


$
(703
)State taxes, net of federal benefit


23



299



(64
)Federal alternative minimum tax


-



102



5Losses (benefited) not benefited


176



(1,787
)


(229
)Non deductible stock-based compensation


124



105



147Other non deductible expenses


106



259



108Change in valuation allowance


2,960



(326
)


1,984Provision for income taxes

$
143


$
429


$
1,248


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 Table of Contents


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 (liabilities) are as follows, (in thousands):





December 31,2010


2009Deferred tax assets:Net operating loss carryforwards

$
21,652


$
20,742Capitalized software development costs


10



22Deferred revenue


2,476



1,723Research credit carryforwards


3,012



2,635Other


3,031



1,922Gross deferred tax assets


30,181



27,044Less: Valuation allowance


30,181



27,044Total  deferred tax assets, net


-



-Deferred tax liabilities:Goodwill


(355
)


(237
)Net deferred tax liability

$
(355
)

$
(237
)





The Company’s operations are in a cumulative loss position for the three-year period ended December 31, 2010, primarily as a result of operating losses in 2010 and 2008 resulting from lower than expected booked sales.  For purposes of assessing the realization of the deferred tax assets, this cumulative loss position is considered significant negative evidence that it is more likely than not the Company will not be able to realize the deferred tax assets in the future. As a result, the Company continues to maintain a full valuation allowances on its deferred tax assets.  Management will reassess the realization of the deferred tax assets each reporting period. To the extent that the financial results of the Company improve and the deferred tax assets become realizable, the Company will be able to reduce the valuation allowances through earnings.  The Company’s valuation allowance increased by approximately $3.1 million in 2010 and decreased by $2.4 million in 2009.





As of December 31, 2010, the Company has U.S. federal and state net operating loss carryforwards of approximately $56.6 million and $42.8 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2030 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2012 through 2030.





As of December 31, 2010, the Company has U.S. federal and state tax credit carryforwards of approximately $1.5 million and $1.5 million, respectively.  The federal credit will expire at various dates beginning in 2011 through 2029, if not utilized. California state research and development credits can be carried forward indefinitely.





In connection with the Company's adoption of Accounting Standards Codification 718 (“ASC 718”), the Company uses the "with-and-without" approach described in EITF Topic No. D-32, "Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations," to determine the recognition and measurement of excess tax benefits. In addition, the Company has elected to account for indirect effects of stock option based awards on other tax attributes, such as research and alternative minimum tax credits, through the income statement.  Accordingly, the Company has elected to recognize excess tax benefits from stock option exercises in additional paid in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to the Company.





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





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





The Company does not provide for U.S. federal income and state income taxes on undistributed earnings of the China subsidiary at December 31, 2010, because these earnings are intended to be indefinitely reinvested.  Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to nominal U.S. federal and state income taxes.


45
 Table of Contents


The Company accounts for uncertain tax positions under Financial Accounting Standard Board (“FASB”) Accounting Standards Codification 740-10 “Accounting for Uncertainty in Income Taxes” (“ASC 740-10”). ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. At December 31, 2010, the Company had a liability for unrecognized tax benefits of $2.5 million.  The Company believes there may be changes in its unrecognized tax positions over the next twelve months, but will not be a material adjustment.





Interest and penalty costs related to unrecognized tax benefits are classified as a component of Income Tax Expense in the accompanying consolidated statements of operations and the corresponding liability in Other liabilities in the accompanying consolidated balance sheets. The Company recognized an immaterial amount of interest expense related to unrecognized tax benefits for the year ended December 31, 2010.





The Company files U.S. federal, state and foreign income tax returns. Material jurisdictions are Federal and California tax returns, which remain open to examination by the appropriate governmental agencies for tax years 2006 to 2010. The federal and state taxing authorities may choose to audit tax returns for tax years beyond the statute of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. The Company is not currently under audit in any major tax jurisdiction.





A reconciliation of the Company’s unrecognized tax benefits is as follows (in thousands):





December 31,2010


2009


2008Balance at January 1

$
2,397


$
1,883


$
1,876Additions for tax positions of prior years


-



434



-Additions for tax positions related to the current year


154



130



106Reductions for tax positions of prior years


(4
)


(50
)


(99
)Settlements during the current year


-



-



-Balance at December 31

$
2,547


$
2,397


$
1,883





14. Stockholders’ Equity





Common Stock





At December 31, 2010, the Company had reserved shares of common stock for future issuance as follows:





Stock options outstanding


2,892,974Stock awards outstanding


342,752Stock options available for future grants


1,260,426Employee stock purchase plan


143,5284,639,680





15. Commitments and Contingencies





Leases





The Company has a non-cancelable lease agreement for its corporate office facilities in Oakland, California.  The minimum lease payment was approximately $78,000 per month through 2008. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013.  The Company also has lease agreements for the Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month, and for the former Reading Assistant operations in Waltham, Massachusetts through September 2011 at an average monthly rent of approximately $12,000.  Following the closure of the Waltham office in December 2009, the Company has sublet this property through September 2011 at a monthly rent of approximately $5,000.  In June 2010, the Company signed a lease for an office in Shanghai, China for 2,500 square feet at a rate of approximately $4,000 per month through May 2012 to be used for research and development.





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 booked sales of products using the licensed technology.  Royalty expenses were $0.5 million, $0.8 million and $0.8 million for the years ended December 31, 2010, 2009 and 2008, respectively, and are included in cost of product revenues.


46
 Table of Contents


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





At December 31, 2010, the Company's future minimum lease payments and future payments under its royalty agreements are as follows (in thousands):





2011


2012


2013


2014


2015 and thereafter


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

$
1,219


$
1,274


$
1,242


$
-


$
-


$
3,735Minimum royalty obligations


150



150



150



150



-



600Total

$
1,369


$
1,424


$
1,392


$
150


$
-


$
4,335





Rent expense under all operating leases was $1.1 million, $1.3 million and $1.2 million for the years ended December 31, 2010, 2009 and 2008, respectively.





16. 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. The Company matched contributions by plan participants for the year ended December 31, 2008. The matching contributions were $0.4 million. The Company did not match contributions by plan participants for the years ended December 31, 2009 and 2010.





17. Related Party Transactions





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





The Company has a 3.5% equity interest in Posit Science. The royalty income recorded from Posit Science of $120,000, $154,000 and $150,000 for years ended December 31, 2010, 2009 and 2008, respectively.





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





Also in place are consulting agreements with two of the founders, who are or were also members of the Board of Directors. Dr. Paula Tallal, who is a current Board member, provides ongoing consulting in the areas of customer relationships and research planning and in fiscal 2010, 2009 and 2008 she received total compensation of approximately $80,000, $69,000 and $111,000, respectively. Dr. Michael Merzenich, who retired as a Board member in October 2008, provides consulting services including public speaking, meetings with third parties and other projects as agreed from time to time, and in fiscal 2010, 2009 and 2008 received total compensation of approximately zero, $45,000 and $28,000, respectively.


47
 Table of Contents


18. Interim Financial Information (unaudited)





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





Three Months EndedMarch 31


June 30


September 30


December 31(1)


TotalFiscal Year 2010:Total revenues

$
11,065


$
12,307


$
10,234


$
9,778


$
43,384Gross profit


8,112



9,453



7,430



6,949



31,944Net loss

$
(1,899
)

$
(781
)

$
(825
)

$
(6,185
)

$
(9,690
)Basic and diluted net loss per share:

$
(0.10
)

$
(0.04
)

$
(0.04
)

$
(0.34
)

$
(0.52
)Fiscal Year 2009:Total revenues

$
8,624


$
10,616


$
20,293


$
15,755


$
55,288Gross profit


6,027



8,061



17,042



12,584



43,714Net income (loss)

$
(2,861
)

$
(314
)

$
6,455


$
1,520


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

$
(0.16
)

$
(0.02
)

$
0.36


$
0.08


$
0.27Diluted

$
(0.16
)

$
(0.02
)

$
0.35


$
0.08


$
0.26





(1) Net loss for the three months ended December 31, 2010 includes a $3.9 million non-cash impairment charge.





ITEM 9. CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE





None.





ITEM 9A. CONTROLS AND PROCEDURES





Evaluation of Disclosure Controls and Procedures





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





As required under Rule 13a-15(b) of the Exchange Act, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K, and concluded that our disclosure controls and procedures were effective as of December 31, 2010.





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


48
 Table of Contents


Management's Report on Internal Control over Financial Reporting





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




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




Changes in Internal Controls over Financial Reporting





There were no changes in our internal control over financial reporting that occurred during the year ended December 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.





ITEM 9B. OTHER INFORMATION





None.


49
 Table of Contents


PARTIII





ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





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





Information required by this item respecting our directors, audit committee and code of ethics is set forth under the caption “Proposal 1: Election of Directors” in our Proxy Statement relating to our 2011 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. SECURITYOWNERSHIP 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 RELATIONSHIPSAND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





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





ITEM14. PRINCIPAL ACCOUNTANT FEES AND SERVICES





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





50
 Table of Contents


PARTIV





ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES





(a)
Documents filed as part of this report:





(1)
Financial Statements





Report of Independent Registered Public Accounting Firm


Consolidated Balance Sheet – December 31, 2010 and 2009


Consolidated Statements of Operations – Years Ended December 31, 2010, 2009 and 2008


Consolidated Statements of Stockholders’ Equity – Years Ended December 31, 2010, 2009 and 2008


Consolidated Statements of Cash Flows – Years Ended December 31, 2010, 2009 and 2008


Notes to Consolidated Financial Statements





(2)
Financial Statement Schedules





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





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





Beginning Balance


Charge (credit) to Operating Expenses


Additions (deductions) to Allowance


Ending Balance2010

$
97


$
(18
)

$
(3
)

$
762009

$
296


$
(75
)

$
(124
)

$
972009

$
96


$
574


$
(374
)

$
296








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





(b)
Exhibits





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


51
 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/ D. Andrew Myers

March 4, 2011D. Andrew MyersPresident, Chief Executive Officer





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




Signature

Title

Date/s/ D. Andrew Myers

President, Chief Executive Officer, Director

March 4,2011D. Andrew Myers

(Principal Executive Officer)/s/ Robert E. Feller

Chief Financial Officer, Treasurer

March 4,2011Robert E. Feller

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

Director

March 4,2011Edward Vermont Blanchard, Jr./s/ Robert C. Bowen

Chairman of the Board , Director

March 4,2011Robert C. Bowen/s/  Gayle A. Crowell

Director

March 4,2011Gayle A. Crowell/s/Rodman W. Moorhead, III

Director

March 4,2011Rodman W. Moorhead, III/s/Dr. Michael A. Moses

Director

March 4,2011Dr. Michael A. Moses/s/Lance R. Odden

Director

March 4,2011Lance R. Odden/s/  Shari Simon

Director

March 4,2011Shari Simon/s/  Dino A. Rossi

Director

March 4,2011Dino A. Rossi/s/Dr. Paula A. Tallal

Director

March 4,2011Dr. Paula A. Tallal/s/  Jeffrey D. Thomas

Director

March 4,2011Jeffrey D. Thomas


Table of Contents




EXHIBIT INDEX





Incorporated by ReferenceExhibit Number

Description

Form

File Number

Date of First Filing

Exhibit Number

Filed Herewith3.1

Amended and Restated Certificate of Incorporation

10-Q

000-24547

5/7/2007

3.13.2

Amended and Restated Bylaws

S-1/A

333-143093

7/16/2007

3.23.3

Certificate of Amendment to the Amended and Restated Certificate of Incorporation

S-1/A

333-143093

7/16/2007

3.34.1

Reference is made to Exhibits 3.1 and 3.24.2

Specimen Stock Certificate

S-1/A

333-56545

7/17/1998

4.310.1*

Form of Indemnity Agreement with each of our directors and executive officers

S-1

333-56545

6/10/1998

10.110.2*

1999 Equity Incentive Plan, as amended

—

—

—

—

X10.3*

Forms of Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement under the Incentive Plan

10-K

000-24547

3/14/2006

10.310.4*

Forms of Stock Option Grant Notice, Stock Option Agreement and Stock Bonus Agreement under the Incentive Plan

10-Q

00-24547

8/14/2003

10.310.5(9)*

1999 Non-Employee Directors’ Stock Option Plan, as amended

10-K

000-24547

4/15/2005

10.410.6*

1999 Employee Stock Purchase Plan, as amended

10-Q

000-24547

8/14/2003

10.610.7*

Form of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan

10-K

000-24547

3/3/2010

10.710.8*

Milestone Equity Incentive Plan

10-Q

000-24547

5/14/2004

10.2910.9*

2002 CEO Option Plan

8-K

000-24547

6/7/2002

99.210.10*

Employment Agreement dated as of May 31, 2002 by and between Scientific Learning Corporation and Robert C. Bowen

8-K

000-24547

6/7/2002

99.110.11*

Letter Agreement dated January 2004 by and between the Registrant and Robert C. Bowen amending the Employment Agreement

10-Q

000-24547

5/14/2004

10.2810.12*

Amendment to Employment Agreement with Robert C. Bowen made as of January 1, 2009.

8-K

000-24547

12/7/2007

10.210.13*

Amendment No. 2 to Employment Agreement with Robert C. Bowen

8-K

000-24547

1/2/2009

10.210.14*

Retirement Agreement by and between Scientific Learning Corporation and Robert C. Bowen, effective as of January 1, 2010

10-K

000-24547

3/3/2010

10.14


Table of Contents




Exhibit Number

Description

Form

File Number

Date of First Filing

Exhibit Number

Filed Herewith10.15*

Independent Contractor Agreement by and between Scientific Learning Corporation and Robert C. Bowen, effective as of January 1, 2010

10-K

000-24547

3/3/2010

10.1510.16*

Offer of Employment Letter Agreement with D. Andrew Myers

8-K

000-24547

12/7/2007

10.110.17*

Letter Agreement with D. Andrew Myers amending the terms of his employment, dated December 15, 2008

8-K

000-24547

1/2/2009

10.110.18*

Independent Contractor Agreement dated April l7, 2003 between the Registrant and Paula A. Tallal and Project Assignment thereunder dated December 17, 2004

8-K

000-24547

12/20/2004

99.110.19*

Independent Contractor Project Assignment between the Registrant and Paula A. Tallal effective January 1, 2010

10-K

000-24547

3/3/2010

10.1910.20*

Independent Contractor Project Assignment between the Registrant and Paula A. Tallal effective January 1, 2011

—

—

—

—

X10.21*

Independent Contractor Agreement dated July 25, 2007 between the Registrant and Michael A. Moses

8-K

000-24547

7/26/2007

10.210.22*

Independent Contractor Project Assignment between the Registrant and Michael A. Moses effective January 1, 2010

10-K

000-24547

3/3/2010

10.2110.23*

Independent Contractor Project Assignment between the Registrant and Michael A. Moses effective January 1, 2011

—

—

—

—

X10.24*

2009 Management Incentive Plan

8-K

000-24547

2/23/2009

10.110.25*

2010 Management Incentive Plan

8-K

000-24547

2/11/2010

10.110.26*

2011 Management Incentive Plan

8-K

000-24547

2/24/2011

10.110.27*

Letter Agreement related to Salary Deferral Plan

8-K

000-24547

8/1/2008

10.110.28*

Change of Control Benefit Plan.

8-K

000-24547

5/21/2010

10.110.29

Loan and Security Agreement dated as of January 15, 2004 by and between the Registrant and Comerica Bank

8-K

000-24547

2/5/2004

99.110.30

First Amendment to Loan and Security Agreement, dated as of September 29, 2004, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement

10-K

000-24547

4/15/2005

10.3010.31

Second Amendment to Loan and Security Agreement, dated as of December 2, 2005, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement

10-K

000-24547

3/14/2006

10.19


Table of Contents


Exhibit Number

Description

Form

File Number

Date of First Filing

Exhibit Number

Filed Herewith10.32

Third Amendment to Loan and Security Agreement, dated as of September 5, 2006, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement

10-K

000-24547

3/8/2007

10.2010.33

Fourth Amendment to Loan and Security Agreement, dated as of June 5, 2007, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement

S-1/A

333-143093

7/16/2007

10.2210.34

Fifth Amendment to Loan and Security Agreement, dated as of June 30, 2008, by and between Comerica Bank and the Registrant, amending the Loan and Security Agreement

10-Q

000-24547

8/6/2008

10.210.35

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

8-K

000-24547

4/30/2009

10.110.36

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

10-K

000-24547

3/3/2010

10.3310.37†

Seventh Amendment to Loan and Security Agreement, dated as of February June 30, 2008, by and between Comerica Bank and the Registrant, including Prime Referenced Rate Addendum to Loan and Security Agreement, amending the Loan and Security Agreement

10-K

000-24547

3/3/2010

10.3410.38

Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California

S-1

333-56545

6/10/1998

10.1310.39

Amendment No. 3 to Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California, amending the agreement

10-Q

000-24547

11/14/2003

10.3610.40

Amendment No. 4 to Exclusive License Agreement, dated September 27, 1996, with the Regents of the University of California, amending the agreement

10-K

000-24547

3/8/2007

10.2310.41

Amendment No. 5 to License Agreement of September 27, 1996 between the Regents of the University of California and Registrant, effective as of July 1, 2010

10-Q

000-24547

8/13/2010

10.2


Table of Contents


Exhibit Number

Description

Form

File Number

Date of First Filing

Exhibit Number

Filed Herewith10.42

Lease, dated as of October 1, 2003, with Rotunda Partners II

10-Q

000-24547

11/14/2003

10.3710.43

First Amendment to Lease dated February 2008, between TriPointe Tucson, LLC and the Company

10-Q

000-24547

5/9/2008

10.310.44

Commercial Lease, dated February 26, 2008, between Clematis, LLC and the Company

10-Q

000-24547

5/9/2008

10.410.45

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

8-K

000-24547

10/1/2003

99.110.46

SLC License Agreement dated as of September 30, 2003 by and between the Registrant and NSC

8-K

000-24547

10/1/2003

99.210.47

NSC License Agreement dated as of September 30, 2003 by and between NSC and the Registrant

8-K

000-24547

10/1/2003

99.310.48

Amendment No. 1 to SLC License Agreement between Posit Science Corporation and Registrant, effective as of July 1, 2010

10-Q

000-24547

8/13/2010

10.310.49

Consent of UC Regents to Amendment No. 1 to SLC License Agreement, dated June 25, 2010

10-Q

000-24547

8/13/2010

10.410.50

Amendment No. 2 to SLC License Agreement between Posit Science Corporation and Registrant, effective as of July 1, 2010

10-Q

000-24547

8/13/2010

10.510.51

Asset Purchase Agreement between Registrant and JTT Holdings, Inc., d/b/a/ Soliloquy Learning dated December 18, 2007

8-K

000-24547

12/21/2007

2.123.1

Consent of Independent Registered Public Accounting Firm

—

—

—

—

X31.1

Certification of Chief Executive Officer (Section 302)

—

—

—

—

X31.2

Certification of Chief Financial Officer (Section 302)

—

—

—

—

X32.1

Certification of Chief Executive Officer (Section 906)

—

—

—

—

X32.2

Certification of Chief Financial Officer (Section 906)

—

—

—

—

X




†
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.