<PAGE>

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                _______________

                                   Form 10-K
   FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTION 13 or 15(d) OF THE
                       SECURITIES EXCHANGE ACT OF 1934.

[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                                      ACT OF 1934

                  For The Fiscal Year Ended December 31, 2000


         [_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

                   For the Transition Period From ___ to ___

                        Commission File Number 0-27717

                             SMARTERKIDS.COM, INC.


                          DELAWARE                           04-3226127
               (State or other jurisdiction of            (I.R.S. Employer
               incorporation or organization)          Identification Number)



                  15 Crawford Street, Needham, MA               02494
              (Address of principal executive offices)        (Zip Code)


      Registrant's telephone number, including area code: (781) 449-7567

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

                                     None

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

                         Common Stock, $.01 par value

     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 report(s), and (2) has been subject to such
filing requirements for the past 90 days. Yes    [X]   No [_]

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

     The aggregate market value of the voting stock held by non-affiliates of
the registrant, as of March 26, 2001, was approximately $13.5 million (based on
the closing price of the Registrant's Common Stock on March 26, 2001, of $.75
per share).

     The number of shares outstanding of the registrant's $.01 par value Common
Stock as of March 26, 2001 was 20,830,180.
<PAGE>

                             SMARTERKIDS.COM, INC.

                          ANNUAL REPORT ON FORM 10-K

                         YEAR ENDED DECEMBER 31, 2000

                               TABLE OF CONTENTS

<TABLE>
<S>                                                                                                        <C>
PART I.................................................................................................     3
------
 ITEM 1.   BUSINESS....................................................................................     3
 ------------------
 ITEM 2.   PROPERTIES..................................................................................    11
 --------------------
 ITEM 3.   LEGAL PROCEEDINGS...........................................................................    11
 ---------------------------
 ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.........................................    11
 -------------------------------------------------------------
PART II................................................................................................    11
-------
 ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................    11
 -------------------------------------------------------------------------------
 ITEM 6.   SELECTED CONSOLIDATED FINANCIAL DATA........................................................    13
 ----------------------------------------------
 ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......    14
 -----------------------------------------------------------------------------------------------
 ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..................................    30
 --------------------------------------------------------------------
 ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................................................    30
 -----------------------------------------------------
 ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE........    30
 ----------------------------------------------------------------------------------------------
PART III...............................................................................................    30
--------
 ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT..........................................    30
 ------------------------------------------------------------
 ITEM 11.  EXECUTIVE COMPENSATION......................................................................    30
 --------------------------------
 ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT OF SMARTERKIDS.COM...........    31
 -------------------------------------------------------------------------------------------
 ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..............................................    31
 --------------------------------------------------------
PART IV................................................................................................    31
-------
 ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.............................    31
 -------------------------------------------------------------------------
SIGNATURES.............................................................................................    32
----------
</TABLE>
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                                    PART I

Except for the historical information contained herein, the matters discussed in
this Annual Report on Form 10-K are forward - looking statements that involve
risks and uncertainties.  SmarterKids.com makes such forward -looking statements
under the provision of the "Safe Harbor" section of the Private Securities
Litigation Reform Act of 1995.  Any forward-looking statements should be
considered in light of the factors described below in Item 7 under "Factors That
May Affect Future Results."  Actual results may vary materially from those
projected, anticipated or indicated in any forward-looking statements.  In this
Annual Report on Form 10-K, the words "anticipates," "believes," "expects,"
"intends," "future," "could," and similar words or expressions (as well as other
words or expressions referencing future events, conditions or circumstances)
identify forward-looking statements.

ITEM 1.  BUSINESS

Overview

  SmarterKids.com was incorporated in Delaware in March 1994. SmarterKids.com is
an online educational store, launched in November 1998, dedicated to helping
parents help their children learn, develop and grow. SmarterKids.com believes
that its site offers one of the Internet's most personalized shopping
experiences, linking teacher-reviewed toys, games, books, software and hands-on
activities through SmarterKids.com's patent-pending evaluation and
recommendation process. SmarterKids.com provides educational content, including
product reviews, learning styles surveys and personalized product
recommendations, to help parents and gift givers find quality products and make
informed purchase decisions tailored to a child's individual developmental needs
and learning goals.

  SmarterKids.com serves as a resource for parents, offering specialty centers,
the Grade Expectations! guide to education standards and thousands of
educational products, including both well-known brands and hard-to-find quality
offerings, for children ages infant through 12.

  SmarterKids.com integrates carefully selected products, helpful content and
interactive tools with an intuitive and easy-to-use website to create a
compelling and unique online shopping experience. SmarterKids.com only sells
products that its team of educators certified by state regulatory agencies
believe have educational, developmental or learning value. SmarterKids.com's
collection of products includes over 4,500 books, toys and games, and software
titles from over 300 suppliers. Because SmarterKids.com is focused on education,
many of its products, particularly toys and games, are often not found on many
of the other websites that offer children's products. The My Kid's Store
personalization area on the SmarterKids.com website allows parents to build a
confidential educational profile of their child that can include information
about the child's age and grade, learning styles, learning goals and performance
on standardized tests. The SmarterKids.com SmartPicks technology then uses this
profile to make product recommendations from SmarterKids.com's distinctive
assortment of products tailored to a child's individual developmental profile
and goals.

  SmarterKids.com's principal executive offices are located at 15 Crawford
Street, Needham, Massachusetts 02494. SmarterKids.com's telephone number is
(781) 449-7567 and its website is www.smarterkids.com.

Industry Background

  SmarterKids.com's business lies at the intersection of the consumer market for
educational and developmental products for children and Internet-based commerce.

  The Educational Products Market.  As a result of a number of societal trends,
including constraints on school budgets and the increasing use of standardized
tests, many parents are taking a more active role in their children's
education. In their efforts to help their children learn, improve their
children's standardized test scores and make learning fun, parents are
increasingly purchasing educational books, toys and games, and software.

  Parents are faced with the challenge of finding quality educational products
and selecting the right products for their children. With thousands of
educational products to choose from and few reliable sources of
information, finding the appropriate products for a specific child's needs and
goals can be overwhelming and

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confusing. Parents seek a resource for comprehensive and trusted educational
content and product information to help them make informed purchase decisions.

  Limitations of the Traditional Retail Channel. The traditional retail
channel, including mass-market retailers, has numerous participants and is
highly fragmented. SmarterKids.com believes that, in general, store-based
retailers face challenges in providing a shopping experience that meets the
needs of parents, including:

  .  narrow selection of products due to physical space limitations;

  .  high costs from the need to build and operate multiple retail locations;

  .  lack of flexibility in product display and merchandising capabilities due
     to physical space limitations;

  .  lack of convenience due to limited hours of operation and geographic
     location; and

  .  lack of focus on educational products and limited educational expertise due
     to the lack of involvement of professional educators in these stores.

   SmarterKids.com has also found that specialty educational retailers and
creative toy and game retailers that are focused on education often lack the
sales expertise or time to analyze a child's specific needs due to the lack of
involvement of professional educators in these stores. As a result, the
traditional retail channel fails to satisfy parents' needs for selection,
convenience, personalized service and advice and information.

   Growth of the Internet and Consumer Electronic Commerce. Because of the
inherent limitations of traditional retail channels of distribution, the
Internet has dramatically affected the way consumers and businesses are buying
and selling products and services. The Internet is well suited for consumer
commerce for a number of reasons, including:

  .  increased convenience due to the ability to access the Internet at any time
     from almost any location;

  .  virtually unlimited "shelf" space to allow merchants to offer a wide
     selection of products and services;

  .  low facilities and staffing costs;

  .  merchandising flexibility due to the merchant's ability to quickly update
     and customize product selection and presentation, editorial content and
     prices;

  .  enhanced knowledge of customers' needs from the merchant's ability to
     gather, process and store large amounts of customer information; and

  .  the ability to provide a large amount of targeted information.

  In addition, consumers are also using the Internet to obtain information and
manage personal needs.

  Limitations of Online Retailers That Offer Educational Products. Although
online retailers have a number of advantages, SmarterKids.com believes that
those that offer educational products as a component of their larger product mix
have been limited in a number of ways because they generally:

  .  do not evaluate the products they offer;

  .  lack extensive educational and editorial content; and

  .  do not assess an individual child's needs to personalize the online
     experience.

  The limitations of traditional and online retailers create a significant
opportunity for an educational resource that combines educational expertise and
assessment tools, a wide range of quality educational products and the power of

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the Internet to help parents make informed purchase decisions.

  The SmarterKids.com Solution

  SmarterKids.com is an online retailer focused on children's educational books,
toys and games, software, music and video and school supplies.  SmarterKids.com
combines expertise in children's education with sophisticated product analysis
to help parents make better purchase decisions. Key features of the
SmarterKids.com solution include:

  Broad Assortment of Carefully Selected and Reviewed Educational Products.
SmarterKids.com's collection of educational products includes over 4,500 books,
toys and games, and software titles from over 300 suppliers. SmarterKids.com
continues to carefully select and add products to its assortment that meet its
quality standards. SmarterKids.com consults with certified educators who select
only products that have educational, developmental or learning value.
SmarterKids.com products are also selected based on how a child uses the
product, and whether the product is fun. Once selected, the SmarterKids.com
review process then determines product suitability based on the skills taught,
effectiveness in addressing each skill, the appropriate grade level(s), the
teaching approach, learning style and the occasion for use, such as bedtime,
travel or group play. Each product is assigned a rating for "fun," "ease-of-use"
and "reusability" and is then given an overall "expert review." SmarterKids.com
also provides product reviews prepared by third parties. Because it is focused
on education, many of SmarterKids.com's products, particularly toys and games,
are not found on many of the other popular websites that offer children's
products.

  Compelling Educational Content and Contextual Merchandising. SmarterKids.com
believes that it is an authority on educational products. Each member of the
SmarterKids.com team of educators holds a degree in education, has teaching
experience and has designed and implemented developmental and educationally
appropriate curriculum for children. This team of educators develops
SmarterKids.com content, including educational articles, parenting advice and
product reviews, and licenses educational content from third parties. The
benefit SmarterKids.com provides parents comes, first, by selecting the best
educational products in the marketplace to offer from the SmarterKids.com
website and, second, by providing online advice and information about specific
products to help parents and gift givers make appropriate selections. The
SmarterKids.com website also integrates content with access to relevant
products. For example, the Smarter Parents Resource Center suggests weekly and
monthly educational activities parents can do with their children and then
suggests products to expand on these activities. The SmarterKids.com Teacher
Talk Glossary helps parents understand commonly used educational terms.
SmarterTips helps parents prepare their children for standardized tests.
SmarterSites connects parents to other relevant educational websites.
SmarterKids.com's exclusive monthly columns, "TotTime" by Jean Warren and
"Raising Smarter Kids" by Dr. Dorothy Rubin, are authored by education experts
with more than 100 published books to their credit. In addition, parents can get
daily education news headlines from the world's top news sources in Today's
Headlines. In addition, SmarterKids.com launched specialty centers focused on
the individual product and informational needs of Gifted & Talented and Special
Needs children, furthering its mission to help all children learn, develop, and
grow.

  Convenient and Easy-to-Use Website. SmarterKids.com integrates carefully
selected products, helpful content and interactive tools with an intuitive and
easy-to-use interface. SmarterKids.com organizes its website around age and
grade levels, which is the way parents typically think about the educational
development of their children. SmarterKids.com offers full search and browsing
capabilities that enable parents to find products easily. Furthermore,
SmarterKids.com notifies registered parents when it offers relevant new products
or specials. SmarterKids.com provides customers the convenience and flexibility
of shopping 24-hours-a-day, seven-days-a-week, with dedicated customer service
and reliable and timely product delivery.

  Technology That Matches Products With a Child's Unique Educational Profile.
Parents can use SmarterKids.com's proprietary technology to find products that
meet their child's unique educational needs. The My Kid's Store personalization
area allows parents to build an evolving and confidential educational profile of
their child that can include information about the child's age and grade,
learning goals and results from:

 .  the Learning Styles Survey that parents can fill out online;

 .  skills check-up assessment tests that children can take online;

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 .  CD-ROM based skills tests that parents can order from the SmarterKids.com
website; and

 .  scores from state-sponsored standardized tests.

  SmarterKids.com's proprietary SmartPicks technology then uses this
developmental profile to make targeted product recommendations. SmartPicks
"reshuffles" the entire store so that it emphasizes those products that the
SmarterKids.com educational team believes are appropriate for the individual
child's unique needs and individual goals. On subsequent visits, the
SmarterKids.com website will recognize registered members and display products
and services tailored to a child's developmental profile and goals.
SmarterKids.com believes it is the first and presently the only educational
products and services website to offer this level of personalization.

Shopping at SmarterKids.com

  The SmarterKids.com website is designed to be easy and convenient to use.  The
SmarterKids.com website provides informative reviews of our products and other
useful educational information and is organized in the same way that parents
typically think about the educational development of their kids--by age and
grade level.

  Website Design and Utility. The primary means by which SmarterKids.com's
products and features are organized is by SmarterKids.com's five age and grade
ranges--infant, toddler, preschool through kindergarten, grades 1-3 and grades
4-6, each grade range is referred to as an "aisle" on the SmarterKids.com
website. Parents naturally think about their children in terms of their age and
grade, and, by organizing its website in this manner, SmarterKids.com is able to
emphasize its unique focus on the individual child.

  Within each age and grade range, or "aisle," visitors can browse through links
organized by parents' or teachers' favorite, subject matter, brand, keyword or
theme. Each aisle also has pictures and prices of highlighted products with
links to teachers' reviews of these products.

  From the SmarterKids.com home page, or within each aisle, customers may access
a number of helpful areas within the website, including:

 .  product categories such as Parents' Favorites, Teachers' Favorites, Best
   Sellers, Monthly Picks, Great Gift Ideas, Kids' Favorites or Twenty under
   $20;

 .  product groups, organized by well-known brands or favorite characters;

 .  SmarterKids.com's Learning Styles Survey;

 .  subject links, to find products which address a particular educational or
   developmental area; and

 .  a keyword search box, where customers can enter a product name, manufacturer
   name or descriptive words to find a product.

  These areas are constantly evaluated and refined to reflect the feedback
SmarterKids.com gathers from its customers and any seasonal, periodic or
promotional opportunities SmarterKids.com pursues.

  Products. SmarterKids.com offers five product types--books, toys and games,
software, music and video and school supplies--ranging in price from under $2.00
to $799.00. These products range from those based on popular brands and licensed
characters to hard-to-find specialty items. SmarterKids.com sets its prices on
parity with the average prices of similar products offered by its online
competitors. Each product listing has a picture of the product; narrative
review; indication of skills developed, educational approach utilized, and best
application; and ratings for ease of use, fun, reusability and depth of
instruction. With one click, a user can see all applicable brands, categories
and special offers for each product type. For example, a parent might select a
vividly illustrated book that teaches letter recognition, software that uses an
engaging interactive story to develop creativity, or a puzzle that teaches motor
skills and spatial-relationship awareness.

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  The Grade Expectations! section of the SmarterKids.com website allows parents
to select products aligned to educational grade standards based on an
interpretation of widely accepted national, state, and local curriculum
guidelines.

  My Kid's Store offers what SmarterKids.com believes to be one of the most
personalized shopping experiences in electronic commerce. Parents enter
information related to their child's education and development to build a
personal profile, and SmarterKids.com uses the information to present an
educationally appropriate assortment of products. The more information that a
parent enters, the more precise will be the product recommendations made by
SmartPicks, SmarterKids.com's proprietary personalization technology. My Kid's
Store incorporates a child's age and grade, learning goals and results from:

 .  the Learning Styles Survey that parents fill out online;

 .  a skills check-up assessment test that children can take online;

 .  a CD-ROM-based skills test that parents can order from the SmarterKids.com
   website; and

 .  scores from state-sponsored standardized tests.

  For example, when a parent wishes to focus a first grade child on pre-reading
skills, SmartPicks presents only those products appropriate to that age and
skill goal. Further individual customization can be achieved when a parent
completes a Learning Styles Survey to determine whether a child learns best
through a linguistic, visual, musical, interpersonal, intrapersonal,
mathematical or physical style. If a child's learning style is visual,
SmartPicks will customize this child's shopping area by suggesting products that
teach pre-reading skills to a first grader through visual learning.  SmartPicks
retains a child's information for future reference by the parent.  When a parent
returns to the SmarterKids.com website, new products will automatically be
suggested that achieve the learning goals and fit the learning style and age
range of the child.

  SmarterKids.com protects all information entered into My Kid's Store and
elsewhere and strictly adheres to commonly accepted privacy standards
established by TrustE and the Better Business Bureau, non-profit organizations
who are dedicated to establishing a trusting environment for making purchases
and gathering information on the Internet. Information regarding TrustE and the
Better Business Bureau can be found at www.truste.org and www.bbb.com.
                                       --------------     -----------

  Product selection, check-out and payment functions are easy and intuitive.
SmarterKids.com stocks each item that it sells and is able to show the customer
the availability for each product. SmarterKids.com's credit card approval
technology prevents customers from experiencing delays in check-out. Customers
receive e-mail confirmations of their orders, notification of shipment, and the
ability to track their shipment through the United Parcel Service and Federal
Express.

  Website content is designed and selected to achieve SmarterKids.com's mission
of helping parents help their children learn. SmarterKids.com's product reviews
are prepared by a team of educators. To promote trust, SmarterKids.com
encourages customers to access explanations of product review methodology.
SmarterKids.com's Parents Center suggests weekly learning activities that
parents can do with their children, helps parents prepare their children for
standardized tests, and offers a Teacher Talk Glossary to explain terms used by
education professionals. SmarterSites connects parents to relevant and powerful
information sources. Parents who register for My Kid's Store receive twice-
monthly e-mailed newsletters.

Marketing and Sales

  SmarterKids.com uses a multi-faceted advertising and promotional strategy to
build awareness and attract customers to its website. SmarterKids.com uses a
personalized database marketing approach to build its customer base and
encourage repeat transactions. SmarterKids.com emphasizes responsive and
reliable customer service to earn customer loyalty.

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  E-mail is the primary vehicle by which SmarterKids.com communicates with its
customers and registered users. SmarterKids.com sends customers periodic
newsletters and notification of private, customer-only offers. SmarterKids.com
personalizes its information and offers to specific subsets of its customers,
according to the products they have purchased and the information they have
provided in their children's My Kid's Store profiles, enhancing the value added
and SmarterKids.com's relationship with them.

  SmarterKids.com's online marketing efforts include relationships with
companies who maintain websites that have a large, existing customer base.
SmarterKids.com places banners, buttons and text links on its websites in
return for a specified number of "impressions", or times they are viewed on-
screen, and jointly develops content, promotions and e-mail marketing programs.
These relationships generally include content sharing arrangements and require
SmarterKids.com to pay a fee for delivery of Internet traffic.  In these
relationships, SmarterKids.com is usually designated on these companies'
websites as the preferred vendor of, if not the exclusive vendor of, online
retailers of children's educational books, toys and games, and software.  For
example, SmarterKids.com is the exclusive e-commerce partner of the Microsoft
Encarta website and is indicated by the fact that the SmarterKids.com website
link is the only website link for a children's educational products retailer
displayed on the Microsoft Encarta website home page.

  National Computer Systems, or NCS, is the largest processor of standardized
tests for children in kindergarten through grade 12 in the United States. NCS
provides processing and scoring for over 30 million student assessment tests,
such as the Iowa Test of Basic Skills, in all 50 states and for the U.S.
Department of Education. In May 1999, NCS launched its WeHelpKids.com website,
offering a variety of electronic HelpTests and value-added services aimed at
providing assessment and identification of a student's academic strengths and
weaknesses. WeHelpKids.com contains several direct links to the SmarterKids.com
website, which draws parents eager to support and encourage their children's
learning. The links are promoted through both a banner promotion and the NCS
ReportCard service. The NCS ReportCard service allows parents to enter the
results of their children's state standardized tests on WeHelpKids.com and
receive personalized product recommendations from SmarterKids.com's SmartPicks
system based on those test results. WeHelpKids has commenced this service as a
pilot program for Michigan standardized tests and intends to add tests and
services for tests given in other states. The agreement with NCS provides that
SmarterKids.com pay NCS a commission based upon a percentage of the gross margin
on sales generated by customers originating from WeHelpKids.com and expires in
March 2001 unless renewed. In connection with the establishment of its
promotional services relationship with NCS, SmarterKids.com issued to NCS
warrants to purchase 112,500 shares of SmarterKids.com common stock at an
exercise price of $1.33 per share. With the consent of NCS, SmarterKids.com
cancelled warrants to purchase 84,375 shares of  SmarterKids.com common stock in
November 2000. The remaining 28,125 warrants become exercisable upon the
achievement by NCS of certain milestones.

  Through programs managed by LinkShare, SmarterKids.com has relationships with
over 10,000 websites that feature links to SmarterKids.com in return for a
commission based on net sales that result from such referrals. These websites
range from online malls to individuals' websites. LinkShare recruits affiliates,
collect commissions from SmarterKids.com and pays the participating websites.

  Offline marketing is an increasingly important component of SmarterKids.com's
customer acquisition and branding efforts. SmarterKids.com advertises in a
variety of parenting-oriented and other magazines and through
direct mail and free-standing inserts.

  SmarterKids.com obtains products from a network of large and small vendors,
manufacturers and distributors. SmarterKids.com carries inventory of the
products available for sale on its website.  SmarterKids.com currently conducts
its distribution operations through one facility operated by SmarterKids.com,
consisting of approximately 139,000 square foot facility in Mansfield,
Massachusetts.

  SmarterKids.com sends orders from its website to its distribution facilities
over secure connections and warehouse management systems that optimize the pick,
pack and ship process. The warehouse management system provides the website with
data on inventory quantities, which enables SmarterKids.com to display
information about the availability of the products on its website.  The
management system also enables SmarterKids.com to offer a variety of gift wrap
choices, custom gift cards and custom to/from labels for each individual gift.
In addition, SmarterKids.com offers an order tracking service for its customers
on its website.

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<PAGE>

  SmarterKids.com offers three levels of shipping service in the United States:
standard, premium and express. SmarterKids.com has developed relationships with
United Parcel Service, the United States Postal Service and Federal Express to
maximize its overall service level to all 50 states and select international
locations.

Customer Service

  SmarterKids.com seeks to provide a customer experience that exceeds customer
expectations. Its goals include:

 .  prompt shipping;

 .  responding to all e-mail inquiries within the same day;

 .  maintaining a return rate of less than 1%; and

 .  maintaining at least 99% of inventory items in stock at any time.

  SmarterKids.com maintains a toll-free telephone customer service center
staffed with customer service representatives trained to assist customers with
product selection, order processing, shipping and billing and any other
questions or problems. SmarterKids.com trains its representatives to be
competent and courteous. SmarterKids.com gives representatives wide discretion
to ensure that customers are satisfied with their purchases and their purchasing
experience.

Technology

  SmarterKids.com has implemented a broad array of scalable systems for website
management, search, customer service, electronic transaction management and data
interchange, e-mail, order processing, payment processing, office administrative
services, and accounting. These systems use a combination of proprietary and
commercially-available technologies. SmarterKids.com focuses its internal
development efforts on creating and improving specialized software that is
unique and able to enhance its business. SmarterKids.com uses a set of
applications for:

 .  evaluating and reviewing products for eligibility in its store;

 .  accepting and validating customer orders;

 .  managing customer telephone and e-mail inquiries and requests for service;

 .  transmitting order and related information among our website, headquarters,
   and fulfillment locations;

 .  profiling customers' order histories and purchasing patterns;

 .  conducting and managing customer payment transactions; and

 .  interacting with its fulfillment center.

  SmarterKids.com develops or selects systems that are based on industry-
standard architectures that have been designed to minimize downtime in case of
outages or catastrophic occurrences. They provide 24-hours-a-day, seven-days-a-
week availability. The SmarterKids.com transaction processing methods and
databases are designed without arbitrary capacity constraints and are scalable
to any volume of demand that it expects to encounter. SmarterKids.com has
implemented load balancing systems and redundant servers to provide for fault
tolerance.

  Since September 1999, SmarterKids.com's systems infrastructure has been hosted
at Exodus Communications in Waltham, Massachusetts. Exodus provides redundant
communication lines from multiple providers, 24-hour monitoring and engineering
support, its own generators and multiple back-up systems. Exodus also maintains
private peering relationships. Private peering refers to a private network that
Exodus built with major Internet

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providers. Customers who connect through those service providers will be routed
faster through the private network and avoid the unpredictable performance of
the public Internet. SmarterKids.com pays, on average, approximately $22,000 in
fees to Exodus per month for the hosting services. In the months of November and
December these fees typically increase to approximately $27,000 to cover costs
associated with extra usage during the holiday season. The agreement will
continue to renew automatically for successive one-year terms unless it is
earlier terminated by either party. SmarterKids.com may terminate for cause,
including failure of Exodus to provide services for multiple or excessive
periods. Either SmarterKids.com or Exodus many terminate the agreement at will
after giving 90 days written notice. The contract contains no financial
penalties associated with its termination.

Competition

  SmarterKids.com believes that it is the only specialty education retailer
selling children's products exclusively over the Internet.  In the larger market
of children's educational products, SmarterKids.com competes against several
companies, which can be classified into the following groups:

 .  mass market retail chains, such as Kmart, Target and Wal-Mart;

 .  mass market book sellers, toy stores and computer hardware and software
   stores, such as Barnes & Noble, Toys "R" Us and CompUSA;

 .  traditional regional or local bookstores, toy stores and computer and
   software stores;

 .  traditional and online specialty educational retailers, such as Learning
   Express and Zany Brainy;

 .  online book sellers, toy sellers and computer software sellers, such as
   Amazon.com, KBkids.com, and Beyond.com; and

 .  educational catalog distributors, such as Scholastic.

  While SmarterKids.com believes that it is the only specialty education
retailer selling children's products exclusively over the Internet,  its market
share of the educational products market is less than those of many of its
competitors in each of the above categories.  SmarterKids.com believes that the
principal competitive factors in its market are:

 .  brand recognition and trust;

 .  ability to attract and retain consumers;

 .  breadth of product selection;

 .  product pricing;

 .  availability of educational and authoritative information; and

 .  quality and responsiveness of customer service.

  SmarterKids.com believes that in order to better compete on these factors, it
will need to continue to:

 .  build brand recognition as the brand matures:

 .  expand on its base of over 250,000 customers;

 .  expand its line of over 4,500 educational products;

 .  competitively price product offerings;

                                       10
<PAGE>

     . deliver education content; and

     . provide quality customer service.


Intellectual Property Rights

     SmarterKids.com regards the protection of its intellectual property as
critical to its future success and relies on a combination of copyright,
trademark, service mark and trade secret laws, license agreements and
contractual restrictions to establish and protect its proprietary rights in
SmarterKids.com website architecture and technology and services.
SmarterKids.com has a pending patent application relating to the SmartPicks
product selection algorithm it uses on its website. SmarterKids.com has entered
into confidentiality and invention assignment agreements with its employees and
contractors in order to limit disclosure of proprietary information and to
protect SmarterKids.com's ownership interest in its website architecture and
technology. SmarterKids.com cannot assure you that these contractual
arrangements or the other steps taken by it to protect its intellectual property
will prove sufficient to prevent misappropriation of its technology or deter
independent third-party development of similar technologies.

Employees

     As of December 31, 2000, SmarterKids.com had 98 full-time employees,
including 35 in marketing and sales, 16 in customer service, two in editorial
and education review, 20 in development and 25 in general and administrative. In
connection with the restructuring announced in the fourth quarter of 2000, 48 of
these employees have been given notice of termination, to be effective by June
30, 2001. From time to time, SmarterKids.com also employs independent
contractors to support these operational areas. The employees of SmarterKids.com
are not represented by a union and SmarterKids.com believes that its employee
relations are good.

ITEM 2.  PROPERTY

SmarterKids.com is headquartered in Needham, Massachusetts, where it leases an
office with approximately 39,152 square feet under a lease expiring in October
2004. SmarterKids.com believes that these facilities are adequate to meet its
current requirements and that suitable additional or substitute space will be
available as needed. In addition, since the second quarter of 2000,
SmarterKids.com has leased a 139,000 square foot distribution center in
Mansfield, Massachusetts under a lease expiring in March 2005. The
distribution center allows SmarterKids.com to better manage its fulfillment
process.

ITEM 3.  LEGAL PROCEEDINGS

     SmarterKids.com is not a party to any material legal proceedings, though
from time to time it may become a party to various legal proceedings arising in
the ordinary course of its business.


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

Not applicable.

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS'

SmarterKids.com's common stock is listed and traded on the Nasdaq National
Market under the symbol "SKDS." SmarterKids.com commenced its initial public
offering of common stock on November 23, 1999 at a price to the public of $14.00
per share. As of March 26, 2001, there were approximately 5,100 holders of
record of SmarterKids.com's common stock.

                                       11
<PAGE>

     The following table sets forth, for the periods indicated, the high and low
closing sales prices for the common stock as reported by the Nasdaq National
Market. The quotations represent interdealer quotations, without adjustments for
retail mark ups, mark downs, or commissions, and may not necessarily represent
actual transactions.

                                                                High       Low
                                                                ----       ---
Year ended December 31, 2000:
   January 1, 2000 through March 31, 2000...................  $ 8.375    $3.9375
   April 1, 2000 through June 30, 2000......................  $ 4.0625   $1.5000
   July 1, 2000 through September 31, 2000..................  $ 2.3125   $1.0625
   October 1, 2000 through December 31, 2000................  $ 2.125    $0.5812
Year ended December 31, 1999:
   November 23, 1999 through December 31, 1999                $15.3125   $6.5625

     On March 26, 2001, the last reported sale price of the common stock on the
Nasdaq National Market was $.75 per share.

SmarterKids.com has not paid any cash dividends on our common stock and
currently intends to retain any future earnings for use in our business.

Recent Sales of Unregistered Securities

During the fiscal year ended December 31, 2000, SmarterKids.com issued the
following securities that were not registered under the Securities Act of 1933,
as amended:

   (a) Issuances of Capital Stock

       None.

   (b) Issuance of Warrants.

     During the quarter ended June 30, 2000, the Company issued warrants for the
purchase of 16,667 shares of common stock with an exercise price of $3.00 per
share in connection with a $1.0 million three-year equipment line of credit
facility secured to TLP Leasing. The warrant is exercisable at any time at the
discretion of the warrantholder. The warrants have been valued and a discount of
$9,000 has been recorded on the lease obligation. The discount is being
amortized to interest expense over the life of the line of credit.

   (c) Grants and Exercises of Stock Options.

     From January 1, 2000 to December 31, 2000, the Company has granted stock
options to purchase 4,014,424 shares of common stock with an exercise price
ranging from $1.50 to $6.44 per share to employees, directors and consultants
pursuant to our 1999 Stock Plan. Options to purchase 2,325,574 shares of
SmarterKids.com common stock were repriced and are included in the total shares
granted.

     From January 1, 2000 to December 31, 2000, 326,414 options have been
exercised at a weighted average exercise price of $0.13 per share.

     No underwriters were involved in the foregoing sales of warrants and
options. Such sales were made in reliance upon an exemption from the
registration provisions of the Securities Act set forth in Section 4(2) thereof
relative to sales by an issuer not involving any public offering or the rules
and regulations thereunder, or, in the case of the exercise of options to
purchase common stock, Rule 701 under the Securities Act. All of the foregoing
securities are deemed restricted securities for purposes of the Securities Act.

Use of Proceeds

     On November 23, 1999, pursuant to a Registration Statement on Form S-1
(File No. 333-86787) the Company completed an initial public offering of
4,500,000 shares of common stock $.01 par value per share, at an initial public
offering price of $14.00 (5,175,000 shares including 685,500 over-allotment
shares and 16,500 shares officers by selling stockholders) resulting in net
proceeds to the Company of approximately $65.9 million. As of December 31, 2000,
SmarterKids.com has used $34.5 million of the offering proceeds for working
capital and approximately $31.4 million remain in cash and short-term
investments or were used for the purchase of temporary investments consisting of
cash equivalents and short-term investments.


                                       12
<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with our
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and financial statements and related notes. The statement of
operations and balance sheet data for all periods presented were derived from
our audited financial statements and related notes.


<TABLE>
<CAPTION>

                                                                                            Year Ended December 31,
                                                                              -----------------------------------------------------
                                                                                1996       1997        1998       1999        2000
                                                                              --------   --------    -------    --------    --------
                                                                                       (in thousands, except per share data)
<S>                                                                           <C>        <C>         <C>        <C>         <C>
Statement of Operations Data:
   Revenues..............................................................    $ 1,240    $ 1,416     $ 2,300   $  5,421     $ 10,206
   Gross profit..........................................................        833        925       1,372      1,416        2,286
   Loss from operations..................................................     (1,700)      (997)     (3,361)   (35,480)     (34,509)
   Net loss..............................................................     (1,649)    (1,014)     (3,342)   (34,728)     (32,674)
   Net loss attributable to common stockholders..........................     (1,649)    (1,081)     (3,596)   (34,917)     (32,674)
   Basic and diluted net loss per common share...........................    $ (1.10)   $ (0.72)    $ (2.34)  $  (9.20)       (1.59)
   Shares used to compute basic and diluted net loss per common share....      1,501      1,502       1,534      3,796     $  20,519


                                                                                                As of December 31,
                                                                              -----------------------------------------------------
                                                                                1996       1997        1998       1999        2000
                                                                              --------   --------    -------    --------    --------
                                                                                       (in thousands, except per share data)
<S>                                                                           <C>        <C>         <C>        <C>         <C>
Balance Sheet Data:
   Cash and cash equivalents.............................................    $   433   $   293     $  4,273  $ 55,621     $   17,557
   Short-term investments................................................          -         -            -    11,735         13,831
   Working capital.......................................................        333       110        3,066    60,126         25,293
   Restricted cash.......................................................        199         -            -       500          1,028
   Total assets..........................................................      1,470     1,145        5,504    82,335         43,688
   Long-term debt and capital lease obligations, net of current portion..        104        41            -        34            685
   Redeemable preferred stock............................................      3,251     4,011       10,287         -              -
   Stockholders' equity (deficit)........................................     (2,791)   (3,839)      (7,162)   63,634         32,753
</TABLE>


                                      13

<PAGE>

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

The following discussion contains forward-looking statements which involve risks
and uncertainties. SmarterKids.com makes such forward-looking statements under
the provision of the "Safe Harbor" section of the Private Securities Litigation
Reform Act of 1995. Any forward-looking statements should be considered in light
of the factors described below in this Item 7 under "Factors That May Affect
Future Results." Actual results may vary materially from those projected,
anticipated or indicated in any forward-looking statements. In this Item 7, the
words "anticipates," "believes," "expects," "intends," "future," "could," and
similar words or expressions (as well as other words or expressions referencing
future events, conditions, or circumstances) identify forward-looking
statements. The following discussion and analysis should be read in conjunction
with "Selected Financial Data" and the accompanying financial statements and
related notes included elsewhere in this Annual Report on Form 10-K.


Overview

     SmarterKids.com is an online retailer focused exclusively on children's
educational books, toys and games, software, mucic and video, and school
supplies.

     From inception through March 1998, SmarterKids.com's activities consisted
primarily of the conception, development, publishing, marketing and sales of its
proprietary educational and entertainment CD-ROM software. In March 1998,
SmarterKids.com determined that the sale of third-party products over the
Internet provided a better opportunity to attain scale and profitability that
was not attainable in the CD-ROM market and that due to its popularity, use of
the Internet as a means to sell products and services was the next step in the
development of the company. SmarterKids.com then began transitioning its
business model to online sales of third-party educational products and commenced
development of the SmarterKids.com website. In November 1998, SmarterKids.com
launched its website, discontinued the sale of its proprietary CD-ROM products
through traditional retail channels and began offering its proprietary CD-ROM
products on a limited basis through SmarterKids.com's online channel.

     While SmarterKids.com's online retail revenues have grown since launching
its website, over the same period, marketing and sales expenses increased
significantly as a result of SmarterKids.com's promotional activities.
SmarterKids.com expects that the rate at which it incurs losses will depend on
the extent it continues to incur additional expenses to advertise and promote
its website, expand its product offerings and website content, enhance and
upgrade its website and other systems, expand its fulfillment capabilities and
hire additional personnel.

     Prior to November 1998, revenues consisted solely of sales of
SmarterKids.com's proprietary CD-ROM products and were recognized upon shipment,
net of return allowances as determined by historical trends of actual returns.
Cost of revenues consisted primarily of production and shipping costs. Marketing
and sales expenses consisted primarily of promotions and advertising of
SmarterKids.com's products through national computer software retailers.
Development costs consisted primarily of compensation for employees developing
SmarterKids.com's proprietary CD-ROM software. General and administrative costs
consisted primarily of compensation for employees and professional fees.

     Revenues in 1999 and 2000 consisted of online sales of third-party
educational products and charges to customers for shipping. Also included in
fiscal 1999 and 2000 revenues are sales of our proprietary CD-ROM products,
which are offered on a limited basis. The revenue in fiscal 2000 also includes
previously deferred revenue related to gift certificates sold to a third party
in 1999, which expired unused. In each of the years ended December 31, 1999 and
2000, SmarterKids.com derived approximately 2% of its revenues from outside of
the United States. Revenues are recognized when the products are received by
customers and are net of promotional discounts, coupons and return allowances,
which are determined by historical trends of actual returns. Under
SmarterKids.com's online retail business model, its actual returns and therefore
its allowance for returns are lower than the returns from its historical CD-ROM
business which utilized an indirect sales channel. The provision for write-offs
and returns in 1998 and, almost entirely, in 1999 were related to the historical
CD-ROM business and the provision for write-offs and returns in 2000 were
related only to the online retail business. The decline in product returns was
due to the change in the primary sales channel. Under SmarterKids.com's online
retail business model

                                       14
<PAGE>

products are sold directly to consumers. Under the historical CD-ROM business,
products were sold to distributors, who were able to return unsold products. The
returns from distributors were in bulk quantities. Cost of revenues consisted
primarily of the cost of products sold to customers and SmarterKids.com's
shipping costs. SmarterKids.com anticipates that its gross margins will
fluctuate from quarter to quarter depending on consumer preferences for its mix
of products.

     Marketing and sales expenses consisted primarily of the cost of advertising
and promotional activities, fulfillment services fees to J.L. Hammett Co.
through July 1, 2000 and costs to operate SmarterKids.com's own distribution
facility thereafter, commissions to online marketing companies, and expenses for
personnel engaged in marketing, merchandising and customer service activities.
Fulfillment fees paid to J.L. Hammett Co. were based on a percentage of the cost
to SmarterKids.com of its products. This percentage was fixed and did not vary
with the prices of SmarterKids.com's products. Commissions to online marketing
companies are based on a percentage of revenues generated through these
relationships. Approximately 5% and 10% of SmarterKids.com's revenues in the
years ended December 31, 1999 and 2000, respectively, were derived from these
relationships.

     Development expenses consisted primarily of payroll and related costs for
personnel performing website design, development, testing, technology
maintenance and content maintenance. SmarterKids.com believes that continued
investment in website development and maintenance is critical to attaining its
strategic objectives.

     General and administrative expenses consisted primarily of payroll and
related costs for executive and administrative personnel, professional service
expenses and other general corporate expenses. In November 1999, SmarterKids.com
incurred a one-time cost of $861,000 in connection with the settlement and legal
expenses of a patent infringement lawsuit, which cost was included in general
and administrative expenses for the quarter and year ended December 31, 1999.

     Restructuring charges consisted of employee termination benefits related to
the SmarterKids.com's approved and implemented restructuring program. The
restructuring program has been undertaken in order to reduce operating expenses
in the SmarterKids.com's business and is expected to be completed in June 2001.
The program included a net reduction of 60% of SmarterKids.com's workforce.
Accordingly, during the fourth quarter of 2000, SmarterKids.com recorded a
charge of $1.3 million related to employee termination benefits. As of
December 31, 2000, $61,000 has been paid out and approximately $1.2 million
remains outstanding.

     Interest income consists primarily of interest earned on capital invested
in commercial paper, corporate and treasury notes. Interest expense is related
to short-term lease obligations and borrowings under our equipment lines of
credit. Also included in other expense in fiscal 2000 are transaction expenses
of $693,000 related to our proposed combination with Earlychildhood. The
transaction expenses consist primarily of legal, accounting, and investment
banking fees.

     With respect to SmarterKids.com's need to attract, retain and motivate
qualified employees and certain marketing and service providers, since September
1995, SmarterKids.com has provided them with equity-based compensation. Stock
compensation expenses represent non-cash charges related to stock options and
warrants given to employees and directors, consultants, J.L. Hammett Co. and
NCS. For employee and director grants, the compensation charge reflects the
difference between the exercise price of the options and the estimated fair
value of the underlying common stock on the date of the grant. This compensation
charge is deferred initially and amortized to expense over the vesting period of
the applicable options. For non-employee grants, the compensation charge
reflects the fair value of the options and warrants on the initial measurement
date (typically the date of grant for those exercisable immediately or with
fixed vesting periods, or the date when vesting becomes fixed for those with
variable vesting periods), as well as subsequent re-measurements of such fair
value until the options and warrants vest. Accordingly, SmarterKids.com cannot
currently estimate additional charges related to future re-measurement of
unvested non-employee options and warrants. SmarterKids.com may in the future
grant additional equity-based compensation to non-employees to secure marketing
or other service relationships. As of December 31, 2000, $3.4 million of
deferred stock compensation remained to be amortized to expense, generally over
the next three years, for stock options and warrants granted through
December 31, 2000.

     The market for children's educational books, toys and games, software,
music and video and school supplies is highly seasonal. Accordingly,
SmarterKids.com expects to experience seasonal fluctuations in its

                                       15
<PAGE>

revenues. In particular, SmarterKids.com expects a disproportionate amount of
its revenues to be realized during the fourth quarter of each calendar year,
coinciding with the holiday shopping season.


Results of Operations

                                                           Year Ended
                                                          December 31,
                                                  -----------------------------
                                                   1998       1999       2000
                                                  -------   --------   --------
                                                         (in thousands)
Net revenues:
     Online retail...........................     $    22   $  5,421   $ 10,206
     Propriertary CD-ROM.....................       2,278         --         --
                                                  -------   --------   --------
          Total net revenues.................       2,300      5,421     10,206
                                                  -------   --------   --------
Cost of revenues:
     Online retail...........................          20      4,005      7,920
     Propriertary CD-ROM.....................         908         --         --
                                                  -------   --------   --------
          Total cost of revenues.............         928      4,005      7,920
                                                  -------   --------   --------
     Gross profit............................       1,372      1,416      2,286
                                                  -------   --------   --------

Operating expenses:
     Marketing and sales.....................       2,769     30,132     28,641
     Development.............................       1,438      2,864      3,034
     General Administrative..................         526      3,900      3,820
     Restructuring costs.....................          --         --      1,300
                                                  -------   --------   --------
          Total operating expenses...........       4,733     36,896     36,795
                                                  -------   --------   --------
     Loss from operations....................      (3,361)   (35,480)   (34,509)
     Interest and other income (expense),
       net...................................          19        752      1,835
                                                  -------   --------   --------
     Net loss................................     $(3,342)  $(34,728)  $(32,674)
                                                  =======   ========   ========

Years Ended December 31, 1998, 1999 and 2000

     Revenues.  Revenues were $2.3 million, $5.4 million and $10.2 million in
the years ended December 31, 1998, 1999 and 2000, respectively. The increase in
revenue from 1998 to 1999 was primarily attributable to the transition of our
business model to online sales of third-party educational products and reflected
the results of our significant marketing efforts. The increase in revenue from
1999 to 2000 resulted from further marketing efforts and brand-building during
the more recent periods, including an increased base of repeat customers, as
well as revenue recognized from expired gift certificates. In fiscal 2000, we
recognized $604,000 of previously deferred gift certificate revenue on gift
certificates expiring unused.

     Cost of revenue.  Cost of revenues consists primarily of the cost of
products sold to customers and the cost of shipping products to our customers.
SmarterKids.com anticipates that its gross margins will fluctuate from year to
year depending on consumer preferences for its mix of products. The cost of
revenues was $928,000, $4.0 million and $7.9 million in fiscal year 1998, 1999
and 2000, respectively. During fiscal year 2000, the SmarterKids.com recorded an
inventory obsolescence charge of $477,000 for primarily software products held
in inventory. The increase in cost of revenues from 1998 to 1999 was
attributable to the increase in online sales of third-party educational
products. The increase in cost of revenues from 1999 to 2000 was principally
attributable to growth in online sales. SmarterKids.com's gross margin decreased
from 59.7% in 1998 to 26.1% in 1999, as a result of the new online retail
business model. SmarterKids.com's gross margin decreased from 26.1% in 1999 to
22.4% in 2000 due to slightly lower gross margins on new products introduced,
obsolescence charges and increased freight charges.

     Marketing and sales.  Marketing and sales expenses consist primarily of the
cost of advertising and promotional activities, fulfillment costs, commissions
to online marketing companies, expenses for personnel engaged in marketing,
merchandising activities, and stock compensation expense. Fulfillment costs
represent costs incurred in operating and staffing the distribution center and
the customer service department, picking and packing customers' orders for
shipment, responding to inquires from customers, credit card fees, as well as
fees paid to J.L. Hammett Co., a fulfillment partner during fiscal 1999 and the
first six months of 2000. As of July 1, 2000,

                                       16
<PAGE>

SmarterKids.com discontinued using J.L. Hammett Co. as a third party fulfillment
partner due to the opening of its own distribution facility.

     Marketing and sales expenses were $2.8 million, $30.1 million and $28.6
million in the years ended December 31, 1998, 1999, and 2000, respectively.
Included in marketing and sales expenses was stock compensation of $91,000, $1.2
million, and $1.6 million in the years ended December 31, 1998, 1999 and 2000,
respectively. Advertising expenses for 1998, 1999 and 2000 were $1,154,000,
$21,314,000 and $11,469,000, respectively. The increase from 1998 to 1999 was
primarily attributable to the initiation of SmarterKids.com's advertising
campaigns and promotional activities, fees to its fulfillment partner, J.L.
Hammett Co., as well as the hiring of additional employees, related expenses
required to implement its new Internet business model and stock compensation
related to options granted to employees. The increase from 1999 to 2000 was
primarily attributable to fees to SmarterKids.com's previous fulfillment
partner, J.L. Hammett Co., and the hiring of employees to staff the distribution
center, which opened for operations July 1, 2000.

     Fulfillment costs included in marketing and sales expense were $1.5 million
and $4.6 million for the years ended December 31, 1999 and 2000, respectively.
Due to the nature of the business related to selling proprietary CD-ROM
products, fulfillment costs of $52,000 were included in cost of goods for the
year ended 1998.

     In September 2000, the Emerging Issues Task Force (EITF) reached a final
consensus on EITF Issue 00-10, "Accounting for Shipping and Handling Fees and
Costs." This consensus states that all amounts billed to a customer in a sale
transaction related to shipping and handling, if any, represent revenue and
should be classified as revenue. SmarterKids.com already classifies shipping
charges to customers as revenue. With respect to the classification of costs
related to shipping and handling incurred by the seller, including fulfillment
costs, the EITF determined that the classification and amount of such costs is
an accounting policy decision that should be disclosed. SmarterKids.com
classifies fulfillment costs in marketing and sales expenses. These costs are
primarily composed of distribution facility expenses, including equipment and
supplies, payroll and expenses for personnel engaged in distribution activities,
third party fulfillment fees, credit card fees and the costs of customer
support. These costs represent facility costs necessary for warehousing
inventory, as well as costs incurred to pick and pack a customer order and the
related packaging supplies.

     Development.  Development expenses consist primarily of payroll and related
costs for personnel performing website design, development, maintenance, testing
and stock compensation. Development expenses were $1.4 million, $2.9 million and
$3.0 million in the years ended December 31, 1998, 1999 and 2000, respectively.
Included in development expenses was stock compensation expense/(credits) of
$60,000, $1.1 million and ($323,000) in the years ended December 31, 1998, 1999
and 2000, respectively. Development costs related strictly to website
development efforts were $432,000, $2.9 million and $3.0 million in the years
ended December 31, 1998, 1999 and 2000, respectively. The increase from 1998 to
1999 was attributable primarily to costs related to maintaining, testing and
enhancing the features, content and functionality of the SmarterKids.com
website, the hiring of additional employees, as well as stock compensation
related to options granted to employees. The increase from 1999 to 2000 was
attributable primarily to costs related to maintaining, testing and enhancing
the features, content and functionality of the SmarterKids.com website and the
hiring of additional employees.

     General and administrative.  General and administrative expenses consist
primarily of payroll and related costs for executive and administrative
personnel, professional service expenses and other general corporate expenses.
General and administrative expenses were $526,000, $3.9 million and $3.8 million
in the years ended December 31, 1998, 1999 and 2000, respectively. Included in
general and administrative expenses was stock compensation of $36,000, $1.0
million, and $590,000 in the years ended December 31, 1998, 1999 and 2000. The
increase from 1998 to 1999 was attributable primarily to hiring additional
employees as SmarterKids.com expanded its operations and infrastructure to
support future growth, the transition to being a public company and stock
compensation related to options granted to employees. In November 1999,
SmarterKids.com also incurred a one-time cost of $861,000 in connection with the
settlement and related legal expenses of a patent infringement lawsuit, which
cost was included in general and administrative expenses in the quarter ending
December 31, 1999. The increase from 1999 to 2000 was attributable primarily to
the costs related to the expansion of SmarterKids.com's operations and
infrastructure, as well as the hiring of additional employees.

                                       17
<PAGE>

     Stock compensation.  With respect to stock options granted to employees, we
recorded deferred stock compensation of $1.5 million, $5.7 million and zero, and
amortized $81,000, $2.2 million and $1.3 million of stock compensation as an
expense in 1998, 1999 and 2000, respectively. SmarterKids.com recorded
additional stock compensation of $106,000, $1.2 million and $110,000 as an
expense in the years ended December 31, 1998, 1999 and 2000, respectively,
related to options and warrants granted to non-employees. SmarterKids.com
expects to amortize approximately $1.3 million for each of the next three years
based on the current vesting periods and remaining deferred compensation. The
balance of deferred stock compensation related to options and warrants granted
to non-employees representing 28,125 shares of common stock was $4,000 at
December 31, 2000. All other non-employee grants were fixed as of December 31,
2000. For non-employee grants, the compensation charge reflects the fair value
of the options and warrants on the initial measurement date (typically the date
of grant for those exercisable immediately or with fixed vesting periods, or the
date when vesting becomes fixed for those with variable vesting periods), as
well as subsequent re-measurements of such fair value until the options and
warrants vest. Accordingly, SmarterKids.com cannot currently estimate additional
charges related to future re-measurement of unvested non-employee options and
warrants.

     During the second quarter of 2000, SmarterKids.com opened its own
distribution center and discontinued using J.L. Hammett Co. as its fulfillment
partner. In connection with this termination, the remaining deferred
compensation of $1,207,000 was expensed in the year ended December 31, 2000.

     On September 7, 2000, SmarterKids.com completed a direct repricing of
certain employee stock option grants. As part of the repricing, SmarterKids.com
reduced the exercise price of all outstanding options with exercise prices of
greater than $1.50 per share. The new exercise price of these repriced options
was reset to $1.50 per share, which was equal to the market value of the common
stock on September 7, 2000. Options to purchase 2,325,574 shares of
SmarterKids.com common stock were repriced. SmarterKids.com is accounting for
the repriced options as a variable award. In the year ended December 31, 2000,
SmarterKids.com did not record any additional non-cash stock compensation
charges as a result of this repricing since the market price of the common stock
at December 31, 2000 was less than the repriced exercise price.

     Restructuring charges.  During the fourth quarter of 2000, SmarterKids.com
approved and implemented a restructuring program in order to reduce operating
expenses. The restructuring plan is expected to be completed by June 2001. The
program included a net reduction of 60% of its workforce. Accordingly, during
the fourth quarter of 2000, SmarterKids.com recorded a charge of $1.3 million
related to employee termination benefits. As of December 31, 2000, $61,000 has
been paid out and $1.2 million remains outstanding. This restructuring is
expected to generate annual operating expense savings of approximately $4.4
million.

     Interest income and expense, other income and expense.  Interest income
consists primarily of income earned on capital invested in commercial paper,
corporate and treasury notes and auction rates and by interest expense related
to short-term lease obligations and borrowings under SmarterKids.com's equipment
lines of credit. Other expense in fiscal 2000 includes merger expenses related
to our proposed combination with Earlychildhood. The merger expenses consist
mainly of legal, accounting, and investment banking fees. Interest income
increased from $41,000 in 1998 to $732,000 in 1999. Interest income increased
from $732,000 in 1999 to $2.8 million in 2000. Both of the increases were
primarily attributable to an increase in interest income generated from higher
balances of capital invested in commercial paper, corporate and treasury notes
and auction rates. The higher balances of capital were generated from
SmarterKids.com's initial public offering of common stock. SmarterKids.com plans
to continue to invest in held-to-maturity securities, which are conservative in
nature. Interest expense was $18,000, $16,000 and $144,000 in fiscal 1998, 1999
and 2000, respectively. The increase in interest expense from 1999 to 2000 was
primarily attributable to borrowings under SmarterKids.com's equipment lines of
credit, which were secured in fiscal 2000. Other expense in fiscal 2000 includes
$693,000 in transition expenses related to the proposed combination with
Earlychildhood.

                                       18
<PAGE>

Selected Quarterly Results of Operations

     The following table sets forth selected unaudited statement of operations
data for the eight quarters in the period ended December 31, 2000.

<TABLE>
<CAPTION>
                                                                      Quarter Ended (in thousands)
                                    -----------------------------------------------------------------------------------------------
                                      Mar. 31,   June 30,   Sept. 30,    Dec. 31,    Mar. 31,     June 30,    Sept. 30,    Dec. 31,
                                       1999        1999       1999         1999       2000         2000        2000         2000
                                    -----------------------------------------------------------------------------------------------
                                                                       (unaudited, in thousands)
<S>                                 <C>        <C>         <C>         <C>          <C>         <C>         <C>          <C>
Net Revenue:
  Online retail..................... $     94   $    293   $     721   $    4,313   $   1,469   $   1,528   $   1,507    $   5,702
  Proprietary CD-Rom................        -          -           -            -           -           -           -            -
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
    Total net revenues..............       94        293         721        4,313       1,469       1,528       1,507        5,702
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
Cost of revenues:
  Online retail.....................       69        210         516        3,210       1,101       1,149       1,136        4,534
  Proprietary CD-Rom................        -          -           -            -           -           -           -            -
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
    Total cost of revenues..........       69        210         516        3,210       1,101       1,149       1,136        4,534
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
  Gross profit......................       25         83         205        1,103         368         379         371        1,168
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
Operating expenses:
  Marketing and sales...............    2,063      3,723       5,447       18,897       7,600       7,442       6,330        7,269
  Development.......................      572        471       1,008          756         655         693         960          726
  General and administrative........      294        332         845        2,488       1,072         982         891          875
  Restructuring costs...............        -          -           -            -           -           -           -        1,300
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
    Total operating expenses........    2,929      4,526       7,300       22,141       9,327       9,117       8,181       10,170
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------
  Loss from operations..............   (2,904)    (4,443)     (7,095)     (21,038)     (8,959)     (8,738)     (7,810)      (9,002)
Interest and other income
 (expense), net.....................       24         28         248          452         828         654         555         (202)
                                     --------   --------   ---------   ----------   ---------   ---------   ---------    ---------

  Net loss.......................... $ (2,880)  $ (4,415)  $  (6,847)  $  (20,586)  $  (8,131)  $  (8,084)  $  (7,255)   $  (9,204)
                                     ========   ========   =========   ==========   =========   =========   =========    =========
  Basic and diluted net loss per
   share attributable to common
   stockholders.....................    (1.77)     (2.66)      (3.52)       (2.10)      (0.40)      (0.39)      (0.35)       (0.45)
</TABLE>


Liquidity and Capital Resources

     Since inception, SmarterKids.com has incurred significant losses.
SmarterKids.com has met its cash requirements primarily through the sale of
capital stock and the use of lines of credit and capital leases. SmarterKids.com
has received capital from investors in three private venture capital financings
totaling $37.0 million through July 1999. On November 23, 1999, SmarterKids.com
completed an initial public offering of 4,500,000 shares of common stock
resulting in net proceeds of $65.9 million. The primary purposes of the initial
public offering were to increase SmarterKids.com's capitalization and financial
flexibility, create a public market for SmarterKids.com's common stock, and
facilitate future access to public markets. As of December 31, 2000,
SmarterKids.com has used $34.5 million of the offering proceeds for working
capital.

     Net cash used in operating activities was $2.0 million, $25.0 million and
$31.9 million in the years ended December 31, 1998, 1999 and 2000, respectively.
The increase in cash used in operating activities from 1998 to 1999 was
primarily attributable to increased expenses associated with launching and
promoting SmarterKids.com's new website and retail Internet business. The
increase in cash used in operating activities from 1999 to 2000 was primarily
attributable to larger net loss and accounts payable payments to vendors for
inventory, advertising expenses and the build-out of SmarterKids.com's new
distribution center. Accounts payable consist primarily of payments owed to
vendors for inventory, fixed assets, advertising and goods and services.
SmarterKids.com expects its operating cash requirements to decrease as a result
of its restructuring commenced in the fourth quarter of 2000, including reduced
employee levels and significantly reduced spending on marketing activities.

     Net cash used in investing activities has been primarily for purchases of
fixed assets and short-term investments. Cash used in investing activities was
$33,000, $14.9 million and $7.2 million in the years ended December 31, 1998,
1999 and 2000, respectively. The increase in cash used in investing activities
from 1998 to 1999 was primarily attributable to increased purchases of equipment
and the purchase of short-term investment of $11.7 million. The

                                       19
<PAGE>

increase in cash used in investing activities from 1999 to 2000 was primarily
attributable to increased purchases of equipment for the build-out of
SmarterKids.com's new distribution facility and the purchase of short-term
investments.

     Net cash provided by financing activities was $6.0 million, $91.3 million
and $995,000 in the years ended December 31, 1998, 1999 and 2000, respectively.
Net cash provided by financing activities in the year ended December 31, 1998
consisted primarily of net proceeds of $6.1 million from the issuance of Series
B redeemable preferred stock. Net cash provided by financing activities in the
year ended December 31, 1999 primarily reflects the net proceeds of $65.9
million from SmarterKids.com's initial public offering and $25.3 million from
the issuance of Series C redeemable preferred stock. Net cash provided by
financing activities in the year ended December 31, 2000 primarily reflects the
net proceeds of $1.6 million from equipment lines of credit.

     During the first quarter of 2000, SmarterKids.com entered into a $1.5
million three-year equipment line of credit facility. Equipment collateralized
under this agreement approximates $1.5 million at December 31, 2000. The
interest on the agreement is equal to the three-year U.S. Treasury rate plus
3.5%. SmarterKids.com is making payments on this credit facility of $45,000 per
month.

     During the second quarter of 2000, SmarterKids.com entered into a lease
agreement for a 140,000 square foot distribution center in Mansfield,
Massachusetts. The distribution center allows it to better manage its
fulfillment process. As a result, SmarterKids.com discontinued using J.L.
Hammett Co. as its fulfillment partner during the second quarter of 2000. The
five-year operating lease for the warehouse will require minimum payments of
approximately $900,000 per year.

     As of December 31, 2000, SmarterKids.com had $17.6 million of cash and cash
equivalents, $13.8 million of short-term investments, and $1.0 million of
restricted cash. As of that date, SmarterKids.com's principal commitments
consisted of obligations outstanding under an equipment lines of credit and
capital leases in the amount of $1.2 million, commitments for annual facility
lease obligations of $2.0 million, and accounts payable of $5.1 million.

     SmarterKids.com currently anticipates that current cash, cash equivalents
and short-term investments will be sufficient to meet its anticipated needs for
working capital and capital expenditures through the next twelve months.
SmarterKids.com anticipates that it is likely to need additional financing to
execute its business model after the twelve months, or sooner if it needs to
respond to business contingencies such as lower-than-anticipated revenues,
funding additional advertising expenditures, developing new or enhancing
existing content, features or services, enhancing its operating infrastructure,
responding to competitive pressures, or acquiring complementary businesses or
technologies. SmarterKids.com has transitioned customer order fulfillment to its
own distribution facility during the second quarter in 2000. In conjunction with
this transaction, SmarterKids.com invested capital for the infrastructure to
support these fulfillment activities at the new distribution facility. If
SmarterKids.com raises additional funds through the issuance of equity or
convertible debt securities, the percentage ownership of SmarterKids.com's
stockholders may be reduced, and these newly issued securities may have rights,
preferences or privileges senior to those of existing stockholders.
SmarterKids.com cannot be certain that additional financing will be available to
it on favorable terms when required, or at all.

Recent Accounting Pronouncements

     In December 1999, the SEC staff released Staff Accounting Bulletin ("SAB")
101, "Revenue Recognition in Financial Statements", which provides guidance on
the recognition, presentation and disclosure of revenue in financial statements.
As required, the Company adopted SAB 101 in the fourth quarter of 2000. The
adoption of SAB 101 had no material impact on the Company's financial
statements.

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which

                                       20
<PAGE>

was issued in June 2000. The Company will adopt SFAS No. 133 in the first
quarter of2001. SFAS No. 133 requires that all derivative instruments be
reported on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. The Company does not
expect adoption of SFAS No. 133 to have a significant impact on its financial
condition, results of operations, or business practices.

     In March 2000, the Emerging Issues Task Force ("EITF") of the FASB reached
a consensus on EITF Issue 00-2, "Accounting for Web Site Development Costs."
This consensus provided guidance on what types of costs incurred to develop web
sites should be capitalized or expensed. The Company adopted this consensus on
July 1, 2000. The adoption of this consensus had no material impact on the
Company's financial statements.

FACTORS THAT MAY AFFECT FUTURE RESULTS

Our business is difficult to evaluate because we have been operating under our
new business model for less than two years. Our market may not develop as
anticipated, and we may not successfully execute our business strategy.

     We have a limited operating history upon which you can evaluate our
business. We did not launch the SmarterKids.com website and begin selling
children's educational products online until November 1998. In addition, most of
our management team was hired within the last two years. From inception through
March 1998, our activities consisted primarily of the conception, development,
publishing, marketing and sales of proprietary educational and entertainment CD-
ROM software. In March 1998, we began transitioning our business model to online
sales of third-party educational products. In November 1998, we launched our
website, ceased the sale of our proprietary CD-ROM products through traditional
retail channels and now offer our proprietary CD-ROM products on a limited basis
through our online channel.

     We cannot be certain that our business strategy will be successful or that
we will successfully address these and other challenges, risks and
uncertainties.

Our limited operating history makes forecasting difficult. We may be unable to
adjust our spending in a timely manner to compensate for any unexpected revenue
shortfall.

     As a result of our limited operating history with our current business
model introduced in November 1998, it is difficult to accurately forecast future
revenues. Also, we have limited meaningful historical financial data upon which
to base planned operating expenses. We base our current and future expense
levels on our operating plans and estimates of future revenue. Revenue and
operating results are difficult to forecast because they generally depend on the
volume and timing of the orders we receive. As a result, we may be unable to
adjust our spending in a timely manner to compensate for any unexpected revenue
shortfall, which would result in further substantial losses. We may also be
unable to expand our operations in a timely manner to adequately meet customer
demand to the extent it exceeds our expectations.

If we do not complete the proposed combination with Earlychildhood LLC, it could
negatively impact us and the price of our common stock.

     We are party to a Contribution Agreement and Plan of Reorganization and
Merger with Earlychildhood LLC, LearningStar Corp. and S-E Educational Merger
Corp. This contribution agreement provides for our combination with
Earlychildhood and the formation of a new holding company, LearningStar.
Pursuant to this Contribution Agreement, the combination of SmarterKids.com and
Earlychildhood will be effected by (1) the merger of S-E Educational Merger
Corp. with and into SmarterKids.com such that SmarterKids.com becomes a wholly
owned subsidiary of LearningStar, and (2) the contribution of all the
outstanding membership interests in Earlychildhood to LearningStar, such that
Earlychildhood becomes a wholly owned subsidiary of LearningStar. This
transaction is more fully described in the proxy statement mailed to our
stockholders on March 19, 2001. We have called a special meeting of our
stockholders on April 9, 2001 for the purpose of approving and adopting the
Contribution Agreement and the combination that it proposes. If the combination
with Earlychildhood is not completed, we may be subject to a number of material
risks, including the following:

     .  we may be required to pay Earlychildhood a termination fee of $1,300,000
        or reimburse Earlychildhood's out-of-pocket expenses incurred in
        connection with the combination up to a maximum of $350,000;

     .  to the extent that the current market price of our common stock reflects
        a market assumption that the combination will be completed and that the
        value of LearningStar will be greater than our value on a stand-alone
        basis, the market price of our common stock may decline; and

     .  we must pay certain costs related to the transaction, such as legal and
        accounting fees and expenses and financial advisor expenses, even if the
        combination is not completed.

We have a history of losses, and we expect to incur substantial net losses in
the future. If we do not achieve profitability, our financial condition and our
stock price could suffer.

     Since inception, we have incurred significant losses. As of December 31,
2000, we had an accumulated deficit of $75.9 million. We incurred a net loss of
$32.7 million for the year ended December 31, 2000. We expect operating losses
and negative cash flow to continue for the foreseeable future.

     Our ability to become profitable depends on our ability to generate and
sustain higher revenue while maintaining reasonable expense levels. We
anticipate sales growth will moderate during the remainder of the year as we
reduce our marketing investment and focus on those programs that bring us the
most loyal customers. Our focus is on cost-effective top line growth, attracting
the most profitable traffic, new customer acquisition, and reaching

                                       21
<PAGE>

profitability. These efforts may not be effective in converting a large number
of customers from traditional shopping methods to online shopping for
educational products and services or attracting online customers to our website.
In addition, we are obligated to pay commissions based on a percentage of
revenue to companies with which we have online marketing relationships. Through
May 2000, we paid our fulfillment services provider, J.L. Hammett Co., a fee
based on a fixed percentage of the costs of our products to us and will incur
operating expenses related to fulfillment activities in our new distribution
center that opened in June 2000. Some of these costs will increase as our
revenues and orders increase. If we do achieve profitability, we cannot be
certain that we will be able to sustain or increase profitability on a quarterly
or annual basis in the future.

We expect our quarterly operating results to fluctuate. If we fail to meet the
expectations of public market analysts and investors, the market price of our
common stock will decline.

     If our quarterly revenue or operating results fall below investor or
securities analyst expectations, our stock price could fall substantially. The
Company's operating results may fall below investor or analyst expectations
irregardless of the Company's success or profitability. Factors that may cause
our operating results to fluctuate include:

          .  decreases in the number of visitors to our website or our inability
             to convert visitors on our website to customers

          .  the mix of children's educational books, toys and games, and
             software sold by us

          .  seasonality due to the academic year and holiday season

          .  our inability to manage supplier or distributor relationships

          .  price competition

          .  an increase in the level of product returns

          .  increases in the cost of advertising

          .  the amount and timing of operating costs and capital expenditures
             relating to expansion of our operations

          .  unexpected increases in shipping costs and delivery times,
             particularly during the holiday season

          .  technical difficulties or system interruptions

     In addition, general economic conditions and fluctuations in the demand for
children's educational product, over which we have no control, may also cause
our operating results to fluctuate.

     Many of the other risk factors listed in this Annual Report on Form 10-K
may negatively affect our quarterly operating results and contribute to
fluctuations. Our limited operating history makes it difficult to assess the
impact of these factors on our operating results. Because of this difficulty in
predicting future performance, our operating results will likely fall below the
expectations of securities analysts or investors in some future quarter or
quarters, which would likely adversely affect the market price of our common
stock .

Our market is highly seasonal and may cause our operating results to fluctuate
from quarter to quarter. Our annual results are highly dependent on the success
of our holiday selling season.

     The market for children's educational books, toys and games, and software
is highly seasonal increasing significantly during the holiday season. In
addition, Internet usage generally declines in the summer. Accordingly, we
expect to experience seasonal fluctuations in our revenue. In particular, we
expect a disproportionate amount of our revenue to be realized during any
quarter of each calendar year. If for any reason our revenue is below

                                       22
<PAGE>

expectations during the fourth quarter, our annual operating results would be
adversely affected. In the future, our seasonal sales patterns may become more
pronounced, may strain our personnel and fulfillment relationships and may cause
a shortfall in revenue as compared to expenses in a given period. These seasonal
patterns will cause quarterly fluctuations in our operating results and could
adversely affect our financial performance.

We pay commissions to companies with which we have online marketing
relationships. Our profits as a percentage of revenues will decrease as the
proportion of our revenues from these arrangements increases.

     Our relationships with online companies are intended to drive traffic to
our website. Approximately 10% of our revenues in the year ended December 31,
2000 was derived from these relationships. We pay commissions to these companies
based on a percentage of the revenues we derive from these relationships.
Although these relationships are intended to increase the number of our
customers and, therefore, our revenues, as revenues derived from these
relationships increases, our profit as a percentage of revenues will decrease.

We face significant inventory risks because consumer demand can change for
products that we have in inventory or on order.

     The demand for certain products can change what we have in inventory or on
order. As a result, we may own inventory that may become obsolete if customer
orders do not materialize. This risk may be greatest in the first calendar
quarter of each year, after we have significantly increased our inventory levels
for the prior holiday season. This risk will increase as we enter into new
product categories due to our lack of experience in purchasing products for
these categories. In addition, to the extent that demand for our products
increases over time, we may be forced to increase inventory levels. Any such
increase would subject us to additional inventory risks.

The inability to perform our own distribution services could lead to
interruptions in our operations, lost revenues and increased expense.

     In June 2000, we moved our order fulfillment from a third party partner,
J.L. Hammett Co., to our own distribution facility in Mansfield, Massachusetts.
Our inability to manage our distribution center could lead to interruptions in
our operations, lost revenues and increased expense.

Our business relies on our ability to obtain sufficient quantities of quality
merchandise on acceptable commercial terms.

     Vendors may stop selling merchandise to us and we may not be able to secure
identical or comparable merchandise from alternative vendors in a timely manner
or on acceptable terms. From time to time, we expect to experience difficulty in
obtaining sufficient quantities of certain products. If we cannot supply our
products to consumers at acceptable prices, we may lose sales and market share
as consumers make purchases elsewhere. Further, an increase in supply costs
could increase operating losses beyond current expectations.

Intellectual property claims against us can be costly and result in the loss of
significant rights.

     We regard trademarks, copyrights, service marks, trade secrets, patents and
similar intellectual property as important to our success. We rely on trademark
and copyright law, trade secret protection and confidentiality and/or license
agreements with our employees, customers and others to protect our proprietary
rights.

     Other parties may assert infringement or unfair competition claims against
us. In the past, other parties have sent us notice of claims of infringement of
proprietary rights, including trademarks, copyrights and patents related to our
business, and we may receive other notices in the future. If we are forced to
defend against any such claims, whether they are with merit or are determined in
our favor, then we may face costly litigation, diversion of technical and
management personnel and product shipment delays. If there is a successful claim
of infringement against us and we are unable to develop non-infringing
technology or license the infringed or similar technology on a timely basis, or
if we are required to cease using one or more of our business or product names
due to a successful trademark infringement claim against us, it could adversely
affect our business.

                                       23
<PAGE>

     In addition, effective trademark, service mark, copyright, trade secret and
patent protection may not be available in every country in which we sell our
products and services online. Therefore, the steps we take to protect our
proprietary rights may be inadequate and our business could be adversely
affected.

If we are unable to retain or acquire the necessary domain names, our brand and
reputation could be damaged and we could lose customers.

     We currently hold the web domain name SmarterKids.com as well as several
other variations of this domain name. The acquisition and maintenance of domain
names generally is regulated by governmental agencies and their designees. In
the United States, the National Science Foundation has appointed Network
Solutions, Inc., and recently several others, as the current registrars for the
".com", ".net" and ".org" generic top-level domains. The regulation of
domain names in the United States and in foreign countries is subject to change
in the near future. As a result, we may be unable to acquire or maintain
relevant domain names in all countries in which we conduct business.
Furthermore, the relationship between regulations governing domain names and
laws protecting trademarks and similar proprietary rights is unclear. Therefore,
we may be unable to prevent third parties from acquiring domain names that are
similar to, infringe upon or otherwise decrease the value of our trademarks and
other proprietary rights. In addition, other parties hold domain names that are
similar to ours. Any confusion of our website with another party's could
diminish our brand.

We may fail to compete effectively in our market.

     The market for children's educational products online is new, rapidly
evolving and intensely competitive. We expect competition to intensify in the
future. Barriers to entry are minimal and current and new competitors can launch
new websites at a relatively low cost. In addition, the markets for children's
books, toys and games, and software in general, including those for children's
educational products, are very competitive and highly fragmented, with no clear
dominant leader and increasing public and commercial attention.

Our competitors can be divided into several groups, including:

          .  mass market retail chains, such as Kmart, Target and Wal-Mart

          .  mass market book sellers, toy stores and computer hardware and
             software stores, such as Barnes & Noble, Toys "R" Us and CompUSA

          .  traditional regional or local bookstores, toy stores and computer
             and software stores

          .  traditional specialty educational retailers, such as Learning
             Express and Zany Brainy

          .  online book sellers, toy sellers and computer software sellers,
             such as Amazon.com, KBkids.com and Beyond.com

          .  educational catalog distributors, such as Scholastic

     Many of our current and potential competitors have longer operating
histories, larger customer or user bases, greater brand recognition and
significantly greater financial, marketing and other resources than we do. Our
competitors may be able to secure products from vendors on more favorable terms,
fulfill customer orders more efficiently and adopt more aggressive pricing or
inventory availability policies than we can. Traditional store-based retailers
also enable customers to see and feel products in a manner that is not possible
over the Internet. Some of our competitors have significantly greater experience
in selling children's educational products. Many of these current and potential
competitors can devote substantially greater resources to marketing and
promotional campaigns and website and systems development than we can. Their
financial strength could prevent us from increasing market share. In addition,
larger, more well-established and better financed entities are acquiring,
investing in and forming joint ventures with online competitors and publishers
or suppliers of children's educational books, toys and games and software as the
use of the Internet increases. Increased competition may result in reduced
operating margins, loss of market share and diminished brand awareness.

                                       24
<PAGE>

If we enter new business categories and pursue new product offerings and
services that do not achieve market acceptance, our brand and reputation could
be damaged and we could incur additional financial losses.

     We may choose to expand our operations by expanding the breadth and depth
of products and services offered or expanding our market presence through
relationships with third parties. In addition, we may pursue the acquisition of
new or complementary businesses, products, services or technologies, although we
have no present understandings, commitments or agreements with respect to any
material acquisitions or investments. We may not be successful in our efforts to
expand our operations, and potential customers may not react favorably to these
efforts. Furthermore, any new product or service category that is launched by us
but not favorably received by consumers could damage our brand or reputation. An
expansion of our business would also require significant additional expenses,
expose us to additional supplier/distributor inventory risk and strain our
management, financial and operational resources. Given our lack of capital
resources, any expansion program or new business category that is not successful
could strain our financial resources and detract capital from otherwise
successful operations.

We depend upon United Parcel Service and the United States Postal Service to
deliver our products on a timely and consistent basis. A deterioration in our
relationship with either carrier could decrease our ability to track shipments,
cause shipment delays and increase our shipping costs and the number of damaged
products.

     Our supply and distribution system is dependent upon our relationship with
United Parcel Service and the United States Postal Service. If either
relationship is terminated or impaired or if either carrier is unable to deliver
product for us, whether through labor shortage, slow down or stoppage,
deteriorating financial or business condition or for any other reason, we would
be required to use alternative carriers for the shipment of products to our
customers. We may be unable to engage an alternative carrier on a timely basis
or upon terms favorable to us. Potential adverse consequences of changing
carriers include:

     .  reduced visibility into order status and package tracking

     .  delays in order processing and product delivery

     .  increased cost of delivery, resulting in reduced gross margins

     .  reduced shipment quality which may result in damaged products and
        customer dissatisfaction

If we do not successfully maintain and expand our website and the systems that
process customers' orders, we could lose customers and our revenues could be
reduced.

     Our success, in particular our ability to successfully receive and fulfill
orders and provide high quality customer service, largely depends on the
efficient and uninterrupted operation of our computer and communications
systems. As of June 2000, all orders are fulfilled at our own distribution
center in Mansfield, MA.

     Our success also depends on our ability to rapidly expand our website,
transaction-processing systems and network infrastructure without systems
interruptions in order to accommodate significant increases in customer traffic
and demand. Many of our software systems are custom-developed, and we rely on
our employees and third-party contractors to develop and maintain these systems.
If any of these employees or contractors become unavailable to us, we may
experience difficulty in improving and maintaining such systems.

     In addition, we rely on a third party, Exodus Communications, to host our
website and are thus subject to its ability to provide service when and as we
require.

If we do not respond to rapid technological changes, our services could become
obsolete and we could lose customers.

     To remain competitive, we must continue to enhance and improve the
functionality and features of our online store. The Internet and the online
commerce industry are rapidly changing. If competitors introduce new products

                                       25
<PAGE>

and services embodying new technologies or if new industry standards and
practices emerge, our existing website and proprietary technology and systems
may become obsolete. Our future success will depend on our ability to do the
following:

     .    both license and internally develop leading technologies useful in our
          business

     .    enhance our existing services

     .    develop new services and technologies that address the increasingly
          sophisticated and varied needs of our prospective customers

     .    respond to technological advances and emerging industry standards and
          practices on a cost-effective and timely basis

     Ongoing development of our website and other proprietary technology entails
significant expense and technical risks. We may use new technologies
ineffectively or we may fail to adapt our website, transaction-processing
systems and network infrastructure to customer requirements or emerging industry
standards. If we face material delays in introducing new services, products and
enhancements, our customers may forego the use of our services and use those of
our competitors.

Our facilities and systems are vulnerable to unexpected problems including
problems relating to system expansion activities or lack of system capacity. The
occurrence of a natural disaster or other unexpected problem could damage our
reputation and brand and reduce our revenues.

     Although we expect to periodically enhance and expand our website,
transaction-processing systems and network infrastructure, we may experience
interruptions in our systems. We may be unable to project the rate or timing of
increases, if any, in the use of our website. This would make it difficult for
us to effectively upgrade and expand our transaction-processing systems and to
smoothly integrate any newly developed or purchased modules with our existing
systems. To the extent we are required to outsource any technological
enhancements or become dependent on third party proprietary technology,
expanding and upgrading our systems could become more difficult. Due to the
seasonal nature of our business, it is particularly important that we are able
to expand our website, transaction-processing systems and network infrastructure
as necessary in preparation for the holiday season and that we operate during
that period without systems interruptions. Our failure to achieve or maintain
high capacity data transmission without system downtime, particularly during
this period, would adversely affect our business.

     Substantially all of our computer and communications hardware systems
related to transaction processing and network infrastructure are hosted at a
third-party facility owned and operated by Exodus Communications in Waltham,
Massachusetts. Our systems and operations, including our fulfillment operation,
at our new distribution center in Mansfield, Massachusetts, are vulnerable to
damage or interruption from fire, flood, power loss, telecommunications failure,
break-ins, earthquake and similar events. Furthermore, our servers may be
vulnerable to computer viruses, physical or electronic break-ins and similar
disruptions. We have no formal disaster recovery plan, and our business
interruption insurance may not adequately compensate us for losses that may
occur. The occurrence of a natural disaster or unanticipated problems our new
distribution center or at the Exodus Communications facility could cause
interruptions or delays in our business, loss of data or render us unable to
accept and fulfill customer orders. The occurrence of any or all of these events
could adversely affect our reputation, brand and business.

The success of our business depends on the continuing contribution of our key
personnel, including Mr. David A. Blohm, our President and Chief Executive
Officer.

     Our future success is dependent on key members of our management team and
in particular David A. Blohm, our President and Chief Executive Officer. The
competition for qualified personnel in the electronic commerce market is
extremely intense, especially in the Northeastern part of the United States. The
loss of service of Mr. Blohm or a significant number of our employees could have
a material adverse effect on our business. In particular, the loss of several
key programmers could inhibit the development and enhancement of our website and
could

                                       26
<PAGE>

damage customer relations and our brand. Similarly, the loss of several
marketing and sales personnel could inhibit our ability to effectively promote
our website.

We may be subject to product liability claims.

     We face an inherent risk of exposure to product liability claims in the
event that the use of the products we sell results in injury. We may not have
adequate resources in the event of a successful claim against us. Our general
liability insurance may not cover these claims or we may not be indemnified for
any or all of the liabilities that may be imposed. We cannot predict whether
product liability claims will be brought against us in the future or if the
resulting adverse publicity would harm our business.

We depend on the Internet and the development of the Internet infrastructure.

     Our success will depend in large part on continued growth in, and the use
of, the Internet for commerce. The electronic commerce market is new and rapidly
evolving, and the extent of consumer acceptance is uncertain. The issues
concerning the commercial use of the Internet that we expect to affect the
development of the market for our services include security, reliability, cost
of access, ease of access, ease of use, speed and quality of service.

     In addition, popular companies that provide access to Internet transactions
through network access or web browsers, such as America Online, Yahoo, Lycos and
Microsoft, could promote our competitors or charge us a substantial fee for
connection to our website. Either of these developments could adversely affect
our business.

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

     Law and regulations directly applicable to communications or commerce over
the Internet are becoming more prevalent. The U.S. Congress recently enacted
Internet laws, including laws relating to children's privacy, the transmission
of sexually explicit material and taxation of Internet-based enterprises. As
directed by Congress in the Children's Online Privacy Protection Act, the
Federal Trade Commission (the "FTC") recently adopted regulations that became
effective on April 21, 2000, prohibiting unfair and deceptive acts and practices
in connection with the collection and use of personal information from children
under 13 years old on the Internet.

     There can be no assurance that we will adopt policies that conform to
regulations adopted or policies advocated by the FTC or any other governmental
entity. In addition, the FTC has already begun investigations into the privacy
practices of companies that collect information on the Internet. One
investigation resulted in a consent decree pursuant to which an Internet company
agreed to establish programs to implement the principles noted above. We may
become subject to a similar investigation, or the FTC's regulatory and
enforcement efforts may adversely affect our ability to collect demographic and
personal information from users, which could adversely affect our marketing
efforts.

     In addition, the European Union recently enacted its own privacy
regulations. The European Union Directive on the Protection of Personal Data
(the "EU Directive"), which became effective in October 1998, fosters electronic
commerce by establishing a stable framework to ensure both a high level of
protection for private individuals and the free movement of personal data within
the European Union. The European Union and the U.S. Department of Commerce are
currently negotiating an agreement under which the privacy policies of U.S.
businesses may be deemed to be adequate under the EU Directive. Until such time
as an agreement is reached, the European Union has voluntarily agreed to a
moratorium on enforcement of the EU Directive against U.S. businesses. Although
the Company has received approximately 2% of revenues from outside of the United
States in the year ended December 31, 2000, the European legislation and its
adoption via any agreement could adversely affect our ability to expand our
sales efforts to Europe by limiting how information about us can be sent over
the Internet in the EU and limiting our efforts to collect information from
European users.

     The U.S. Omnibus Appropriations Act of 1998 places a moratorium on taxes
levied on Internet access from October 1, 1998 to October 21, 2001. However,
states may place taxes on Internet access if taxes had already been generally
imposed and actually enforced prior to October 1, 1998. States which can show
they enforced Internet

                                       27
<PAGE>

access taxes prior to October 1, 1998 and states after October 21, 2001 may be
able to levy taxes on Internet access resulting in increased cost to access to
the Internet, resulting in a material adverse effect on our business.

     The laws governing the use of the Internet, in general, remain largely
unsettled, even in areas where there has been some legislative action. It may
take years to determine whether and how existing laws such as those governing
intellectual property, privacy, libel and taxation apply to the Internet. In
addition, the growth and development of the market for online commerce may
prompt calls for more stringent consumer protection laws, both in the United
States and abroad. This occurrence may impose additional burdens on companies
conducting business online by limiting how information can flow over the
Internet and the type of information that can flow over the Internet. The
adoption or modification of laws or regulations relating to the Internet could
adversely affect our business. Because we receive a significant amount of orders
as a result of e-mail advertising, new regulations affecting the use of
unsolicited e-mail advertising would impair our marketing efforts.

We may be liable for the content we provide on our website or which is accessed
from our website.

     We believe that our future success will depend in part upon our ability to
deliver original and compelling descriptive content about the children's
educational books, toys and games, and software that we sell on the Internet. As
a publisher of online content, we face potential liability for defamation,
negligence, copyright, patent or trademark infringement, or other claims based
on the nature and content of materials that we publish or distribute. In the
past, plaintiffs have brought such claims and sometimes successfully litigated
them against online services. Although we carry general liability insurance, our
insurance may not cover claims of these types or may be inadequate to indemnify
us for all liability that may be imposed on us. If we face liability,
particularly liability that is not covered by our insurance or is in excess of
our insurance coverage, then our reputation and our business may suffer.

Our revenues and reputation would be adversely affected if our security measures
fail.

     Consumer concerns regarding the security of transactions conducted on the
Internet and users' privacy may inhibit the growth of use of the Internet and
electronic commerce. To securely transmit confidential information, such as
customer credit card numbers, we rely on encryption and authentication
technology that we license from third parties. We cannot predict whether we will
experience compromises of, or breaches in, the technologies we use to protect
customer transaction data.

     We may need to expend significant additional capital and other resources to
protect against security breaches or alleviate problems caused by any such
breaches. We cannot guarantee that security breaches will not occur, and if our
security measures fail, our business could be harmed. Any penetration of our
network security or misappropriation of our users' personal or credit card
information could subject us to liability. Claims could also be based on other
misuses of personal information, including the use of this information for
unauthorized marketing purposes. These claims could result in litigation.

Our revenues and reputation would be adversely affected if we experience
significant credit card fraud.

     Under current credit card practices, merchants are liable for fraudulent
credit card transactions where, as is the case with the transactions we process,
the merchant does not obtain a cardholder's signature. We may be liable for
claims based on unauthorized purchases with credit card information,
impersonation or other similar fraud claims. A failure to adequately control
fraudulent credit card transactions would harm our business.

Privacy concerns and legislation may limit the information we can gather.

     When a visitor first arrives at our website, our software creates a profile
for that visitor. If the visitor registers or logs in, the visitor's identity is
added to the profile, preserving any profile information that was gathered up to
that point. We track both explicit user profile data supplied by the user, as
well as implicit profile attributes derived from the user's behavior on the
website. We also suggest that parents provide us with an educational profile on
their children, an important feature of our website. Privacy concerns relating
to children are particularly acute. Privacy concerns may cause visitors to
resist providing the personal data or avoid websites that track the behavioral
information necessary to support this profiling capability. More importantly,
even the perception of security and

                                       28
<PAGE>

privacy concerns, whether or not valid, may indirectly inhibit market acceptance
of our products. For example, the European Union recently adopted a directive
addressing data privacy that may limit the collection and use of certain
information regarding Internet users. This directive may limit our ability to
target advertising or collect and use information in certain European countries.
In addition, legislative or regulatory requirements may heighten these concerns
if businesses must notify website users that the data captured after visiting
websites may be used to direct product promotion and advertising to that user.
Other countries and political entities, such as the European Union, have adopted
such legislation or regulatory requirements. The United States may adopt similar
legislation or regulatory requirements. If privacy legislation is enacted or
consumer privacy concerns are not adequately addressed, our business, financial
condition and operating results could be harmed.

     Websites typically place "cookies" on a user's hard drive without the
user's knowledge or consent. We use cookies for a variety of reasons, including
the collection of data derived from the user's Internet activity. Most currently
available web browsers allow users to remove cookies at any time or to prevent
cookies from being stored on their hard drives. In addition, some commentators,
privacy advocates and governmental bodies have suggested limiting or eliminating
the use of cookies. Any reduction or limitation in the use of cookies could
limit the effectiveness of our sales and marketing efforts. The FTC and several
states have investigated the use by certain Internet companies of personal
information. We could incur significant additional expenses if new regulations
regarding the use of personal information are introduced or if our privacy
practices are investigated.

Our revenues could decrease if we became subject to sales and other taxes.

     We do not currently collect sales or other similar taxes for physical
shipments of goods into states other than Massachusetts. However, one or more
local, state, federal or foreign jurisdictions may seek to impose sales tax
collection obligations on us. In addition, any new operation in states outside
Massachusetts could subject our shipments in such states to state sales taxes
under current or future laws. A number of legislative proposals have been made
at the federal, state and local level and by foreign governments that would
impose additional taxes on the sale of goods and services over the Internet and
certain states have taken measures to tax Internet-related activities. Although
Congress recently placed a three-year moratorium on new state and local taxes on
Internet access or on discriminatory taxes on electronic commerce, existing
state or local laws were expressly excepted from this moratorium. Further, once
this moratorium expires, some type of federal and/or state taxes may be imposed
upon Internet commerce. The moratorium is presently scheduled to expire on
October 20, 2001. Such legislation or other attempts at regulating commerce over
the Internet may substantially impair the growth of commerce on the Internet
and, as a result, adversely affect our opportunity to derive financial benefit
from such activities. If one or more states or any foreign country successfully
asserts that we should collect sales or other taxes on the sale of our products,
it could adversely affect our business and results of operations.

Smarterkids.com's stock price, like that of other retail e-commerce companies,
is subject to significant volatility which could result in substantial losses
for individual security holders.

     Our stock price has been and is likely to continue to be highly volatile
because of the following factors, some of which are beyond our control:

         .  speculation in the press or investment community
         .  changes in revenue or earnings estimates by the investment community
         .  announcement of new competitors in a highly competitive marketplace
         .  changes in the economic performance and/or market valuations of
            other internet, online commerce or retail companies
         .  volatility in the stock markets, particularly with respect to
            internet stocks, and decreases in the availability of capital for
            Internet-related businesses

     In addition, Smarterkids.com's stock price may be affected by general
market conditions and economic factors unrelated to Smarterkids.com's
performance.

     From November 23, 1999 (the first day of public trading of our common
stock), through December 31, 2000, the high and low sales prices of our common
stock fluctuated between $17.13 and $0.5312. On December 31, 2000, the closing
price of our common stock was $0.5312. In the past, following periods of
volatility in the market price

                                       29
<PAGE>

of their securities, many companies have been the subject of securities class
action litigation. If we were sued in a securities class action, it could result
in substantial costs and a diversion of management's attention and resources and
would cause the prices of our common stock to fall.


ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


The following discussion of the SmarterKids.com's market risk includes "forward-
looking statements" that involve risks and uncertainties. Actual results could
differ materially from those projected in the forward-looking statements.
SmarterKids.com does not use derivative financial instruments for speculative or
trading purposes.

Interest Rate Risk

     SmarterKids.com is exposed to market risk from changes in interest rates
primarily through its investing activities. In addition, SmarterKids.com's
ability to finance future acquisition transactions may be impacted if
SmarterKids.com is unable to obtain appropriate financing at acceptable rates.
SmarterKids.com's investment portfolio consists solely of held-to-maturity
investments in high-grade, commercial bank money market accounts and
certificates of deposit. As of December 31, 2000, SmarterKids.com had securities
classified as held-to maturity investments with an amortized cost value of $7.8
million. SmarterKids.com also had $6.0 million in commercial bank money markets
and $1.0 million of restricted cash in certificates of deposit.

Credit Risk

     Financial instruments which potentially subject SmarterKids.com to
concentrations of credit risk consist primarily of cash, cash equivalents,
short-term investments and accounts receivable. SmarterKids.com does not believe
that it is subject to any unusual credit risk beyond the normal credit risk
associated with commercial banking relationships.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

SmarterKids.com's financial statements together with the related notes and the
report of PricewaterhouseCoopers LLP, independent accountants, are set forth
beginning on page 34 of this Annual Report on Form 10-K.

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

There have been no changes in or disagreements with SmarterKids.com's
independent accountants on accounting or financial disclosure matters during
SmarterKids.com's two most recent fiscal years.

                                   PART III

Anything herein to the contrary notwithstanding, in no event whatsoever are the
sections entitled "Stock Performance Graph" and "Compensation Committee Report
on Executive Compensation" to be incorporated by reference herein from
SmarterKids.com's proxy statement in connection with its annual of stockholders
expected to be held in June 2001.

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Certain information relating to directors and executive officers of
SmarterKids.com is incorporated by reference herein from SmarterKids.com's proxy
statement in connection with its annual meeting of stockholders expected to be
held in June 2001, which proxy statement will be filed with the Securities and
Exchange Commission not later than 120 days after the close of SmarterKids.com's
fiscal year ended December 31, 2000.

ITEM 11.  EXECUTIVE COMPENSATION

Certain information relating to remuneration of directors and executive officers
and other transactions involving management is incorporated by reference herein
from SmarterKids.com's proxy statement in connection with its annual meeting of
stockholders expected to be held in June 2001, which proxy statement will be
filed with the Securities and Exchange Commission not later than 120 days after
the close of SmarterKids.com's fiscal year ended December 31, 2000.


                                       30
<PAGE>


ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT OF
SMARTERKIDS.COM

Certain information relating to security ownership of certain beneficial owners
and management is incorporated by reference herein from SmarterKids.com's proxy
statement in connection with its annual meeting of stockholders expected to be
held in June 2001, which proxy statement will be filed with the Securities and
Exchange Commission not later than 120 days after the close of SmarterKids.com's
fiscal year ended December 31, 2000.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Certain information relating to certain relationships and related transactions
is incorporated by reference herein from SmarterKids.com's proxy statement in
connection with its annual meeting of stockholders expected to be held in June
2001, which proxy statement will be filed with the Securities and Exchange
Commission not later than 120 days after the close of SmarterKids.com's fiscal
year ended December 31, 2000.

                                    PART IV

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

  (a) The following documents are filed as part of this Form 10-K.

      (1)  Financial Statements.

           For a list of the financial information included herein, see Index on
           Page 34.

      (2)  Financial Statement Schedules:

           Financial Statement Schedules have been omitted because the
           information required to be set forth therein is not applicable or is
           shown in the accompanying financial statements or notes thereto
           included in Item 8.

      (3)  Exhibits.

           See Exhibit Index. The Exhibits listed in the accompanying Exhibit
           Index are filed or incorporated by reference as part of this report.

  (b) Reports on Form 8-K.

      On November 15, 2001, SmarterKids.com filed a Current Report on Form 8-K
      with the Securities and Exchange Commission disclosing the signing on
      November 14, 2001 of the Contribution Agreement and Plan of Reorganization
      and Merger by and among SmarterKids.com, Earlychildhood LLC, a California
      limited liability company, S-E Educational Holdings Corp, a Delaware
      corporation later renamed LearningStar Corp. and S-E Educational Merger
      Corp., a Delaware corporation and wholly-owned subsidiary of LearningStar
      Corp. (the "Combination Agreement"). Pursuant to the Combination
      Agreement, and subject to the approval of SmarterKids.com's stockholders
      at a Special Meeting of Stockholders to be held on April 9, 2001,
      SmarterKids.com and Earlychildhood will combine and each will become
      wholly-owned subsidiaries of LearningStar Corp. The business of
      LearningStar Corp. would be the combined businesses currently conducted by
      SmarterKids.com and Earlychildhood. For more information on the
      combination of SmarterKids.com and Earlychildhood, please see the
      SmarterKids.com definitive proxy statement filed with the Securities and
      Exchange Commission on March 15, 2001.

      On January 9, 2001, SmarterKids.com, announced that it had filed a
      preliminary proxy statement with the Securities and Exchange Commission.
      The Company's proxy statement solicits proxies from the SmarterKids.com
      stockholders to approve and adopt the Combination Agreement.

  (c) Exhibits.

      SmarterKids.com hereby files as part of this Annual Report on Form 10-K
      the exhibits listed in Item 14(a)(3) above. Exhibits which are
      incorporated herein by reference can be inspected and copied at the public
      reference rooms maintained by the Securities and Exchange Commission in
      Washington, D.C., New York, New York, and Chicago, Illinois. Please call
      the Securities and Exchange Commission at 1-800-SEC-0330 for further
      information on the public reference rooms. Securities and Exchange
      Commission filings are also available to the public from commercial
      document retrieval services and at the web site maintained by the
      Securities and Exchange Commission at http://www.sec.gov.
                                            ------------------

                                       31
<PAGE>

  (d) Financial Statement Schedules.

      SmarterKids.com hereby files as part of this Annual Report on Form 10-K in
      Item 14(b) attached hereto the financial statement schedules listed in
      Item 14(a)(2) above, if any.


  SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized in Needham,
Massachusetts on the 29th day of March 2001.

                                             SMARTERKIDS.COM, INC.
                                             (Registrant)


                                             By:   /s/ Robert J. Cahill
                                                 -------------------------------
                                                       Robert J. Cahill
                                                      Chief Financial Officer
                                                   (Duly Authorized Officer and
                                                    Principal Financial Officer)


                       POWER OF ATTORNEY AND SIGNATURES

  We, the undersigned officers and directors of SmarterKids.com, Inc., hereby
severally constitute and appoint Robert J. Cahill, our true and lawful attorney,
with full power to him singly, to sign for us and in our names in the capacities
indicated below, any amendments to this Annual Report on Form 10-K, and
generally to do all things in our names and on our behalf in such capacities to
enable SmarterKids.com, Inc. to comply with the provisions of the Securities
Exchange Act of 1934, as amended, and all the requirements of the Securities
Exchange Commission.

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

<TABLE>
<CAPTION>
                   Signature                                      Title                                    Date
                   ---------                                      -----                                    ----
<S>                                                 <C>                                               <C>
               /s/ David Blohm                      President, Chief Executive Officer                March 29, 2001
---------------------------------------------
                  David Blohm                                  and Director
                                                      (principal executive officer)


             /s/ Robert J. Cahill                       Chief Financial Officer,
---------------------------------------------
               Robert J. Cahill                     (principal financial and accounting               March 29, 2001
                                                                 officer)


                /s/ Jeff Pucci                       Co-Founder, Chairman and Director                March 29, 2001
---------------------------------------------
                  Jeff Pucci


              /s/ Richard D'Amore                               Director                              March 29, 2001
---------------------------------------------
                Richard D'Amore
</TABLE>

                                       32
<PAGE>

<TABLE>
<S>                                                              <C>                                  <C>
             /s/ Michael Fitzgerald                              Director                             March 29, 2001
------------------------------------------------
               Michael Fitzgerald

              /s/ Michael Kolowich                               Director                             March 29, 2001
------------------------------------------------
                Michael Kolowich

                /s/ Brian Hickey                                 Director                             March 29, 2001
------------------------------------------------
                  Brian Hickey

By:            /s/ Robert J. Cahill
   ---------------------------------------------
                 Robert J. Cahill
                 Attorney-in-Fact
</TABLE>

                                       33
<PAGE>

                  Exhibit Index to Annual Report on Form 10-K
                    for Fiscal Year Ended December 31, 2000

Exhibit No.   Exhibit
-----------   -------

   2.1*       Contribution Agreement and Plan of Reorganization by and among the
              Registrant. SmarterKids.com, Inc., Earlychildhood.com LLC and S-E
              Educational Merger Corp., dated as of November 14, 2000 (the
              combination agreement).
   3.1(1)     Amendment to the Second Amended and Restated Certificate of
              Incorporation of SmarterKids.com, Inc.
   3.2*       Amended and Restated By-laws of SmarterKids.com, Inc.
   4.4(1)     Specimen certificate for shares of SmarterKids.com's common stock
   9.1*       Stockholder Support Agreement by and among Earlychildhood.com LLC
              and certain stockholders of SmarterKids.com, Inc. dated as of
              Nobember 14, 2000 in connection with the combination agreement.
   9.2*       Consent and Non-Contravention Agreement dated as of November 14,
              2000 by and among Earlychildhood.com LLC, the holders of the
              outstanding membership interests in Earlychildhood.com LLC and
              SmarterKids.com, Inc. in connection with the combination
              agreement.
 10.1(1)      1995 Stock Plan, as amended.
 10.2(1)      1999 Stock Option and Incentive Plan.
 10.3(1)      1999 Non-Employee Director Stock Option Plan.
 10.4(1)      1999 Employee Stock Purchase Plan.
 10.4.1*      Amendment to Employee Stock Purchase Plan.
 10.5(1)      Amended and Restated Investor Rights Agreement dated as of July
              12, 1999 by and among SmarterKids.com, Inc., certain stockholders
              of SmarterKids.com, Inc. and certain senior management of
              SmarterKids.com, Inc.
 10.6(1)      Amended and Restated Stockholders Voting Agreement dated as of
              July 12, 1999 among SmarterKids.com, Inc., certain stockholders of
              SmarterKids.com, Inc. and certain senior management of
              SmarterKids.com, Inc.
 10.7(1)      Lease Agreements dated as of September 1, 1998 and April 16, 1999
              between SmarterKids.com, Inc. and McFarland FLP.
 10.8(1)      Lease Agreement dated September 8, 1999 between Smarterkids.com,
              Inc. and BHX, LLC as Trustee of Crawford Realty Trust.
 10.9*        Lease Agreement dated as of April 7, 2000 between SmarterKids.com,
              Inc. and Keep Your Day Job.LLC.
 10.10(1)(2)  Business Agreement dated as of March 9, 1999 between National
              Computer Systems and SmarterKids.com, Inc.
 10.11*       Loan and Security Agreement dated as of November 24, 1999 between
              SmarterKids.com, Inc. and Silicon Valley Bank.
 10.12*+      Form of SmarterKids.com, Inc. Executive Option Agreement.
 10.13*+      Form of SmarterKids.com, Inc. Change of Control Agreement.
 10.14*+      Form of SmarterKids.com, Inc. Change of Control Agreement for
              Messrs. Blohm and Pucci.
 10.16*       Internet Data Center Services Agreement dated as of June 29, 1999
              by and between SmarterKids.com and Exodus Communications, Inc.
 10.17*       Registration Rights Agreement dated November 14, 2000 by and among
              Registrant and certain stockholders named therein.
 10.18*       Form of Affiliate Agreement in connection with the combination
              agreement.
 10.19*       Form of Lockup Agreement in connection with the combination
              agreement.
 10.20*       Form of Consulting Agreement to be executed by and between
              Registrant and David Blohm upon completion of the combination
              agreement.
 23*          Consent of PricewaterhouseCoopers LLP.
 24.1*        Power of Attorney (Included in signature page).

____________
(1) Incorporated herein by reference to the exhibits to the Company's
    Registration Statement on Form S-1 (File No. 333-86787), as amended.
(2) Confidential materials omitted and filed separately with the SEC.
+   Indicates a management contract or any compensatory plan, contract or
    arrangement.
*   Filed herewith.

                                       34
<PAGE>

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                                        Page
                                                                                                        ----
<S>                                                                                                     <C>
Report of Independent Accountants.....................................................................    36

Balance Sheet as of December 31, 1999 and 2000........................................................    37

Statement of Operations for the years ended December 31, 1998, 1999 and 2000..........................    38

Statement of Stockholders' Equity for the years ended December 31, 1998, 1999 and 2000................    39

Statement of Cash Flows for the years ended December 31, 1998, 1999 and 2000..........................    40

Notes to Financial Statements.........................................................................    41
</TABLE>


                                       35
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
of SmarterKids.com, Inc.:

     In our opinion, the accompanying balance sheet and the related statements
of operations, of stockholders' equity, and of cash flows present fairly, in all
material respects, the financial position of SmarterKids.com, Inc. at December
31, 1999 and 2000, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 2000 in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, 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.


/s/ PricewaterhouseCoopers LLP


Boston, Massachusetts
February 2, 2001

                                       36
<PAGE>

                             SMARTERKIDS.COM, INC.

                                 BALANCE SHEET
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                                                            December 31,
                                                                                        -------------------
                                                                                          1999       2000
                                                                                          ----       ----
<S>                                                                                     <C>         <C>
                                           ASSETS
Current assets:
     Cash and cash equivalents.......................................................   $ 55,621   $ 17,557
     Short-term investments..........................................................     11,735     13,831

     Accounts receivable, net of allowance for doubtful accounts of $27 and $9 at
          December 31, 1999 and 2000, respectively...................................        132        232
     Inventories.....................................................................      8,902      2,080

     Other current assets............................................................      2,403      1,844
                                                                                        --------   --------
               Total current assets..................................................     78,793     35,544
Property and equipment, net..........................................................      2,421      5,296
Intangible assets, net...............................................................        621        274
Restricted cash......................................................................        500      1,028
Other assets.........................................................................         --      1,546
                                                                                        --------   --------
               Total assets..........................................................   $ 82,335   $ 43,688
                                                                                        ========   ========

                              LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Current portion of long term debt and capital lease obligations.................   $     74   $    525
     Accounts payable................................................................     10,996      5,089
     Accrued expenses................................................................      6,699      4,418
     Deferred revenue................................................................        811        188
     Sales returns allowances........................................................         87         30
                                                                                        --------   --------
               Total current liabilities.............................................     18,667     10,250
Long term debt and capital lease obligations, net of current portion.................         34        685
                                                                                        --------   --------
               Total liabilities.....................................................     18,701     10,935
                                                                                        --------   --------

Commitments and contingencies (Note 13)..............................................         --         --

Stockholders' equity:
     Preferred stock, $0.01 par value: 10,000,000 shares authorized;
          no shares issued and a outstanding.........................................         --         --
     Common stock, $0.01 par value; 90,000,000 shares authorized;
          20,301,770 and 20,668,849 shares issued and outstanding, at December 31,
          1999 and 2000, respectively................................................        203        207
     Additional paid-in capital......................................................    112,907    111,809
     Deferred stock compensation.....................................................     (6,286)    (3,399)
     Accumulated deficit.............................................................    (43,190)   (75,864)
                                                                                        --------   --------
               Total stockholders' equity............................................     63,634     32,753
                                                                                        --------   --------
               Total liabilities stockholders' equity................................   $ 82,335   $ 43,688
                                                                                        ========   ========
</TABLE>

  The accompanying notes are an integral part of these financial statements.

                                       37
<PAGE>

                             SMARTERKIDS.COM, INC.

                            STATEMENT OF OPERATIONS
                     (In thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                    Year Ended
                                                                                    December 31,
                                                                           -------------------------------
                                                                              1998        1999        2000
                                                                           -------    --------    --------
<S>                                                                        <C>        <C>         <C>
Net revenues:
      Online retail......................................................  $    22    $  5,421    $ 10,206
      Proprietary CD-ROM.................................................    2,278          --          --
                                                                           -------    --------    --------
            Total net revenues...........................................    2,300       5,421      10,206
                                                                           -------    --------    --------
Cost of revenues:
      Online retail......................................................       20       4,005       7,920
      Proprietary CD-ROM.................................................      908          --          --
                                                                           -------    --------    --------
            Total cost of revenues.......................................      928       4,005       7,920
                                                                           -------    --------    --------
Gross profit.............................................................    1,372       1,416       2,286
                                                                           -------    --------    --------
Operating expenses:
     Marketing and sales (including stock compensation of $91, $1,216,
and $1,624 for 1998, 1999 and 2000, respectively)........................    2,769      30,132      28,641
     Development (including stock compensation of $60, $1,143, and
($323) for 1998, 1999 and 2000, respectively)............................    1,438       2,864       3,034
     General and administrative (including stock compensation of $36,
$1,046, and $590 for 1998, 1999 and 2000, respectively)..................      526       3,900       3,820
    Restructuring costs..................................................       --          --       1,300
                                                                           -------    --------    --------
           Total operating expenses......................................    4,733      36,896      36,795
                                                                           -------    --------    --------
Loss from operations.....................................................   (3,361)    (35,480)    (34,509)
Interest income..........................................................       41         732       2,764
Interest expense.........................................................      (18)        (16)       (144)
Other income.............................................................        -          46           -
Other expense............................................................       (4)        (10)       (785)
                                                                           -------    --------    --------
Net loss.................................................................   (3,342)    (34,728)    (32,674)
Accretion of redeemable preferred stock..................................     (254)       (189)         --
                                                                           -------    --------    --------
Net loss attributable to common stockholders.............................  $(3,596)   $(34,917)   $(32,674)
                                                                           =======    ========    ========

Basic and diluted net loss per common share..............................  $ (2.34)   $  (9.20)   $  (1.59)
Weighted average shares-basic and diluted................................    1,534       3,796      20,519
</TABLE>

The accompanying notes are an integral part of these financial statements.

                                       38
<PAGE>

                             SMARTERKIDS.COM, INC.

                       STATEMENT OF STOCKHOLDERS' EQUITY
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                                                                                          Total
                                                               Common Stock    Additional    Deferred                  Stockholder
                                                            -----------------   Paid-In       Stock       Accumulated    Equity
                                                             Shares    Amount   Capital    Compensation     Deficit     (Deficit)
                                                            ---------  ------  --------    ------------    ----------  ------------
<S>                                                         <C>        <C>     <C>          <C>          <C>         <C>
Balance at December 31, 1997..............................  1,502,750  $  15   $    881     $      (58)  $  (4,677)   $   (3,839)
  Issuance of common stock pursuant to exercise
     of stock options.....................................    125,760      1          9                                       10
  Accretion of redeemable preferred stock
     related to issuance costs............................                           69                       (254)         (185)
  Issuance of warrants for amendment of debt
     agreement............................................                            7                                        7
  Issuance and revaluation of stock options and
     warrants to consultants..............................                          106                                      106
  Deferred stock compensation related to
     employee stock option grants.........................                        1,458         (1,458)                       --
  Amortization of deferred stock compensation.............                                          81                        81
  Net loss................................................                                                  (3,342)       (3,342)
                                                           ----------  -----   --------     ----------   ---------    ----------
Balance at December 31, 1998..............................  1,628,510     16      2,530         (1,435)     (8,273)       (7,162)
  Issuance of common stock pursuant to exercise
     of stock options.....................................    497,028      5        110                                      115
  Issuance of common stock to acquire intangible
     assets...............................................     33,000     --        445                                      445
  Issuance of common stock warrants in connection
     with issuance of Series C redeemable preferred
     stock................................................                          515                                      515
  Conversion of redeemable preferred stock to
    common stock.......................................... 12,732,887    127     35,096                                   35,223
  Accretion of redeemable preferred stock
   related to issuance costs..............................                                                    (189)         (189)
  Issuance and revaluation of stock options and
     warrants to consultants..............................                        2,758        (1,550)                     1,208
  Issuance of common stock pursuant to the exercise of
     warrants.............................................    251,845      3         63                                       66
  Issuance of common stock in initial public offering.....  5,158,500     52     65,892                                   65,944
  Deferred stock compensation related to employee
    stock option grants...................................                        5,734         (5,734)                       --
  Cancellation of unvested employee stock options.........                         (236)           236                        --
  Amortization of deferred stock compensation related                                            2,197                     2,197
    to employee stock options.............................
  Net loss................................................                                                 (34,728)      (34,728)
                                                           ----------  -----   --------     ----------   ---------    ----------
Balance at December 31, 1999.............................. 20,301,770    203    112,907         (6,286)    (43,190)       63,634
  Issuance of common stock pursuant to exercise
    of stock options......................................    326,414      3         41                                       44
  Issuance of common stock related to Employee Stock
    Purchase Plan.........................................     40,665      1         51                                       52
  Initial public offering related costs...................                         (203)                                    (203)
  Issuance of common stock warrants in connection
    with issuance of capital lease obligation.............                            9                                        9
  Revaluation of stock options and warrants to
    consultants...........................................                         (932)         1,563                       631
  Cancellation of unvested employee stock options and
    nonemployee warrants..................................                          (64)            57                        (7)
  Amortization of deferred stock compensation related to
    employee stock options................................                                       1,267                     1,267
  Net loss................................................                                                 (32,674)      (32,674)
                                                           ----------  -----   --------     ----------   ---------    ----------
Balance at December 31, 2000.............................. 20,668,849  $ 207   $111,809     $   (3,399)  $ (75,864)   $   32,753
                                                           ==========  =====   ========     ==========   =========    ==========
</TABLE>

  The accompanying notes are an integral part of these financial statements.

                                       39
<PAGE>

                             SMARTERKIDS.COM, INC.

                            STATEMENT OF CASH FLOWS
                                (In thousands)

<TABLE>
<CAPTION>

                                                                                            Year Ended December 31,
                                                                                     ----------------------------------
                                                                                           1998        1999        2000
                                                                                     ----------    --------    --------
<S>                                                                                  <C>           <C>         <C>
Increase (Decrease) in Cash
Cash flows from operating activities:
  Net loss..........................................................................    $(3,342)   $(34,728)   $(32,674)
  Adjustments to reconcile net loss to net cash used in operating activities:
        Depreciation and amortization...............................................         66         296       2,048
        Stock compensation expense..................................................        187       3,405       1,891
        Debt issue costs............................................................          7          --          --
Changes in assets and liabilities:
        Accounts receivable.........................................................       (348)        783        (100)
        Other current assets........................................................       (125)     (2,250)        559
        Inventories.................................................................         50      (8,798)      6,822
        Other long term assets......................................................         11          15      (1,546)
        Accounts payable............................................................        521      10,163      (5,907)
        Accrued expenses............................................................        482       5,912      (2,272)
        Deferred revenue............................................................         --         811        (623)
        Sales return allowances.....................................................        477        (631)        (57)
                                                                                        -------    --------    --------
Net cash used in operating activities...............................................     (2,014)    (25,022)    (31,859)
                                                                                        -------    --------    --------

Cash flows from investing activities:
       Purchase of short-term investments...........................................         --     (11,735)     (2,096)
       Purchases of property and equipment..........................................        (33)     (2,451)     (4,576)
       Purchase of intangible assets................................................         --        (250)         --
       Deposit of restricted cash...................................................         --        (500)       (528)
                                                                                        -------    --------    --------
Net cash used in investing activities...............................................        (33)    (14,936)     (7,200)
                                                                                        -------    --------    --------

Cash flows from financing activities:
       Proceeds from issuance of common stock, net of issuance costs................         --      65,944          --
       Proceeds from issuance of Series C preferred Stock, net of issuance costs....         --      25,262          --
       Proceeds from issuance of Series B preferred Stock, net of issuance costs....      6,091          --          --
       Proceeds from long-term borrowings...........................................         --          --       1,601
       Repayments of long-term borrowings...........................................        (74)        (81)       (499)
       Proceeds from exercise of common stock options...............................         10         115          29
       Proceeds from exercise of common stock warrants..............................         --          66          15
       Proceeds from purchase of common stock under the Employee Stock Purchase
       Plan.........................................................................         --          --          52


       Increase from estimated initial public offering costs........................         --          --        (203)
                                                                                        -------    --------    --------
Net cash provided by financing activities...........................................      6,027      91,306         995
                                                                                        -------    --------    --------

Net increase (decrease) in cash and cash equivalents................................      3,980      51,348     (38,064)
Cash and cash equivalents at beginning of year......................................        293       4,273      55,621
                                                                                        -------    --------    --------
Cash and cash equivalents at end of year............................................    $ 4,273    $ 55,621    $ 17,557
                                                                                        =======    ========    ========

Supplemental disclosure of cash flow information:
   Cash paid during the year for interest...........................................    $    11    $     28    $    144

Supplemental disclosure of noncash investing and financing activities:
   Capital lease obligations incurred to acquire property and equipment.............    $    --    $    148    $     --
   Issuance of warrants to purchase common stock in exchange for services
    related to redeemable preferred stock offerings.................................    $    69    $    515    $     --
   Issuance of common stock in exchange for purchase of intangible assets...........    $    --    $    445    $     --
   Issuance of warrants to purchase common stock in connection with entering
    equipment line of credit........................................................    $    --    $     --    $      9
 </TABLE>

  The accompanying notes are an integral part of these financial statements.

                                       40
<PAGE>

                             SMARTERKIDS.COM, INC.

                         NOTES TO FINANCIAL STATEMENTS

1.   Formation and Operations of the Company:

     SmarterKids.com, Inc. (the "Company") is an online retailer focused on
children's educational books, toys and games, and software. Prior to 1999, the
Company was engaged in developing, marketing and selling proprietary educational
and entertainment software. The Company primarily sold its products to national
distributors and its principal market was the domestic consumer market. In March
1998, the Company commenced development of the SmarterKids.com website. In
November 1998, the Company began transitioning its business model to online
sales of third-party educational products. In November 1998, the Company
launched its website, and ceased the sale of proprietary CD-ROM products through
traditional retail channels, and now offers its proprietary CD-ROM products on a
limited basis through its website. The Company was incorporated in Delaware on
March 28, 1994 and changed its name to Virtual Knowledge, Inc. effective August
4, 1997. Effective September 1998, the Company changed its name to
SmarterKids.com, Inc.

     The Company incurred losses of $34.7 million and $32.7 million in the year
ended December 31, 1999 and 2000, respectively, and anticipates that it will
incur a net loss for the year ended December 31, 2001. However, the Company has
taken actions to reduce significantly it operating costs by reducing the
existing workforce and reducing advertising spending. The Company currently
anticipates that its available cash will be sufficient to meet its anticipated
working capital and capital expenditure requirements through December 31, 2001.
However, the Company may need to raise additional capital to meet needs in the
longer term to fund more rapid expansion to develop new services and to enhance
existing services in response to competitive pressures, and to acquire
complementary services, businesses or technologies. In the event operations are
not profitable or do not generate sufficient cash to fund the business, or if
the Company fails to receive money to meet its obligations, the Company may have
to substantially cut back its level of operations. These reductions could, in
turn, affect relationships with strategic partners and customers and threaten
the Company's ability to continue as an ongoing concern. If the Company raises
additional funds through further issuance of equity or convertible debt
securities, the percentage of ownership of the Company's current stockholders
will be reduced and such securities may have rights, preferences and privileges
senior to those of our current stockholders. In addition, the Company may not be
able to obtain such financing on terms favorable to it, if at all. If adequate
funds are not available or are not available on terms favorable to the Company,
its business, results of operations and financial condition could be materially
and adversely affected.


2.   Summary of Significant Accounting Policies:

Cash and Cash Equivalents

     The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. The Company
invested its excess cash in 1999 and 2000 primarily in money market funds at
major financial institutions and fixed income notes secured by U.S. Government-
backed securities. These investments are subject to minimal credit and market
risks. At December 31, 1999 and 2000, total cash and cash equivalents were $55.6
million and $17.6 million, respectively. The cash equivalent investments were
stated at amortized cost plus accrued interest, which approximated market value.

Financial Instruments

     The Company's financial instruments consist of cash and cash equivalents,
short-term investments, accounts receivable, accounts payable, long-term debt
and capital lease obligations. The carrying amounts of these instruments at
December 31, 1999 and 2000 approximate their fair values.

     The Company's short-term investments consist of short-term debt securities,
which are classified at the date of purchase as held to maturity. Investments
with remaining maturities of less than twelve months from the balance sheet data
are classified as short-term. At December 31, 2000, these investments were
stated at amortized cost plus accrued interest, which approximated market value.

                                       41
<PAGE>

                             SMARTERKIDS.COM, INC.
                  NOTES TO FINANCIAL STATEMENTS--(Continued)

Inventories

     Inventories are stated at the lower of cost or market value, cost being
determined on a first-in, first-out basis. All inventory consists of finished
goods.

Property and Equipment

     Property and equipment assets are recorded at cost and depreciated using
the straight-line method over their estimated useful lives, generally three
years.

Intangible Assets

     Costs incurred for acquiring trademarks and domain names are capitalized as
intangible assets and amortized over their estimated useful lives, generally 2
years, using the straight-line method. Amortization expense related to
intangibles assets for the years ended December 31, 1999 and 2000 was $74,000
and $347,000, respectively.

Long-Lived Assets

     The Company evaluates the recoverability of its property and equipment,
trade credits and intangible assets in accordance with Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets to be Disposed of" ("SFAS 121"). SFAS 121 requires recognition of
impairment of long-lived assets in the event the net book value of such assets
exceeds the estimated future undiscounted cash flows attributable to such assets
or the business to which such intangible assets relate. No impairments were
required to be recognized during the years ended December 31, 1998, 1999 or
2000.

Concentrations of Credit Risk and Significant Customers

     Management believes its credit policies are prudent and reflect normal
industry terms and business risk. The Company does not anticipate non-
performance by counterparties and, accordingly, does not require collateral.
At December 31, 1999 and 2000, no customer accounted for more than 10% of total
amounts due to the Company.

     Sales to two customers accounted for 40% and 35% of the Company's total net
revenue in 1998.  No customers accounted for more than 10% of the Company's
total net revenue during in 1999 and 2000.

Revenue Recognition

     The Company recognizes revenue from product sales, net of any discounts and
allowances made for estimated product returns, when the products are received by
customers, provided that no significant Company obligations remain and
collection of the receivable is reasonably assured. Allowances made for
estimated returns are determined based on historical trends of actual returns.
Outbound shipping and handling charges billed to customers are included in net
revenues.

Cost of Revenues

     Cost of revenues consist of the cost of merchandise sold to customers and
the Company's shipping costs.

                                       42
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

Marketing and Sales Expenses

     Marketing and sales expenses consist primarily of advertising and
promotional expenditures, payroll and related costs for personnel engaged in
marketing and sales, as well as stock compensation related to options granted to
employees. Fulfillment costs related to online retail products, including the
cost of operating and staffing the distribution center as well as customer
service, are also included in marketing and sales expenses. Advertising costs
are charged to operations as incurred. Advertising expenses for 1998, 1999 and
2000 were $1,154,000, $21,314,000 and $11,469,000, respectively.

     Fulfillment costs included in marketing and sales expense were $1.5 million
and $4.6 million for the years ended December 31, 1999 and 2000, respectively.
Due to the nature of the business related to selling proprietary CD-ROM
products, fulfillment costs were not significant for the year ended 1998.

Development

     Development expenses consist primarily of payroll and related costs for
personnel performing website design, development, testing, technology
maintenance and content maintenance, as well as stock compensation related to
options granted to employees.

Stock Compensation

     Stock options issued to employees and members of the Company's Board of
Directors are accounted for in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and
related interpretations, including FASB Interpretation No. 44. Accordingly,
compensation expense is recorded for options awarded to employees and directors
to the extent that the exercise prices are less than the common stock's fair
market value on the date of grant, where the number of options and exercise
price are fixed. The difference between the fair value of the Company's common
stock and the exercise price of the stock option is recorded as deferred stock
compensation. Deferred stock compensation is amortized to compensation expense
over the vesting period of the underlying stock option. The Company follows the
disclosure requirements of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123") (Note 10). All stock-
based awards to non-employees are accounted for at their fair value in
accordance with SFAS 123.

Interest Income and Expense, Other Income and Expense

     Interest income consists primarily of interest earned on capital invested
in commercial paper, corporate and treasury notes. Interest expense is related
to short-term lease obligations and borrowings under our equipment lines of
credit. Also included in other expense in fiscal 2000 are transaction expenses
of $693,000 related to the proposed combination with Earlychildhood LLC. The
transaction expenses consist primarily of legal, accounting and investment
banking fees.

Net loss per common share

     The Company computes net loss per common share in accordance with SFAS No.
128, "Earnings Per Share," and SEC Staff Accounting Bulletin No. 98. Under the
provisions of SFAS 128 and SAB 98, basic net loss per common share is computed
by dividing net loss attributable to common stockholders by the weighted average
number of common shares outstanding. The calculation of diluted net loss per
common share for the years ended December 31, 1998, 1999 and 2000 does not
include 2,775,141, 3,017,400, and 2,900,500 potential shares of common stock
equivalents, respectively, as their inclusion would be antidilutive.


                                       43
<PAGE>

                             SMARTERKIDS.COM, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

Segment Reporting

     The Company operates domestically only and in a single segment: retail
children's software and other product sales. The Company has no organizational
structure dictated by product lines, geography or customer type.

Comprehensive Income

     The Company had no items of comprehensive income other than its net losses
during the three-year period ended December 31, 2000.

Use of Estimates

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

Recent Accounting Pronouncements

     In December 1999, the SEC staff released Staff Accounting Bulletin ("SAB")
101, "Revenue Recognition in Financial Statements", which provides guidance on
the recognition, presentation and disclosure of revenue in financial statements.
As required, the Company adopted SAB 101 in the fourth quarter of 2000.  The
adoption of SAB 101 had no material impact on the Company's financial
statements.

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, which
was issued in June 2000. The Company will adopt SFAS No. 133 in the first
quarter of 2001. SFAS No. 133 requires that all derivative instruments be
reported on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. The Company does not
expect adoption of SFAS No. 133 to have a significant impact on its financial
condition, results of operations, or business practices.

     In March 2000, the Emerging Issues Task Force ("EITF) of the FASB reached a
consensus on EITF Issue 00-2, "Accounting for Web Site Development Costs."  This
consensus provided guidance on what types of costs incurred to develop web sites
should be capitalized or expensed.  The Company adopted this consensus on July
1, 2000.  The adoption of this consensus had no material impact on the Company's
financial statements.

3.   Allowances for Doubtful Accounts and Sales Returns:

     Allowances for doubtful accounts and sales returns consist of the following
(in thousands):

<TABLE>
<CAPTION>
                                                                                        December 31
                                                                       -------------------------------------------
                                                                              1998          1999           2000
                                                                            --------       -----           -----
           <S>                                                         <C>              <C>            <C>
           Balance at beginning of year..............................        $ 269         $ 745          $ 114
           Additions:
                 Charged against revenues or expense.................          601           360             45
           Deductions:
                 Write-offs and returns..............................         (125)         (991)          (120)
                                                                            --------         -----          -----

           Balance at end of year....................................        $ 745    $      114     $       39
                                                                            ========    ==========     ==========
</TABLE>

                                       44
<PAGE>

                             SMARTERKIDS.COM, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

4.   Property and Equipment:

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

<TABLE>
<CAPTION>
                                                                                                 December 31,
                                                                                              ----------------
                                                                                             1999            2000
                                                                                           --------        -------
                    <S>                                                                    <C>             <C>
                    Software..................................................              $  377          $1,868
                    Furniture and fixtures....................................                 207             232
                    Computer and office equipment.............................               1,774           4,066
                    Leasehold improvements....................................                 507           1,275
                                                                                          --------        --------
                                                                                             2,865           7,441
                    Less--Accumulated depreciation and amortization...........                 444           2,145
                                                                                          --------        --------
                                                                                            $2,421          $5,296
                                                                                          ========        ========
</TABLE>

     Furniture and fixtures and computer and office equipment includes $362,000
at December 31, 1999 and 2000 related to assets held under capital leases.
Accumulated depreciation related to assets held under these leases was $265,000
and $314,000 at December 31, 1999 and 2000, respectively. Depreciation and
amortization expense for the years ended December 31, 1998, 1999 and 2000 was
$66,000, $222,000 and $1.7 million, respectively.

     During April 2000, the Company opened a new distribution facility. As of
December 31, 2000, there was $3,161,000 of capital costs associated with the new
distribution facility held in fixed assets.

5.   Equipment Lines of Credit:

     During the quarter ended March 31, 2000, the Company secured a three-year
equipment line of credit facility. Through December 31, 2000, borrowings and
equipment collateralized under this agreement were $1.5 million. The interest on
the borrowings is the three-year U.S. Treasury rate in effect at the time of the
drawing plus 3.5% (9.89 to 10.06% at December 31, 2000). In accordance with the
agreement, the balance under the line of credit was converted to a 36-month term
loan at the time of funding. Accordingly, the Company is making payments of
approximately $45,000 per month over the term of the loan. At December 31, 2000
a total balance of approximately $1.1 million remains outstanding and no
additional amounts are available under the line.

     During the quarter ended June 30, 2000, the Company secured additional
borrowing capacity of $1.0 million under another three-year equipment line of
credit facility. Through December 31, 2000 borrowings and equipment
collateralized under this agreement were $149,000. The interest on the
borrowings is 9% per annum. The Company issued warrants for the purchase of
16,667 shares of common stock with an exercise price of $3.00 per share in
connection with obtaining the facility. The warrants were fair valued and a
discount of $9,000 was recorded on the lease obligation. The discount is being
amortized to interest expense over the life of the line of credit. The Company
is making payments of approximately $5,000 over the term of the loan. At
December 31, 2000 a balance of approximately $119,000 remains outstanding.

     The following is a schedule of future minimum payments due under the
equipment lines of credit as of December 31, 2000.

     Year Ending December 31,

     2001....................................  $  596
     2002....................................     596
     2003....................................     125
                                              --------
     Total minimum payments..................   1,317
     Less--amount representing interest......     142
                                              --------
     Total...................................  $1,175
                                               ========


                                       45
<PAGE>

                             SMARTERKIDS.COM, Inc.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

     The above credit facilities contain covenants which, among other things,
impose certain limitations or prohibitions on the Company with respect to
additional indebtness and liens: the payment of dividends on, and the redemption
or repurchase, of capital stock of the Company, investments and acquisitions:
the merger and consolidation of the Company with any other entity and the
disposition of any material portion of the Company's assets. Other covenants
include a restriction on quarterly loss amounts and maintenance of a defined
liquidity ratio.

6.   Trade Credits

     During the quarter ended September 30, 2000, the Company entered into a
transaction where the Company traded inventory, consisting mainly of software
products, having a cost value equal to $2.0 million in exchange for $2.0 million
in trade credits. The trade credits can be used for the acquisition of a wide
variety of materials and services required in the Company's ongoing operations,
including for packaging materials, telecommunication services, advertising and
temporary employees. The trade credits can be applied to offset typically 20% of
the cost of such purchases and are usable through December 31, 2006. Upon
completion of the transaction, the Company removed $2.0 million of inventory and
recognized $2.0 million of trade credits in other assets. No gains or losses
were recognized in this transaction. As of December 31, 2000 $49,000 of the
trade credits have been used.

7.   Accrued Expenses:

     Accrued expenses consist of the following (in thousands):


                                               December 31,
                                               ------------
                                            1999          2000
                                            ----          ----
     Marketing.........................    $  261        $  246
     Commissions.......................       171           153
     Professional fees.................       105           156
     Advertising.......................     5,724         1,409
     Restructuring fees................         -         1,239
     Other.............................       438         1,215
                                          ---------    ----------
                                           $6,699        $4,418
                                          =========    ==========


     During the fourth quarter of 2000, the Company approved and implemented a
restructuring program in order to reduce operating expenses in the Company's
business. The restructuring plan is expected to be completed by June 2001. The
program included a net reduction of 60% of the Company's workforce. Accordingly,
during the fourth quarter of 2000, the Company recorded a charge of $1.3 million
related to employee termination benefits. As of December 31, 2000, $61,000 has
been paid out and $1,239,000 million remains outstanding.

8.   Preferred Stock:

     In October 1995, the Company authorized 10,000 shares of preferred stock
and designated 687 preferred shares as Series A convertible preferred stock (the
"Series A preferred"). The Company sold 634 shares of Series A preferred to an
entity affiliated with a common stockholder and member of the Board of Directors
of the Company for net proceeds of $3,000,000. In addition, 53 shares of Series
A preferred were issued in connection with the conversion of a $240,000 note
payable, plus accrued interest of $11,000, due to the same common stockholder.

     In 1997, the Company designated and sold 380 shares of Series B redeemable
convertible preferred stock (the "Series B preferred") for net proceeds of
$710,000. Included in this offering, the Company sold 125 shares of the Series B
preferred for net proceeds of $234,000 to an entity with which the Company
subsequently entered a marketing and licensing agreement. The Company also
entered into a stock purchase agreement with this entity allowing for the
purchase of preferred stock having a conversion value of 250,000 common shares,
at the same terms as the Series B preferred. The option expired unexercised in
July 1998. As payment for certain costs associated with the issuance of the
Series B preferred, the Company issued warrants to purchase 66,000 shares of
common stock (Note 10).

                                       46
<PAGE>

                             SMARTERKIDS.COM, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

     In 1998, the Company issued an additional 3,138 shares of the Series B
preferred for net proceeds of $6,091,000. As payment for certain costs
associated with the issuance of the Series B preferred, the Company issued
warrants to purchase 55,050 shares of common stock (Note 10).

     In July 1999, the Company designated and sold 4,284,091 shares of Series C
redeemable convertible preferred stock (the "Series C preferred") for net
proceeds of $25.3 million. As payment for certain costs associated with the
issuance of the Series C preferred, the Company issued warrants to purchase
113,027 shares of the Series C preferred (Note 10). The Series C preferred was
recorded upon issuance based on the net proceeds less the $515,000 value of the
warrants related to the issuance. The difference between the total net proceeds
at issuance and the total redemption value was being charged to accumulated
deficit over the period from issuance until redemption first became available.

     In November 1999, each Series A and Series B preferred share automatically
converted into 1,500 shares of common stock and each Series C preferred share
automatically converted into 1.5 shares of common stock upon the closing of the
Company's initial public offering of common stock (Note 9).

9.   Common Stock:

     In September 1999, the Company issued 25,500 shares of common stock valued
at $340,000 in connection with the acquisition of intangible assets.

     In November 1999, the Company issued 7,500 shares of common stock valued at
$105,000 in connection with the acquisition of intangible assets.

     On November 23, 1999, the Company completed its initial public offering of
5,158,500 shares of common stock resulting in net proceeds of $65,944,000.  In
connection with the closing of the offering, all outstanding convertible
preferred stock was converted into an aggregate 12,732,887 shares of common
stock.  Additionally, all warrants for the purchase of preferred stock were
converted into warrants for the purchase of shares of common stock.  The
redemption rights of the 25,500 shares of redeemable common stock were
automatically eliminated upon the Company's initial public offering of common
stock.

     On September 1, 2000, 40,665 shares of common stock were issued under the
1999 Employee Stock Purchase Plan.

10.  Warrants:

     In 1997 and 1998, in connection with issuance of the Series B preferred
(Note 8), the Company issued warrants to purchase a total of 66,000 and 55,050
shares, respectively, of the Company's common stock with an exercise price of
$0.13 per share. These warrants were exercisable immediately and expired at the
earlier of a change in control of the Company, completion of an initial public
offering, or five years from the date of grant. The fair values ascribed to
these warrants at the time of issuance were estimated by management to be
$18,000 and $69,000 for 1997 and 1998, respectively. The values of these
warrants were recorded as an increase to accumulated deficit and an increase to
additional paid-in capital. In October 1999, these warrants were exercised for
121,050 shares of common stock at $0.13 per share.

                                       47
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

     In March 1998, in connection with an amended debt agreement, the Company
granted warrants to purchase 5 shares of Series B preferred stock with an
exercise price of $2,000 per share. These warrants were exercisable immediately
and expired five years from date of grant. The fair value ascribed to these
warrants was $7,000 and was recorded as interest expense in 1998. Upon
completion of the Company's initial public offering in November 1999, these
warrants converted into warrants to purchase 7,500 shares of common stock at an
exercise price of $1.33 per share.

     In September 1998, in connection with a warehousing and fulfillment
services agreement, the Company issued warrants to its distribution partner to
purchase 57,000 shares of the Company's common stock with an exercise price of
$1.33 per share. Of these warrants, 15,000 shares vested immediately. Warrants
for an additional 42,000 shares vested in increments of 10,500 every six months,
commencing on March 1, 1999. These warrants expire five years from date of
grant and were remeasured at each reporting period until they vested. The fair
value ascribed to these warrants initially was $51,000, which was recorded as
compensation expense in 1998. In September 1999, in connection with amending and
further formalizing the warehouse and fulfillment services agreement, the
Company granted additional warrants to purchase 108,000 shares of the Company's
common stock with an exercise price of $1.33 per share. These warrants expire
five years from date of grant and were exercisable immediately. Also, the
previously granted warrants for 57,000 shares were amended to be fully
exercisable immediately. Accordingly, the fair market value of these previously
unvested warrants was determined final upon the amendment. The fair value of the
newly issued warrants was determined final when granted. The final value of all
of these warrants was determined to be $1,448,000. As of December 31, 1999,
deferred stock compensation related to all of the warrants held by the
fulfillment service provider was $1,207,000, which was being amortized to
compensation expense over the term of the service agreement as the services are
performed. During the second quarter of 2000, SmarterKids.com opened its own
distribution center and discontinued using J.L. Hammett Co. as its fulfillment
partner. In connection with this termination, the remaining deferred
compensation of $1,207,000 was expensed in the year ended December 31, 2000.

     In December 1998, in connection with a management consulting services
agreement, the Company granted warrants to a consultant to purchase 22,500
shares of the Company's common stock with an exercise price of $1.33 per share.
These warrants were exercisable immediately and were set to expire at the
earlier of a change in control of the Company, completion of an initial public
offering, or five years from the date of grant. The fair value ascribed to these
warrants at the time of issuance was $22,000 and was recorded as compensation
expense in 1998 as this was the period in which the services were provided. In
October 1999, these warrants were exercised for 22,500 shares of common stock.

     In March 1999, in connection with a promotional services program, the
Company issued warrants to an affiliated party to purchase 112,500 shares of the
Company's common stock with an exercise price of $1.33 per share. These warrants
vest upon the attainment of certain performance targets and expire in five
years. The final value of these warrants will be determined upon the attainment
of these performance targets based on their then-current fair value. As of
December 31, 1999, the fair value of this grant was $741,000. Related
compensation expense of $520,000 was recorded in the year ended December 31,
1999. The remaining deferred stock compensation is to be recognized over the
period that the services are provided. In November 2000, by agreement with the
counterparty, the Company cancelled warrants to purchase 84,375 shares of
SmarterKids.com common stock since the services to which they related will not
be performed. As a result of revaluations during the year and the partial
cancellation, the Company recorded a net credit to stock compensation expense of
$(508,000) for the year ended December 31, 2000 related to these warrants. As of
December 31, 2000, warrants to purchase 28,125 shares of common stock were
outstanding and the related deferred stock compensation was $4,000.

     In July 1999, in connection with the issuance of the Series C redeemable
convertible preferred stock (Note 8), the Company issued warrants to purchase
113,027 shares of the Company's Series C preferred stock at an exercise price of
$6.27 per share. These warrants were convertible into warrants to purchase
shares of the Company's common stock based on an exchange ratio of 1.5 shares of
common stock for each share of Series C preferred. These warrants were
exercisable immediately and were set to expire at the earlier of a change in
control of the Company, completion of an initial public offering, or four years

                                       48
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

from the date of grant. The value ascribed to these warrants was $515,000, based
on the fair value on the date of issuance. The value ascribed to these warrants
was recorded as a discount to the Series C preferred stock upon issuance. The
discount was being accreted to the Series C preferred stock balance over the
period from the date of issuance through the expected mandatory redemption date
until the conversion of the preferred stock into common stock at the initial
public offering date. On November 22, 1999, a portion of these warrants were
exercised for 93,295 shares of common stock. Consideration for the exercise
price of these warrants was not cash, but the forfeiture of the warrants for the
remaining 76,246 shares, which had an aggregate value on the exercise date equal
to the exercise price for the warrants.

     In September 1999, in connection with a management consulting services
agreement, the Company granted warrants to a consultant to purchase 15,000
shares of the Company's common stock with an exercise price of $1.33 per share.
These warrants were exercisable immediately and expired at the earlier of a
change in control of the Company, completion of an initial public offering, or
five years from the date of grant. The fair value ascribed to these warrants at
the time of issuance was $213,000 and was recorded as compensation expense
during 1999, the period in which the services were provided. In October 1999,
these warrants were exercised for 15,000 shares of common stock.

     In April 2000, in connection with a new equipment line of credit facility,
the Company issued to the lender warrants to purchase 16,667 shares of common
stock at an exercise price of $3.00 per share. These warrants were exercisable
immediately and expire six years from the date of grant. The fair value of these
warrants was determined to be $9,000, which was recorded as debt discount and
is being amortized to interest expense. As of December 31,2000, these warrants
remained outstanding.

     A summary of the status of stock warrants for the three years ended
December 31, 2000 is presented below:

<TABLE>
<CAPTION>
                                                                     Number of          Weighted-
                                                                     Shares of           Average
                                                                    Common Stock      Exercise Price
                                                                    ------------      --------------
     <S>                                                            <C>               <C>
     Outstanding--December 31, 1997...............................      66,000         $   0.13
        Granted (weighted average fair value of $0.97)............     142,050             0.87
        Exercised.................................................          --               --
        Forfeited.................................................          --               --
                                                                     ---------
     Outstanding--December 31, 1998...............................     208,050             0.64
        Granted (weighted average fair value of $3.14)............     405,041             2.52
        Exercised.................................................    (251,845)            1.81
        Forfeited.................................................     (76,246)            4.18
                                                                     ---------
     Outstanding--December 31, 1999...............................     285,000             1.33
        Granted (weighted average fair value of $2.43)............      16,667             3.00
        Exercised.................................................          --               --
        Forfeited.................................................     (84,375)            1.33
                                                                     ---------
     Outstanding---December 31, 2000..............................     217,292             1.46
                                                                     =========
</TABLE>

     The fair value of each warrant during 1998, 1999 and 2000 was estimated on
the applicable measurement dates using the Black-Scholes option pricing model
with the following assumptions:

                                       1998           1999             2000
                                       ----           ----             ----
     Dividend yield............         0.0%          0.0%             0.0%
     Expected volatility.......        90.0%         90.0%            90.0%
     Risk-free interest rate...         5.0%          5.4%            5.84%
     Expected life (years).....           5           4-5              4-6


     The Company determined that using the Black-Scholes model to value warrants
granted is more appropriate than using the fair value of the services method.

                                      49
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)


10.  Stock Option Plan:

1995 Stock Plan, as Amended

     In 1995, the Company adopted the 1995 Stock Plan (the "Plan"). The Plan
provides for issuance of incentive stock options to employees of the Company and
nonqualified stock options, awards of stock, and direct stock purchase
opportunities to directors, officers, employees and consultants of the Company.
The Board of Directors determines the term of each option, option price, number
of shares for which each option is granted and the rate at which each option is
exercisable. The total number of shares of common stock that may be issued under
the Plan is 3,822,000. In September 2000, options for 461,574 shares of common
stock were repriced (see further below). For holders of 10% or more of the
Company's outstanding common stock, options may not be granted at less than 110%
of the fair market value of the common stock at the date of grant, and the
option term may not exceed five years. The option term for nonqualified stock
options may not exceed ten years from the date of grant. Deferred compensation
under the 1995 Stock Plan is calculated by measuring the intrinsic value of the
options at the date of grant. The amount is then amortized over the vesting
period for employees.

1999 Stock Option and Incentive Plan

     In September 1999, the Board of Directors voted to terminate the Plan
effective on November 23, 1999, the date of the consummation of the Company's
initial public offerings and approved the adoption of the 1999 Stock Option and
Incentive Plan (the "1999 Plan"). The 1999 Plan provides for the grant of stock-
based awards to employees, officers and directors, and consultants or advisors,
including incentive stock options and non-qualified stock options and other
equity-based awards. A total of 3,500,000 shares of common stock may be issued
upon the exercise of options or other awards granted under the 1999 Plan. As of
December 31, 2000, options for 3,552,850 shares were granted under the 1999
Plan, which includes options for 1,864,000 shares that were repriced in
September 2000 (see further below). Deferred compensation under the 1999 Stock
Option Plan is calculated by measuring the intrinsic value of the options at the
date of grant. The amount is then amortized over the vesting period for
employees.

1999 Non-Employee Director Stock Option Plan

     The 1999 Non-Employee Director Stock Option Plan (the "Director Plan")
was adopted by the Board of Directors and approved by stockholders in September
1999 and became effective on November 23, 1999. The Director Plan provides for
the grant of options to purchase a maximum of 200,000 shares of common stock of
the Company to non-employee directors of the Company. A committee appointed by
the Board of Directors will administer the Director Plan. Under the Director
Plan, each director who is not an employee or officer of the Company and who was
not a director at the time of the Company's initial public offering is
automatically granted on the date such person is first elected to the Board of
Directors an option to purchase 45,000 shares of common stock. Each time a non-
employee director is re-elected to the Board, such non-employee director will
automatically receive an option to purchase 2,000 shares of common stock.
Provided that the director continues to serve as a member of the Board of
Directors, one-third of the shares included in each grant will become
exercisable on each of the first, second and third anniversaries of the date of
grant. All options granted under the Director Plan will have an exercise price
equal to the fair market value of the common stock on the date of grant. As of
and through December 31, 2000, no options have been granted under the Director
Plan.

                                      50
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

     The Company recorded deferred stock compensation of $1.5 million, $5.7
million and $0 in 1998, 1999 and 2000, respectively, related to employee stock
option grants. The Company recognized $81,000, $2.2 million and $1.3 million in
non-cash stock compensation expense related to amortization of deferred stock
compensation on employee stock option grants during 1998, 1999 and 2000,
respectively.

Option Repricing
----------------

     In March 2000, the Financial Accounting Standard Board ("FASB") issued FASB
Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44
clarifies the application of Accounting Policy Bulletin ("APB") APB Opinion No.
25 and among other issues clarifies the following: the definition of an employee
for purposes of applying APB Opinion No. 25, the criteria for determining
whether a plan qualifies as a noncompensatory plan, the accounting consequence
of various modifications to the terms of previously issued fixed stock options
or awards, and the accounting for an exchange of stock compensation awards in a
business combination. FIN 44 was effective July 1, 2000, but certain conclusions
in FIN 44 cover specific events that occurred after either December 15, 1998 or
January 12, 2000.

     In September 2000, the Company completed a direct repricing of certain
employee stock option grants. As part of the repricing, the Company reduced the
exercise price of all outstanding options with exercise prices of greater than
$1.50 per share. The new exercise price of these repriced options was reset to
$1.50 per share, which was equal to the market value of the Company's common
stock on September 7, 2000. The number of options repriced totaled 2,325,574
shares. The Company is accounting for the repriced options as variable awards.
In the year ended December 31, 2000, the Company did not record any additional
non-cash stock compensation charges as a result of this repricing since the
market price at December 31, 2000 was less than the repriced exercise price.

     During 1998 and 1999, the Company granted nonqualified stock options under
the Plan to non-employees, for services performed, to purchase 5,250 and 44,250
shares of common stock, respectively. The Company recorded stock compensation
expense related to non-employee stock options of $33,000, $234,000 and $110,000
in 1998, 1999 and 2000, respectively. Such amounts were determined under the
Black-Scholes model based on the fair value of the options granted, including
adjustments for revaluation at each period-end for unvested options. The Company
determined that using the Black-Scholes model to value warrants granted is more
appropriate than using the fair value of the services method.

A summary of the activity under the Plan and the 1999 plan for the three years
ended December 31, 2000 is presented below:

<TABLE>
<CAPTION>
                                                                                    Weighted - Average
                                                                Number of Shares      Exercise Price
                                                                ----------------      ---------------
     <S>                                                           <C>                 <C>
     Outstanding--December 31, 1997.........................        1,481,350             0.07
        Granted (weighted average fair value of $1.22)......        1,238,251             0.14
        Exercised...........................................         (125,760)            0.08
        Forfeited...........................................          (26,750)            0.13
                                                                   ----------
     Outstanding--December 31, 1998.........................        2,567,091             0.07
        Granted (weighted average fair value of $7.96)......        2,201,849             7.72
        Exercised...........................................         (497,028)            0.23
        Forfeited...........................................          (97,713)            0.85
                                                                   ----------
     Outstanding--December 31, 1999.........................        4,174,199             4.09
        Granted (weighted average fair value of $1.29)......        4,014,424             2.02
        Exercised...........................................         (326,414)            0.13
</TABLE>

                                      51
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)


<TABLE>
     <S>                                                           <C>                <C>
        Forfeited...........................................         (467,560)        4.36
        Cancelled...........................................       (2,325,574)        8.30
                                                                   ----------
     Outstanding--December 31,2000..........................        5,069,075         0.88
                                                                   ==========
</TABLE>

     At December 31, 1998, 1999 and 2000, the Company maintained options
available for future grants of 1,126,400, 1,082,263 and 1,177,234, respectively.

     The following table summarizes information about stock options outstanding
at December 31, 2000:

<TABLE>
<CAPTION>
                                         Weighted-                                              Weighted-
                                          Average                                                Average
                                         Remaining                                              Exercise
                                        Contractual        Weighted-          Number of         Price for
                           Number           Life             Average            Shares         Exercisable
        Exercise Price    of Shares       (years)        Exercise Price       Exercisable        Options
     -----------------    ---------       -------        --------------       -----------        -------
     <S>                  <C>           <C>              <C>                  <C>            <C>
                 $0.02      300,000         4.7              $  0.02              300,000        $  0.02
             0.06-0.13    1,391,425         6.6                 0.10            1,073,828           0.13
             0.15-1.33      546,750         6.4                 0.18              445,500           0.15
                  1.50    2,830,900         8.0                 1.50              871,835           1.50
                        -----------                                           -----------
                          5,069,075                                             2,691,163
                        ===========                                           ===========
</TABLE>

     At December 31, 1998 and 1999, of the options outstanding, 988,515 and
2,089,470 shares respectively, were exercisable.

     The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option pricing model with the following assumptions:

<TABLE>
<CAPTION>
                                        1998      1999        2000
                                        ----      ----        ----
     <S>                                <C>       <C>        <C>
     Dividend yield...................  0.0%      0.0%        0.0%
     Expected volatility..............  0.0%     90.0%       90.0%
     Risk-free interest rate..........  5.0%      5.4%        5.8%
     Expected life (years)............    5         5           5
</TABLE>

     Stock compensation expense has been recognized for options granted to
employees pursuant to APB 25 and its interpretations. Had stock compensation
cost been determined based on the fair value of the options at the grant date
consistent with the provisions of SFAS 123, the Company's net loss attributable
to common stockholders would have been increased to the pro forma amounts
indicated below. Because options vest over several years and additional option
grants are expected to be made in future years, the pro forma results for 1998,
1999 and 2000 are not representative of pro forma results for future years.

<TABLE>
<CAPTION>
                                                                      Year Ended December 31,
                                                                 --------------------------------
                                                                    1998         1999        2000
                                                                    ----         ----        ----
     <S>                                                         <C>          <C>          <C>
     Net loss attributable to common stockholders
     (in thousands):
          As reported.................................            $(3,596)    $(34,917)    $(32,674)
          Pro forma...................................             (3,621)     (36,639)    $(33,442)
     Net loss per common share:
          As reported.................................            $ (2.34)    $  (9.20)    $  (1.59)
          Pro forma...................................              (2.63)       (9.65)       (1.63)
</TABLE>

1999 Employee Stock Purchase Plan

     The 1999 Employee Stock Purchase Plan (the "Stock Purchase Plan") was
adopted by the Board of Directors and approved by stockholders in September
1999, and became effective upon completion of the Company's initial public
offering in November 1999. The Stock Purchase Plan provides for the issuance of
a maximum of 400,000 shares of common stock. The Board of Directors and the
Compensation Committee administer the Stock Purchase Plan. All employees whose
customary employment is for more than 20 hours per week and for more than three

                                       52
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

months in any calendar year and who have completed more than 1 day of employment
on or before the first day of any six-month payment period are eligible to
participate in the Stock Purchase Plan. Outside directors and employees who
would own 5% or more of the total combined voting power or value of the
Company's common stock immediately after the grant may not participate in the
Stock Purchase Plan. As of December 31, 2000, 40,665 shares of common stock have
been issued under the Stock Purchase Plan.

11.  Income Taxes:

     Deferred tax assets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                                   December 31,
                                                                     ----------------------------------------
                                                                      1998            1999             2000
                                                                     -------        --------         --------
     <S>                                                             <C>            <C>              <C>
     Net operating loss carryforwards...........................     $ 2,261        $ 15,322         $ 27,003
     Research and development credit carryforwards..............          90             136               99
     Stock compensation expense.................................          81             495              736
     Other......................................................         404              64              943
                                                                     -------        --------         --------
       Deferred tax assets......................................       2,836          16,017           28,781
     Deferred tax asset valuation allowance.....................      (2,836)        (16,017)         (28,781)
                                                                     -------        --------         --------
         Net deferred tax assets................................     $    --        $     --         $     --
                                                                     =======        ========         ========
</TABLE>

     At December 31, 2000, available net operating loss carryforwards for
federal and state tax purposes were approximately $67,000,000, which expire
through 2020. At December 31, 2000, the Company has research and development tax
credit carryforwards of approximately $99,000 available to reduce future federal
tax liabilities which expire in 2019. Approximately $400,000 of the net
operating loss carryforwards relate to the exercise of non-qualified stock
options and disqualifying disposition of incentive stock options the tax benefit
from which, if realized, will be credited to the additional paid-in-capital.

     Under the provisions of the Internal Revenue Code, certain substantial
changes in the Company's ownership could result in an annual limitation of the
amount of net operating loss carryforwards and research and development credit
carryforwards which can be utilized in future years.

     Income taxes computed using the federal statutory income tax rate differ
from the Company's effective tax rate primarily due to the following (in
thousands):

<TABLE>
<CAPTION>
                                                                       Year Ended December 31,
                                                               -------------------------------------------
                                                                1998              1999              2000
                                                               -------          --------          --------
     <S>                                                       <C>            <C>              <C>
     Income tax expense (benefit) at US federal
          statutory tax rate...............................    $(1,136)         $(11,807)         $(11,109)
     State income taxes, net of federal tax
          effect...........................................       (221)           (2,050)           (1,962)
     Permanent items.......................................          1               751               439
     Other.................................................        (24)               75              (132)
     Change in deferred tax asset valuation
          allowance........................................      1,380            13,031            12,764
                                                               -------          --------          --------
     Provision for income taxes  ..........................    $    --          $     --          $     --
                                                               =======          ========          ========
</TABLE>

12.  Defined Contribution Plan:

     In January 1996, the Company adopted a defined contribution plan under
Section 401(k) of the Internal Revenue Code covering substantially all
employees. Under the plan, employees may contribute the lower of up to 15% of
their salaries or a dollar amount prescribed by the Internal Revenue Code. The
Board of Directors may elect to make a discretionary contribution to the plan.
The Company made no contributions during the years ended December 31, 1998, 1999
and 2000.

                                       53
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

13.  Commitments and Contingencies:

     Leases

     The Company leases its facilities and certain computer equipment under
noncancelable operating leases. In April 2000, the Company entered into an
operating lease for a new distribution facility. The five-year lease requires
minimum annual payments of approximately $900,000. Rental expense under
operating leases for the years ended December 31, 1998, 1999 and 2000 was
$121,000, $499,000 and $1,752,000, respectively. During 1999, the Company
entered into capital leases for the acquisition of certain assets.

     Future minimum lease obligations as of December 31, 2000 are as follows (in
thousands):

<TABLE>
<CAPTION>
                                                 Operating    Capital
                                                   Leases      Leases
                                                   ------      ------
     <S>                                         <C>          <C>
     Year Ending December 31,
          2001...............................      $2,071      $   36
          2002...............................       2,011          --
          2003...............................       1,917          --
          2004...............................       1,748          --
          2005...............................         225          --
                                                   ------      ------
     Total minimum lease payments............      $7,972      $   36
                                                   ======
     Less--amount representing interest......                       1
                                                               ------
     Total...................................                  $   35
                                                               ======
</TABLE>

Restricted Time Deposit

     In connection with a facility lease entered into in 1999, the Company is
required to maintain, on behalf of the landlord, a certificate of deposit in the
amount of $500,000, which is restricted as to its use.  In connection with the
warehouse facility lease entered into in the second quarter of 2000, the Company
was required to maintain, on behalf of the landlord, $500,000 in an interest-
bearing account, which will be restricted as to its use.

License Agreements

     The Company has entered into agreements with various third parties whereby
the Company is obligated to pay a royalty ranging from 3% to 11% of the revenues
on certain of its software products. Royalty expenses in the years ended
December 31, 1998, 1999 and 2000 were not significant.

Legal Matters

     On July 15, 1999, a patent infringement suit was filed against the Company.
Specifically, the suit alleged that the SmartPicks technology developed by the
Company in connection with its web-based product line infringes on a patent held
by the plaintiff. This patent purports to disclose and claim a computer system
for matching appropriate educational products with a child's developmental
profile comprising so-called "static and dynamic data." In November 1999, the
Company settled the patent infringement lawsuit, and the lawsuit was dismissed.
The settlement agreement granted the Company a non-exclusive license to the
plaintiff's patent.  Through December 31, 1999, the Company incurred legal
expenses and settlement costs of $861,000 pursuant to the above referenced
patent litigation. These expenses have been included in general and
administrative expenses in the Company's statement of operations for the year
ended December 31, 1999.

     The Company is party from time to time to certain other litigation matters
and claims which are normal in the course of its operations and, while the
results of litigation and claims cannot be predicted with certainty,

                                       54
<PAGE>

                             SMARTERKIDS.COM, INC.

                  NOTES TO FINANCIAL STATEMENTS--(Continued)

management believes that the final outcome of such matters will not have a
materially adverse effect on the Company's financial position or results from
operations.

14.  Subsequent Events:

Proposed Combination

     On November 14, 2000, the Company entered into an agreement to combine with
Earlychildhood LLC.  In the proposed transaction, the Company's stockholders
will convert their outstanding shares of common stock and Earlychildhood's
members will exchange their membership interests for shares of common stock of
LearningStar Corp., a newly formed company.  Also, the Company's outstanding
stock options and warrants will be converted to options and warrants to receive
common stock of LearningStar.  After the conversion, holders of the Company's
common stock, stock options and warrants will own approximately one-third of
LearningStar's shares on a diluted basis.  The completion of the combination is
subject to certain conditions, including approval by the Company's stockholders.

15.  Quarterly Financial Information (Unaudited)

<TABLE>
<CAPTION>
                                                                                  Quarter Ended
                                                 ---------------------------------------------------------------------------------
                                                 Mar. 31,   June 30,  Sept. 30,  Dec. 31,  Mar. 31,  June 30,  Sept. 30,  Dec. 31,
                                                   1999       1999      1999       1999      2000      2000       2000      2000
                                                 ---------------------------------------------------------------------------------
<S>                                              <C>        <C>       <C>        <C>       <C>       <C>       <C>        <C>
                                                                             (unaudited, in thousands)
Net revenues.................................      $    94  $   293   $   721    $  4,313  $ 1,469   $ 1,528   $ 1,507    $ 5,702
Gross profit.................................           25       83       205       1,103      368       379       371      1,168
Loss from operations.........................       (2,904)  (4,443)   (7,095)    (21,038)  (8,959)   (8,738)   (7,810)    (9,002)
Net loss.....................................       (2,880)  (4,415)   (6,847)    (20,586)  (8,131)   (8,084)   (7,255)    (9,204)
Basic and diluted net loss per share
  attributable to common
  stockholders...............................        (1.77)   (2.66)    (3.52)      (2.10)   (0.40)    (0.39)    (0.35)     (0.45)
</TABLE>

                                       55