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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

Form 10-K

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

For the fiscal year ended December 31, 2009

Commission file number: 1-34283

Rosetta Stone Inc.(Exact name of registrant as specified in its charter)

Delaware(State of incorporation)

043837082(I.R.S. Employer Identification No.)1919 North Lynn St., 7th Fl,
Arlington, Virginia(Address of principal executive offices)

22209(Zip Code)


Registrant's
telephone number, including area code: 800-788-0822

Securities Registered Pursuant to Section 12(b) of the Act:

Title of Each Class

Name of Each Exchange on Which RegisteredCommon Stock, par value $0.00005 per share

New York Stock Exchange


Securities
Registered Pursuant to Section 12(g) of the Act: None

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

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period
that the registrant was required to submit and post such
files). Yes o    No o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated filer o

Accelerated filer o

Non-accelerated filer ý (Do not check if a
smaller reporting company)

Smaller reporting company o


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

The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $300 million as of June 30,
2009 (based on the last sale price of such stock as quoted on the New York Stock Exchange).

As
of March 2, 2010, there were 20,251,027 shares of common stock outstanding.

Documents incorporated by reference:Portions of the definitive Proxy Statement to be delivered to stockholders in connection
with the 2010 Annual
Meeting of Stockholders to be held on May 26, 2010 are incorporated by reference into Part III.



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TABLE OF CONTENTS



PagePART IItem 1.

Business

3Item 1A.

Risk Factors

18Item 2.

Properties

38Item 3.

Legal Proceedings

38PART IIItem 5.

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities

39Item 6.

Selected Financial Data

41Item 7.

Management's Discussion and Analysis of Financial Condition and Results of
Operations

43Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

66Item 8.

Financial Statements and Supplementary Data

66Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure

66Item 9A

Controls and Procedures

67Item 9B

Other Information

67PART IIIItem 10.

Directors, Executive Officers and Corporate Governance

67Item 11.

Executive Compensation

68Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters

68Item 13.

Certain Relationships and Related Transactions, and Director
Independence

68Item 14.

Principal Accounting Fees and Services

68PART IVItem 15.

Exhibits and Financial Statement Schedules

68


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PART I

Item 1.Business

Overview

We are a leading provider of technology-based language learning solutions. We develop, market and sell language learning solutions
consisting of software, online services and audio practice tools primarily under ourRosetta Stonebrand. Our teaching method, which we call Dynamic Immersion, is designed to leverage the innate, natural language learning ability that children use to learn their native language. Our courses
are based on our proprietary interactive technologies and pedagogical content, and utilize a sophisticated sequencing of images, text and sounds to teach a new language without translation or grammar
explanation. We believe our award-winning solutions provide an effective, convenient and fun way to learn languages. We currently offer our self-study language learning solutions in 31
languages. Our customers include individuals, educational institutions, armed forces, government agencies and corporations.

People
throughout the world seek to learn foreign languages for a variety of reasons, including to learn about other cultures, to communicate with friends and family, to enhance their
career prospects, to travel internationally and to obtain personal enjoyment and enrichment. According to a December 2007 industry analysis we commissioned from The Nielsen Company, a market research
firm, which we refer to as the Nielsen survey, the language learning industry worldwide represented over $83 billion in consumer spending in 2007, of which more than $32 billion was for
self-study. According to the Nielsen survey, the language learning industry in the United States, where we generated 92% of our revenue in 2009, represented over $5 billion in
consumer spending in 2007, of which over $2 billion was for self-study.

The
strength and breadth of our solutions have allowed us to develop a business model that we believe distinguishes us from other language learning companies. Our scalable technology
platform and our proprietary content can be deployed across many languages. This has enabled us to cost-effectively develop a broad product portfolio. We have a multi-channel marketing and
distribution strategy that directly targets customers, utilizing print, online, television and radio advertising, public relations initiatives and our branded kiosks. Approximately 82% of our revenue
in 2009 was generated through our direct sales channels, which include our call centers, websites, institutional sales force and kiosks. We also distribute our solutions through select retailers such
as Amazon.com, Apple, Barnes & Noble, Office Depot and Borders. According to an August 2008 survey we commissioned from Global Market Insite Inc., or GMI, a market research services
firm, which we refer to as the GMI survey,Rosetta Stoneis the most recognized language learning brand in the United States. Additionally, of those
surveyed who had an opinion of our brand, over 80% associated it with high quality and effective products and services for teaching foreign languages. January and February 2009 internal studies showed
aided brand awareness for Rosetta Stone in the US was approximately 74-79%, based on general population surveys and confirmed thatRosetta
Stoneis the most recognized language learning brand in the United States.

We
grew our revenue from $25.4 million in 2004 to $252.3 million in 2009, representing a 58% compound annual growth rate.

Our Industry

Market Size.According to the Nielsen survey, the worldwide language learning industry represented more than $83 billion in
consumer spending
in 2007, of which more than $32 billion was for self-study. The Nielsen survey also estimated that the language learning industry in the United States, where we generated 92% of our
revenue in 2009, represented more than $5 billion in consumer spending in 2007, of which more than $2 billion was for self-study. In a more recent study in 2009 we

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estimated
the language learning industry represented more than $4.5 billion in consumer spending, of which $2.4 billion was for self-study.

The
language learning market is highly fragmented and consists of the following primary models: classroom instruction utilizing the traditional approach of memorization, grammar and
translation; immersion-based classroom instruction; self-study books, audio tapes and software that rely on grammar and translation; and free online offerings that provide basic content
and opportunities to practice writing and speaking.

Key Drivers of Demand in Language Learning Market.We believe that language learning is becoming more important and valued by
individuals and
institutions in the United States and throughout the world. The demand for language learning is driven in part by:



Limitations of Traditional Methods for Language Learning.The human brain has a natural capacity to learn languages. Children learn
their native
language without using rote memorization or adult analytical abilities for grammatical understanding. They learn at their own pace through their immersion in the language spoken around them and using
trial and error. They do not rely on translation. By contrast, foreign languages have traditionally been taught by focusing on memorization, grammar translation and word translation, typically in an
academic classroom setting. This traditional method involves learning complex grammar rules, conjugating verbs and memorizing vocabulary lists. Students have little practice speaking or listening in
the classroom, and practice outside the classroom typically involves rote listening to audio recordings and pronunciation exercises, with little or no
feedback on pronunciation accuracy. Many students who were taught languages using the traditional method regard it as ineffective and boring.

Emergence of Immersion Language Learning.To address some of the shortcomings of traditional language learning methods, language
learning specialists
have developed an alternative method for teaching language known as immersion learning, in which only the target language is spoken. We believe that immersion learning is more effective than the
traditional translation and grammar method in helping learners move towards conversational fluency. Immersion learning provides a more natural, direct learning environment, where the learner deduces
meaning and develops an intuition of language structure. This is similar to the manner in which children learn their native language, without an awareness of formal grammar rules or the necessity to
translate. Most immersion learning programs, however, require either one-on-one teaching, a small group course or travel to a foreign country. These programs can cost several
thousand dollars and are less convenient than self-study alternatives.

Use of Interactive Technologies.There has been a rapid adoption of interactive technologies and software tools to help learning in
both consumer and
institutional markets, supported by the rapid increase in computing technologies and internet use. According to a 2008 report by Euromonitor

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International, Inc.,
a market research firm, there will be more than one billion personal computers in use, and 1.7 billion internet users, by 2009. Given busy lifestyles, adult language
learners seek solutions that work flexibly and do not require physical classroom attendance. Educators are interested in deploying learning tools that are relevant to their students, who have had
extensive exposure to computer software and interactive games. Corporations are recognizing the value and effectiveness of using their technology investment to help increase the skills of their
workforce. According to a July 2007 report by Global Industry Analysts, Inc., a market research firm, the global demand for the delivery of instructional content through the use of electronic
technology, or eLearning, will grow an average of 21% annually between 2007 and 2010, reaching a total estimated value of $53 billion by 2010.

The Need for a High-Quality, Trusted Solution.Consumers and institutions face a confusing array of alternatives when choosing a
language
course due to the fragmented nature of the language learning market. Most providers of language learning offer little information to potential customers about their teaching methods and do not have
well known brands. The few major internationally known language learning providers generally offer only classroom instruction, which is not convenient for all prospective language learners. In
addition, there are numerous self-study courses in the market available at a variety of price points, most of which are offered as audio and books and do not provide an interactive,
immersion learning experience. There are also many community websites that provide free opportunities to practice.

We
believe that language learners seek a trusted name-brand solution that is more convenient and affordable than classroom alternatives, and more effective, interactive and
engaging than other self-study options. We believe the combination of these elements is not offered by traditional providers of language instruction.

The Rosetta Stone Solution

Our mission is to change the way people learn languages. We believe our solutions provide an effective way to learn languages in a
convenient and engaging manner. Our approach, calledDynamic Immersion, eliminates translation and grammar explanation and is designed to leverage the
innate, natural language learning ability that children use to learn their native language. We consider traditional translation and grammar methods as obstacles that delay and impede the successful
acquisition of language proficiency, and our solutions avoid those elements. Our computer-based self-study courses allow our customers to learn using the immersion method on their own
schedule and for a price that is significantly lower than most classroom-based or one-on-one alternatives. Although other audio and software publishers claim to teach with
immersion methods, we believe that we are the only self-study solution that teaches strictly without any translation or explicit grammar explanations. Our proprietary solutions have been
developed over the past 16 years by professionals with extensive linguistic, educational and instructional technology expertise. We estimate that our content library consists of more than
25,000 individual photographic images and more than 400,000 professionally recorded sound files. We design the sequencing of our content to optimize learning. The result is a rigorous and complete
language learning curriculum that is also designed to be flexible, fun and convenient.

Our
language learning solutions are built upon a flexible software platform that supports multiple languages and is deployable on personal computers, on local networks and online. The
platform incorporates a number of proprietary technologies that are key to enabling language learning, including:



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Rosetta
Stone offers a broad product suite, with courses currently available in 31 languages. Our courses are available in up to five levels of proficiency per language, with each level
providing approximately 40 hours of instruction and containing multiple units, lessons and activities.

In
July 2009, we introducedRosetta Stone TOTALe,an online language learning solution that integrates our online courses with
coach-led practice sessions, fun and engaging language games, interaction with native speakers and live support from customer service agents.

We
also provide an online peer-to-peer practice environment calledSharedTalk, at www.sharedtalk.com, where registered language learners meet for language
exchange to practice their foreign language skills. During 2009, we had more
than 125,000 activeSharedTalkusers.

Our
innovative solutions have received numerous awards and recognitions, including our placing #14 on the 2009 Inc. 5000 list for the education industry, the 2009 National
Parenting Publications Awards (NAPPA) Honors Award for Rosetta Stone Version 3 Personal Edition, four classroom specific awards in 2009 for Classroom Version 3, two enterprise specific awards in 2009,
the 2008 CODiE awards for best corporate learning solution and best instructional solution in other curriculum areas sponsored by the Software & Information Industry Association, the 2008
education product of the year awarded by MacWorld, the 2008 BESSIE multilevel foreign language award for Spanish Levels 1, 2, and 3 awarded byComputED
Gazettein 2008, the 2008 EDDIE Award for our classroom edition as the best foreign language website awarded byComputED
Gazette, the 2007 EDDIE multilevel foreign language award for Chinese levels 1 and 2 and a 2007 multilevel
English-as-a-second-language, or ESL, award for English levels 1, 2, and 3 awarded byComputED Gazette.

Competitive Strengths

We consider the foundations of our success to be the quality and breadth of our solutions, the strength of our brand and our direct
distribution model. Together, we believe these elements represent a business model with attractive economics that differentiates us from other language learning providers. The quality of our solutions
supports our price point, which in turn allows us to deploy a multi-channel marketing effort and a broad-based direct distribution network. We focus on educating consumers about the benefits of our
solutions by leveraging our advertising and our kiosk network to drive customers to our call centers and websites, where they can learn about our solutions, try product demonstrations and then
transact directly with us.

We
believe our competitive strengths include:

Advanced Technology-Enabled Language Learning System.Our proprietary solutions combine effective immersion learning with the benefits
of flexibility
and interactivity to provide for an efficient and engaging language learning experience. We intend to remain at the forefront of technological and pedagogical advances in language learning.

Scalable and Adaptable Platform and Content.Our solutions are designed to be efficiently delivered across multiple languages, systems
and geographic
markets. For example, we deploy many of the same images and image combinations across multiple languages, which accelerates our ability to add new languages. Because our solutions do not rely upon
translation from the target language into the learner's native language, they require only modest localization to be used by learners from other native language backgrounds. This facilitates our
ability to sell our existing language courses in new international markets. In addition, our software platform is engineered to work in the same way both

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online
and locally installed, allowing for multiple delivery methods. We also use the same platform for all editions of our solutions: personal, enterprise, classroom and home school.

Effective Multi-Channel Marketing and Distribution Model.We believe that our multi-channel marketing
and distribution strategy is a competitive strength because it enables us to market and serve our diverse customer base more broadly and make marketing impressions with a high frequency and at a
relatively low cost per impression. As compared to competitors that rely primarily on retailers or online vendors to sell their products, our direct marketing and distribution strategy enables us to
exert more control over our own growth and the customer experience. Our marketing, sales and distribution efforts are highly integrated and focused on direct interaction with consumers. As a result,
we are able to present a tightly controlled and unified message to the marketplace. Our television, online, print and radio advertising includes a "call to action" that drives customers directly to
our websites and call centers, where we seek to convert them to sales. Our marketing tools and techniques allow us to attribute sales results to specific marketing initiatives. We utilize this data to
continuously improve the efficiency of our websites, call centers, advertising and media planning and buying. We also operated 242 kiosks as of December 31, 2009, which extend our direct
interaction with customers and allow them to experience our solutions with the guidance of one of our product specialists. Our kiosks are located in airports, malls and other strategic,
high-traffic locations. In our institutional markets, sales efforts are led by our direct sales force. We conduct our institutional marketing primarily through tradeshows and customer
visits. Our marketing campaigns also support this channel. We augment our direct distribution network with select retailers, including Amazon.com, Apple, Barnes & Noble and Borders. We also
offer our products in a limited number of ZoomShop unmanned automated kiosks. During the year ended December 31, 2009, approximately 82% of our revenue came from our direct channels, including
our websites, call centers, kiosks and institutional sales force, and the remainder was attributable to sales through retailers.

Leading and Trusted Brand, with a Differentiated, High-Quality Positioning.According to the GMI survey,Rosetta
Stoneis the most recognized brand of language learning solutions in the United States. Additionally, of those surveyed who had an opinion of our brand, over 80% associated the
brand with high-quality and effective products and services for teaching foreign languages. We believe we have positionedRosetta Stoneas a
premium brand and a trusted choice for learning languages. Our marketing message centers on key points of differentiation from our competitors' traditional language offerings by focusing on our
learners' own intrinsic competence. We believe that continued marketing and brand building will drive broader demand for our products and help us pursue our goal of making Rosetta Stonethe preeminent
language learning brand.

Enthusiastic and Loyal Customer Base.Our customers exhibit loyalty and enthusiasm for our products and many promote sales of our
products through
word-of-mouth referrals. Our latest survey of our individual customers in the United States, completed in August 2009, revealed that 90% of respondents expressed satisfaction
with our solutions, with a satisfaction rating of 6 or higher on a 10-point scale, and 88% would recommend our solutions to friends or colleagues. Our latest survey of our institutional
customers in the United States, completed in February 2010, revealed that 85% of respondents expressed satisfaction with our solutions, with a satisfaction rating of 6 or higher on a
10-point scale, and 83% said that they would recommend our solution to other organizations.

Effective Products.We believe our solutions are effective. According to a January 2009 study we commissioned from Roumen Vesselinov,
Ph.D, visiting
assistant professor, Queens College, City University of New York, after 55 hours of study using our Spanish program the average WebCAPE score will be at a level sufficient to fulfill the
requirements for one semester of study in a college that offers six semesters of Spanish. Statistically, the study concluded that such an outcome would occur with 95% confidence. WebCAPE, which stands
for Web-based Computer Adaptive Placement Exam, is a standardized test which, according to their website, is used by over 500 colleges and universities for

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placement.
In addition, approximately 64% of the students participating in the study increased their oral proficiency by at least one level on a seven-level scale based on the American Council on the
Teaching of Foreign Languages (ACTFL) OPIc test, which is used worldwide by academic institutions, government agencies, and private corporations for evaluating oral language proficiency.

In
May 2009, we commissioned Rockman et al, an independent evaluation research and consulting firm, to conduct a quantitative study to measure the effectiveness of the Rosetta Stone
solution including newRosetta Stone TOTALe, and product features such asRosetta Studio, our live
online language learning practice sessions with dedicated conversation coaches. According to the study, after 64 hours of study with Rosetta Stone Spanish (Latin American) and six hours of Rosetta Studiosessions, 78% of the students participating in the study increased their oral proficiency by at least one level on the seven-level scaled
developed by ACTFL. Based on the overall results from the research study, the researchers from Rockman et al concluded that the Rosetta Stone solution is both an effective and efficient means of
learning foreign languages.

Our Strategy

Our goal is to strengthen our position as a leading provider of language learning solutions through the following strategies:

Extend Our Technological and Product Leadership.We intend to apply new technologies to maintain our product leadership. We currently
are working on
a variety of product development initiatives. For example, in July 2009, we introducedRosetta Stone TOTALe,a new web-based service that
extends our existing language courses by offering opportunities for practice with dedicated language conversation coaches and other language learners to increase language socialization, offering
online learning games and interaction with native speakers and offering live support from customer service agents. We provideRosetta Stone TOTALeprimarily as a bundle with our software and audio
offerings. At the same time, we expect to provide augmented free peer-to-peer language practice, building on our existing success with www.sharedtalk.com. In addition, we are evaluating opportunities to
extend our learning solutions to hand-held devices, and we intend to
continue to advance our proprietary software platform and our speech recognition technology.

Expand Our Core Product Portfolio.We plan to expand our product portfolio by adding more advanced course levels for our existing
languages. We give
learners the option to purchase our solutions at a single level of difficulty, or as a bundle of all available levels. Currently, six of our languages are offered in all five levels of proficiency and
another 19 of our languages are offered in the first three levels of proficiency. Our other six languages are available in only one level of proficiency. We also plan to add new languages and new
skill development and remediation courses for advanced language learners. We believe that there is an opportunity to increase our revenue as we introduce additional levels of proficiency to our
existing languages. In addition, we believe that there may be opportunities for us to introduce additional language learning solutions containing industry-specific content.

Increase U.S. Market Share.To increase our penetration of the U.S. market and expand our brand awareness, we intend to increase our
marketing
campaigns through the purchase of additional television, print, radio and online advertising, and to explore new media channels. We believe that our multi-channel marketing model helps to build
greater brand awareness, which over time will further increase our marketing efficiency. We also intend to continue to add select retail relationships and kiosks. For example, a selection of our
solutions has become available in Office Depot, Books-A-Million and London Drugs retail outlets. For our institutional business, we expect to expand our direct sales force
along with our institutional marketing activities. During the third quarter of 2010 we plan to introduce a new version of our core offering called Rosetta Stone Version 4 TOTALe, which integrates our
current Version 3 language learning software solution with ourRosetta Stone TOTALe

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web-based
service offering that includes socialization features and dedicated language conversation coaches.

Increase Our Focus on Sizeable Non-U.S. Markets.We generated approximately 8% of our revenue in 2009 from sales outside the United
States. According to the Nielsen survey, over 90% of the $83 billion spent in 2007 on consumer language learning products and services was spent outside the United States. We therefore believe
that there is a significant opportunity for us to expand our business internationally utilizing many of the successful marketing and distribution strategies we have used in the United States. We have
established subsidiaries in the United Kingdom, Japan and Germany as well as a branch office in South Korea to develop our international business. In addition, we are
exploring opportunities to expand our presence in Asia, Europe and South America. Because our solutions do not rely upon translation from the target language into the learner's native language, they
require only modest localization to be used by learners from other native language backgrounds, and thus we believe that we can efficiently scale our business internationally.

Products and Services

We offer language learning solutions in 31 languages under theRosetta Stonebrand.
Each language currently has up to five levels, with each consecutive level representing a higher level of proficiency. We sell each level as a standalone unit, although we offer a price incentive to
customers to purchase all available levels of a language as a bundle, where that option is available. In August 2007, we released our Version 3 solution for ten of our best selling languages.
We released an additional four languages in Version 3 in March 2008 and we released an additional seven languages in Version 3 in September 2008. In May 2009, we released Levels 4
and 5 in English (US) and Spanish (Latin America) as well as an additional four languages in Version 3. In July 2009, we releasedRosetta Stone TOTALe,
our new web-based service offering that includes a component of dedicated language conversation coaching. In November 2009, we released Levels 4 and 5 in 4 additional languages in
Version 3. As of December 31, 2009, all Version 3 languages are sold with Audio Companion and all Version 3 languages, except for Latin, are available with Rosetta Stone TOTALeweb-based services.

We
have four different editions: personal, enterprise, classroom and home school. Each edition utilizes the same core software product, but includes different ancillary features as
follows:



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With
our personal edition, we offer a compact disc audio practice tool, theAudio Companion, in all 25 Version 3 languages. Audio Companionis a series of
digital audio files that contain lessons directly aligned to the Rosetta Stone curriculum, allowing users to practice and
carry on their immersive experience when they are away from a computer. The lessons on theAudio Companioncan be transferred to MP3 players. The Audio Companionprovides a convenient opportunity for practicing material that was previously learned through the software program. Unlike other common
audio products, Rosetta Stone does not rely solely on an audio environment to teach, so we can create an immersive audio environment, using only the target language, which reinforces material learned
from our software program.

Our
solutions are available both pre-packaged and by subscription online through our language learning portal. For the year ended December 31, 2009, approximately 87%
of our revenue was from CD-ROM sales to both consumers and institutions, while approximately 13% was from online subscriptions.

We
currently offer the following languages:

Level 1

Level 2

Level 3

Level 4

Level 5

Audio
Companion

TOTALe

Version 2

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We also provide an online peer-to-peer practice environment called SharedTalk, atwww.sharedtalk.com, where registered language learners meet for language exchange and to
practice their foreign language skills. During 2009, we had more than 125,000 activeSharedTalkusers.

In
July 2009, we introducedRosetta Stone TOTALe, an online language learning solution that integrates our online courses with
coach-led practice sessions, fun and engaging language games, interaction with native speakers and live support from customer service agents.

In
addition, we have developed Rosetta Stone products for the exclusive use of Native American communities to help to save their endangered languages, including Mohawk, Chitimacha,
Innutitut and Iñupiaq.

Technology

We develop most of our own technology, including our proprietary unified language learning software platform. Our newest application,
Version 3, currently supports up to five levels of proficiency and is available in 25 languages. Version 2, our legacy application, is available for our other 6 languages. We intend to
offer additional languages on Version 3. The technology underlying both Version 2 and Version 3 is designed to handle the complexities of a wide variety of languages, including
languages written from right-to-left such as Arabic and Hebrew and languages with characters such as Chinese and Japanese.

Our
Version 3 platform is flexible and capable of meeting a wide range of market requirements, including:



In
each of these cases, the learner receives the same engaging language learning experience and content.

We
have developed a speech recognition technology focused on the unique challenges of language learners, stressing non-native speech understanding and pronunciation feedback.
This technology, which is included in Version 3, is available for 25 of our languages and runs on all widely
available operating systems and on local and online applications. Our speech recognition models include languages traditionally not supported by general-purpose speech recognition software, such as
Irish.

We
have developed proprietary algorithms we callAdaptive Recall,which are designed to enhance the learner's experience by reintroducing
content at longer and longer intervals in order to improve long-term retention.Adaptive Recall,available in Version 3, is designed
to be efficient with a learner's time, bringing material back in the program less and less frequently as the learner remembers over extended periods of time.

We
have developed a proprietary student management system, which is designed to allow teachers and administrators to configure their own lesson plans using our content and exercises and
to review reports for evaluation of student progress.

We
have developed an intuitive user interface that assists in the learner's transition from listening comprehension to speaking, making language skill development an integrated
experience.

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We
have also created proprietary content development tools that allow our curriculum specialists to write, edit, manage and publish our course materials. These tools allow authors,
translators, voicers, photographers and editors to work efficiently and cooperatively across multiple locations.

Content and Curriculum

The foundation ofDynamic Immersionis our proprietary content, consisting of a total
of more than 25,000 individual photographic images and more than 400,000 professionally recorded sound files. Each Version 3 language contains approximately 10,000 individual photographic
images and 15,000 professionally recorded sound files. We believe these photographic images and recorded sound files are a competitive strength, as we have created many of the pictures and all of the
sound files ourselves. We believe that our images and their juxtaposition convey a universal meaning, which makes it possible for us to broadly deploy the same images across multiple languages. In
addition, we have developed a sophisticated method for sequencing the images, which is designed to build a rich curriculum that incrementally teaches the user the most important and relevant language
skills necessary to achieve fluency. We believe that our sequence of images is as effective for
someone learning Arabic or Mandarin Chinese as it is for someone learning Spanish or English. To supplement our core content, we incorporate specific nuances for each language, such as dual forms for
parts of speech in Arabic. Our ability to tailor our content also enables us to develop customized versions of our language learning solutions to address the specific needs of various industries. For
example, we created a customized version of our Arabic learning solution for the U.S. Army, which includes military-specific content, such as vocabulary, images and curriculum sequencing. In the
future, we may develop customized versions for other industries, such as healthcare, business, real estate and retail.

In
addition to visual learning experiences, our Version 3 solutions incorporate an integrated speech program utilizing our voice recognition application, which works in languages
that are traditionally not supported by general-purpose speech recognition software. As an integral component of the program, this voice recognition feature works with our learners to promote the
appropriate pronunciation of the words and concepts included in the lesson.

Throughout
the curriculum sequence, our program combines the introduction of new concepts, practice of recent material and production of key phrases. As learners progress along our
curriculum, they transition from seeing and recognizing to speaking as our program prompts them to pronounce the words they are being taught. Our solution covers all aspects necessary for fluency
within a completely immersive environment without requiring translation or explanation, including alphabet, vocabulary, intuitive grammar, reading, writing, listening, pronunciation and conversation.
While rigorous and complete, the curriculum is designed to remain flexible, allowing learners to alter their individual pace and focus of instruction to meet their particular goals and abilities. The
language content for our respective courses is organized into up to five levels of proficiency, with each level providing approximately 40 hours of instruction and containing multiple units,
lessons and activities.

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Customers

Our customers include individuals, home school parents, educational institutions, armed forces, government agencies, corporations and
not-for-profit institutions. We sell to our customers through a direct-to-consumer and institutional marketing and distribution strategy.

Channel

Customer Type

Representative CustomersConsumer

Individual

Based on our internal studies, 60% annually earn more than $75,000 and 44% earn more than $100,000Retailers

Amazon.com, Apple, Barnes & Noble, Borders, Office Depot, Books-A-Million, London DrugsInstitutional

Educational Institutions

Primary and Secondary Schools: New York City Department of Education (NY), DeKalb County Schools (GA), Cherokee County Board of Education (GA), Yonkers Public Schools (NY), Oakland Unified School District (CA),
Manatee County Schools (FL)Universities: James Madison University, University of Wisconsin, West Chester University, Virginia Commonwealth University, Clark Atlanta University, Jackson State UniversityGovernment, Armed Forces and Not-for-Profit Organizations

U.S. Department of Homeland Security, U.S. Immigration and Customs Enforcement, Foreign Service Institute, Defense Intelligence Agency, U.S. Department of the Air Force, U.S. Army, U.S. Marines, The Church of Jesus
Christ of Latter-Day Saints, Council for Adult and Experiential Learning, Pacific Training Institute Clinic, AARP, Neighborhood House of St. Paul, Seattle GoodwillCorporations

Reuters Group Plc, General Motors Corp., Pride International Inc., Res-Care, Inc., Cerner Corp., Tyco Electronics Corp., Molex Inc., Experian Information Solutions, Inc., Marriott
International, Inc., Whole Foods Market Inc.


Marketing and Distribution Channels

Our multi-channel marketing and distribution model consists of print, online, television and radio direct-response advertising, kiosks,
our institutional sales force and retail resellers. We believe that this marketing and distribution model, through which each channel complements and supports the others,
provides:



Consumer sales accounted for approximately 79% of our revenue for the year ended December 31, 2009. Our consumer distribution
model comprises a mix of our call centers, websites, network of kiosks and select retail resellers, such as Amazon.com, Apple, Barnes & Noble and Borders. We also offer our products in a
limited number of ZoomShop unmanned automated kiosks. We believe these channels complement each other, as consumers that have seen our direct-to-consumer advertising may
purchase

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at
our kiosks or retailers, and those who have seen our solutions demonstrated at our kiosks may purchase solutions through our retailers, websites or call centers.

Direct to Consumer.Our direct-to-consumer channel, which we define as sales generated through either our websites or call
centers, accounted for approximately 57% of our consumer revenue for the year ended December 31, 2009. We utilize several forms of advertising to drive our
direct-to-consumer sales, including print, online, television and radio. We advertise in a variety of national publications, such asTime, The
Economist, The New YorkerandNational Geographic. Our online media strategy encompasses banner and paid search advertising, as
well as affiliate relationships. We work with various online agencies to buy both impression-based
and performance-based traffic. All our advertisements include a "call to action," which encourages potential customers to visit our websites or contact a call center to order a product or a
CD-ROM demo. Our advertisements include promotional codes that encourage customers to indicate which television or radio spot or publication they are responding to in order for us to track
performance of each discrete media buy. By using different codes for different advertising media and campaigns, we can track the link between our media buying and the demand it generates. This gives
us insight into the effectiveness of each form of advertising we purchase, which enables us to more closely tie our advertising spending to the results achieved. We receive our orders in the
direct-to-consumer channel through our websites and call centers. Our marketing to this channel also supports the kiosk and retail channels.

Rosetta Stone Kiosks.As of December 31, 2009, we operated 242 retail kiosks, including 3 full service retail outlets, in airports,
 malls and
other strategic high-traffic locations in 39 states and the District of Columbia. This does not include the ZoomShop unmanned automated kiosks in which we offer our products. As of
December 31, 2009, we also operated 9 kiosks in the United Kingdom, 12 in Japan and 20 in South Korea. Some of our international kiosks are inside the stores of other retailers. These
company-operated kiosks accounted for approximately 20% of our consumer revenue for the year ended December 31, 2009. With bright and colorful displays, efficient use of retail space and
limited capital investment, we believe that our company-operated kiosks are an effective outlet for selling our solutions and reinforcing our brand image. We believe that our kiosks enhance our
ability to build strong consumer relationships and promote additional customer interest through the provision of personal demonstrations by our sales associates.

Most
of our kiosk site licenses range between three to six months with renewal options. Our policy is to close under-performing kiosks expeditiously.

We
also offer our products in a limited number of unmanned ZoomShop automated kiosks. Although these devices do not offer the one-on-one experience that the
kiosks provide, there are interactive demonstrations on their touch screens with audio that helps illustrate our teaching techniques. These devices allow us to quickly establish a presence in retail
locations for a very low capital commitment.

Retailers.Sales to retailers accounted for approximately 23% of our consumer revenue for the year ended December 31, 2009. Our
retailers
enable us to provide additional points of contact to educate consumers about our solutions, expand our presence beyond our own kiosks and websites, and further strengthen and enhance our brand image.
Our retail relationships include Amazon.com, Apple, Barnes & Noble, Books-A-Million, Borders, Office Depot and London Drugs. Sales in the retail channel are highly
correlated with our media expenditures in the direct-to-consumer channel.



Institutional sales accounted for approximately 21% of our revenue for the year ended December 31, 2009. Our institutional
distribution model is focused on targeted sales activity primarily through a direct sales force in four markets: schools, colleges and universities; the U.S. armed forces

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and
federal government agencies; corporations; and not-for-profit organizations. Regional sales managers are responsible for sales of our solutions in their territories and
supervise account managers who are responsible for maintaining our customer base.

Educational Institutions.These customers include primary and secondary schools and represented approximately 44% of our institutional
sales for the
year ended December 31, 2009. In our experience, colleges, universities and schools frequently rely on references from peer institutions and an official
request-for-proposal, or RFP, process when selecting a vendor. We generate sales leads from sources such as visiting potential customer sites to provide briefings on our
solutions and the industry, interacting with attendees at trade shows and conferences, responding to inbound calls based on recommendations from existing customers and monitoring and responding to
RFPs.

Federal Government Agencies and Armed Forces, Not-for-Profit.These customers include governmental agencies and armed forces
and organizations developing workforces to serve non-native speaking populations, offering literacy programs and preparing members for overseas missions and accounted for approximately 25%
of our institutional sales for the year ended December 31, 2009. Many customers in this market license our products through online subscriptions. We have recently been adding sales
representatives to this group to allow greater focus by senior sales executives on expanding some of our key relationships.

Corporations.We promote interest in this market with onsite visits, trade show and seminar attendance, speaking engagements and direct
mailings.
Many of our customers in the market prefer online subscription delivery. Corporations represented 12% of our institutional revenue for the year ended December 31, 2009.

Home Schools.We promote interest in this market through advertising in publications focused on home schooling, attending local trade
shows and
seminars and direct mailings. Home school sales accounted for approximately 19% of our institutional revenue for the year ended December 31, 2009.



International sales accounted for approximately 8% of our revenue for the year ended December 31, 2009. In the near term, our
international activity is primarily focused on successfully growing our business in the United Kingdom, Germany, South Korea and Japan, where we are utilizing many of the same
direct-to-consumer and channel strategies that we developed in the domestic market. We opened our United Kingdom office in 2005, our Japan office in 2007, and our Korean office
in 2009. Over time, we believe that we will be able to develop a similar business model in other markets in Europe, Asia and Latin America.

Product Development

Our product portfolio is a result of significant investment in product development over 16 years. Our product development
focuses on both software and content development. Our development efforts include both creating new solutions and adding new languages to existing solutions. Our development team has specific
expertise in speech recognition, interface design, immersion learning and instructional design.

In
2006, we licensed speech recognition technology for language learning from the Regents of the University of Colorado. We subsequently hired several of the original developers of this
technology to begin building our expertise in speech recognition. Since 2006, we have made significant improvements to the original technology. We believe that this technology and expertise
distinguishes us from other companies in our industry.

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In August 2007, we launched a new product platform, Version 3, in ten languages in our consumer channels. This product launch was the culmination of over three
years of research and development. Version 3 provides a significant set of new features and benefits, including our proprietary speech recognition technology. We subsequently introduced four
additional Version 3 languages in March 2008 and seven more Version 3 languages in September 2008. We also introduced theAudio Companioncompact disc
practice tool in all 14 of our then-available Version 3 languages in June 2008 and introduced theAudio Companionin the seven new Version 3
languages in September 2008. In May 2009, we released Levels 4 and 5 in English (US) and Spanish (Latin America) as well as an additional four languages in Version 3. In July 2009, we released Rosetta Stone
TOTALe, our new web-based service offering that includes a component of dedicated language conversation coaching. In November
2009, we released Levels 4 and 5 in 4 additional languages in Version 3. As of December 31, 2009, all Version 3 languages are sold with Audio Companion and all Version 3 languages,
except for Latin, are available withRosetta Stone TOTALeweb-based services.

Our
research and development expenses were $26.2 million in the year ended December 31, 2009.

Sourcing and Fulfillment

Our strategy is to maintain a flexible, diversified and low-cost manufacturing base. We use third-party contract
manufacturers and suppliers to obtain substantially all our product and packaging components and to manufacture finished products. We believe that we have good relationships with our manufacturers and
suppliers and that there are alternative sources in the event that one or more of these manufacturers or suppliers is not available. We continually review our manufacturing and supply needs against
the capacity of our contract manufacturers and suppliers with a view to ensuring that we are able to meet our production goals, reduce costs and operate more efficiently.

We
package and distribute our products primarily from our fulfillment facility in Harrisonburg, Virginia. We also contract with third-party fulfillment vendors in Munich, Netherlands and
Tokyo, Japan. From Tokyo, we distribute products for consumer orders in Japan. From Munich, we distribute products for consumer orders in Europe. We distribute products for the remainder of our orders
from Harrisonburg, Virginia.

Competition

The language learning industry is highly fragmented and subject to rapidly changing consumer preferences and industry trends. We expect
competition in the markets that we serve to persist and intensify. We face varying degrees of competition from a wide variety of companies providing language learning solutions
including:



Our
competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), Random House Ventures LLC (Living Language), Disney Publishing Worldwide and
McGraw-Hill Education.

We
believe that the principal competitive factors in our industry include:



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We
believe that we compete favorably on the basis of these factors.

Intellectual Property

Our ability to protect our core technology and intellectual property is critical to our success. We rely on a combination of measures
to protect our intellectual property, including patents, trade secrets, trademarks, trade dress, copyrights and non-disclosure and other contractual arrangements.

We
have one U.S. patent that has been granted and several international and U.S. patents pending. Many of these pending patents relate to our language teaching methods.

We
hold a perpetual, irrevocable and worldwide license from the University of Colorado allowing us to use speech recognition technology for language learning solutions. We entered into
the license agreement in December 2006, and paid the University of Colorado an up-front license fee.

We
have registered a variety of trademarks, includingRosetta Stone,Rosetta World, Rosetta Stone Language Learning
Success& global design,Audio Companion, Dynamic Immersion,The Fastest Way to Learn a Language.
Guaranteed.,Adaptive
Recall,Contextual Formation, the Rosetta Stone blue stone logo and design, the Rosetta Stone blue stone logo and
design/Language Learning Success,Rosettastone.com,and SharedTalk. We have applied to register ourTOTALe, rWorld,Rosetta Studio, Rosetta Course, Rosetta Stone Totale and Simbiotrademarks. All these
trademarks
are the subject of either registrations or pending applications in the United States, as well as numerous countries worldwide where we do business. We intend to continue to strategically register,
both domestically and internationally, trademarks we utilize today and those we develop in the future.

We
own the copyright on our Version 2 English editions. We are registering or have registered in the United States our Version 2 non-English editions and all editions of our
Version 3 languages.

We
believe that the distinctive marks that we use in connection with our solutions are important in building our brand image and distinguishing our solutions from those of our
competitors. These marks are among our most valuable assets. In addition to our distinctive marks, we own several copyrights and trade dress rights to our solutions, product packaging and user
manuals. We also place significant value on our trade dress, which is the overall image and appearance of our solutions, and we believe that our trade dress helps to distinguish our solutions in the
marketplace.

Furthermore,
our employees, contractors and other parties with access to our confidential information sign agreements that prohibit the unauthorized disclosure of our proprietary rights,
information and technology.

Employees

As of December 31, 2009, we had 1,738 total employees, consisting of 922 full-time and 816 part-time
employees. Our personnel consisted of 266 employees in sales and marketing, 333 employees

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in
research and development, 190 in general and administrative and 894 kiosk sales employees. None of our employees is represented by a collective bargaining agreement. We believe our employee
relations are good.

Other Information

Our Internet address iswww.rosettastone.com. We make available free of charge through
our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to
the Securities Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the United States Securities and Exchange Commission (SEC).

Item 1A.Risk Factors

In addition to the other information set forth in this annual report on Form 10-K, you should carefully consider the
risk factors discussed below and in other documents we file with the Securities and Exchange Commission, which could materially affect our business, financial condition or future results. These are
not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business,
financial condition and/or operating results.

Our actual operating results may differ significantly from our guidance.

From time to time, we may release guidance in our quarterly earnings releases, quarterly earnings conference call, or otherwise,
regarding our future performance that represent our management's estimates as of the date of release. This guidance, which includes forward-looking statements, is based on projections prepared by our
management. These projections are not prepared with a view toward compliance with published guidelines of the American Institute of Certified Public Accountants, and neither our registered public
accountants nor any other independent expert or outside party compiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect
thereto.

Projections
are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and
competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We
generally state possible outcomes as high and low ranges which are intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not
fall outside of the suggested ranges. The principal reason that we release guidance is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not
accept any responsibility for any projections or reports published by any such persons.

Guidance
is necessarily speculative in nature, and it can be expected that some or all of the assumptions of the guidance furnished by us will not materialize or will vary significantly
from actual results. Accordingly, our guidance is only an estimate of what management believes is realizable as of the date of release. Actual results will vary from our guidance and the variations
may be material. In light of the foregoing, investors are urged not to rely upon, or otherwise consider, our guidance in making an investment decision in respect of our common stock.

Any
failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in our "Risk Factors" and in this annual report on
Form 10-K could result in the actual operating results being different from our guidance, and such differences may be adverse and material.

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Risks Related to Our Business

Because we generate all of our revenue from language learning solutions, a decline in demand for our language learning solutions or for language learning solutions in
general could cause our revenue to decline.

We generate substantially all of our revenue from our language learning solutions, and we expect that we will continue to depend upon
language learning solutions for substantially all of our revenue in the foreseeable future. Because we are dependent on our language learning solutions, factors such as changes in consumer preferences
for these products may have a disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in our language learning software products declines, or if
consumer interest in learning foreign languages in general declines, we would likely experience a significant loss of sales. Some of the potential developments that could negatively affect interest in
and demand for language learning software products include:



Because a substantial portion of our revenue is generated from our consumer business, if we fail to accurately forecast consumer demand and trends in consumer preferences,
our Rosetta Stone brand, sales and customer relationships may be harmed.

Demand for our language learning software products and related services, and for consumer products and services in general, is subject
to rapidly changing consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:



A
decline in consumer demand for our solutions, or any failure on our part to satisfy changing consumer preferences, could harm our business and profitability.

We depend on discretionary consumer spending in the consumer segment of our business. Adverse trends in general economic conditions, including retail shopping patterns,
airport traffic or consumer confidence, may compromise our ability to generate revenue.

The success of our business depends to a significant extent upon discretionary consumer spending, which is subject to a number of
factors, including general economic conditions, consumer confidence, employment levels, business conditions, interest rates, availability of credit, inflation and taxation. Adverse trends in any of
these economic indicators may cause consumer spending to decline further,

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which
could hurt our sales and profitability. We depend on the continued popularity of malls as shopping destinations and the ability of mall anchor tenants and other attractions to generate customer
traffic for our retail mall-based kiosks. We also depend on continued airline travel to generate traffic for our retail kiosks located in airports. Decreases in mall or airport traffic
adversely affect the sales from our kiosks and our profitability and financial condition. In addition, an increase in the taxation of online sales could result in reduced online purchases or reduced
margins on such sales. Furthermore, consumers may defer purchases of our solutions in anticipation of new products or new versions from us or our competitors.

Intense competition in our industry may hinder our ability to generate revenue and may diminish our margins.

The market for foreign language learning solutions is rapidly evolving, highly fragmented and intensely competitive, and we expect both
product and pricing competition to persist and intensify. Increased competition could cause reduced revenue, price reductions, reduced
gross margins and loss of market share. Our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), a subsidiary of CBS Corporation, Random House
Ventures LLC (Living Language), Disney Publishing Worldwide, a subsidiary of Walt Disney Company, and McGraw-Hill Education, a subsidiary of The McGraw-Hill Companies.
Many of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources than we do, as well as greater name
recognition worldwide. The resources of these competitors also may enable them to respond more rapidly to new or emerging technologies and changes in customer requirements, reduce prices to win new
customers and offer free language learning software or online services. We may not be able to compete successfully against current or future competitors.

As
the market for foreign language solutions continues to develop, a number of other companies with greater resources than ours could attempt to enter the market or increase their
presence by acquiring or forming strategic alliances with our competitors or our distributors or by introducing their own competing products. These companies and their products may be superior to any
of our current competition. We may not have the financial resources, technical expertise, marketing, distribution or support capabilities to compete effectively with any of these new entrants to the
market.

As
we continue to expand into foreign markets, we expect that we will experience competition from local foreign language learning companies that have strong brand recognition and more
experience in selling to local consumers and a better understanding of local marketing, sales channels and consumer preferences.

Our
success will depend on our ability to adapt to these competitive forces, to adapt to technological advances, to develop more advanced products more rapidly and less expensively than
our competitors, to continue to develop an international sales network, to adapt to changing consumer preferences and to educate potential customers about the benefits of using our solutions rather
than our competitors' products and services. Existing or new competitors could introduce new products and services with superior features and functionality at lower prices. This could impair our
ability to sell our products and services.

Demand for paid language learning solutions such as ours could decline if effective language learning solutions become available for free.

Presently there are a number of free online language websites offering limited vocabulary lists and grammar explanations and tips. In
addition, there are some online services offering limited free lessons and learning tools, including one sponsored by the U.S. Department of Education to help immigrants learn English. Many of these
websites offer free language practice opportunities with other language learners. If these free products become more sophisticated and competitive or gain widespread acceptance by the public, demand
for our solutions could decline.

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Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures.

Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures,
including our ability to:



Our
planned marketing expenditures may not result in increased revenue or generate sufficient levels of product and brand name awareness, and we may not be able to increase our net sales
at the same rate as we increase our advertising expenditures.

Much
of our radio, television and print advertising has been through the purchase of "remnant" advertising segments. These segments are random time slots and publication dates that have
remained unsold and are offered at discounts to advertisers who are willing to be flexible with respect to time slots. There is a limited supply of this type of advertising and the availability of
such advertising may decline or the cost of such advertising may increase. In addition, if we increase our marketing budget we cannot assure you that we can increase the amount of remnant advertising
at the discounted prices we have obtained in the past. If any of these events occur, we may be forced to purchase time slots and publication dates at higher prices, which will increase our costs.

Our business depends on our Rosetta Stone brand, and if we are not able to maintain and enhance our brand, our business and operating results may be harmed.

We believe that market awareness of ourRosetta Stonebrand in the United States has
contributed significantly to the success of our business. We also believe that maintaining and enhancing theRosetta Stonebrand is critical to
maintaining our competitive advantage. As we continue to grow in size, expand our products and services and extend our geographic reach, maintaining the quality and consistency of our language
learning solutions, and thus the quality of our brand, may be more difficult. In addition, software piracy and trademark infringement may harm ourRosetta
Stonebrand by undermining our reputation for quality software programs.

We depend on search engines and other online sources to attract visitors to our websites, and if we are unable to attract these visitors and convert them into customers in a
cost-effective manner, our business and financial results may be harmed.

Our success depends on our ability to attract online consumers to our websites and convert them into customers in a
cost-effective manner. We depend, in part, on search engines and other online sources for our website traffic. We are included in search results as a result of both paid search listings,
where we purchase specific search terms that will result in the inclusion of our listing, and algorithmic searches that depend upon the searchable content on our sites. Search engines and other online
sources revise their algorithms from time to time in an attempt to optimize their search results.

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If
one or more of the search engines or other online sources on which we rely for website traffic were to modify its general methodology for how it displays our websites, resulting in
fewer consumers clicking through to our websites, our sales could suffer. If any free search engine on which we rely begins charging fees for listing or placement, or if one or more of the search
engines or other online sources on which we rely for purchased listings, modifies or terminates its relationship with us, our expenses could rise, we could lose customers and traffic to our websites
could decrease.

Our expansion into international markets may not succeed and imposes special risks.

Our business strategy contemplates continued expansion into international markets. We are currently expanding our direct sales channels
in Europe and Asia. In addition, we are expanding our indirect sales channels in Europe, Asia and Latin America through retailer and distributor arrangements with third parties. If we are unable to
expand our international operations successfully and in a timely manner, our ability to pursue our growth strategy will be impaired. Such expansion may be more difficult or take longer than we
anticipate, and we may not be able to successfully market, sell, deliver and support our products and services internationally.

Our
international operations and our efforts to increase sales in international markets are subject to a number of risks that are in addition to or different than those affecting our
U.S. operations, including:



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The
effects of any of the risks described above could reduce our future revenue from our international operations and could harm our overall business, revenue and financial results.

Our introduction of Rosetta Stone Version 4 TOTALe will increase our costs as a percentage of revenue, may not succeed and may harm our business, financial results and
reputation.

We have publicly announced plans to introduce Rosetta Stone Version 4 TOTALe in the third quarter of 2010. Rosetta Stone Version 4
TOTALe integrates our existing language learning software solutions with web-based services, which will provide opportunities for practice with dedicated language conversation coaches and
other language learners to increase language socialization. These web-based services will have a much higher cost as a percentage of revenue than our software solutions. We expect to offer
Rosetta Stone Version 4 TOTALe primarily by bundling the web-based services of TOTALe with our software and audio offerings. At the same time, we expect to provide augmented, free
peer-to-peer language practice. We will devote significant capital, personnel and management attention to develop and launch Rosetta Stone Version 4 TOTALe, including replacing
our existing product packaging with Version 4 TOTALe packaging, expanding our staff of conversational coaches and customer support employees, incurring related research and development expenses, and
incurring significant marketing expenses relating to the launch of the new offering. The services associated with Rosetta Stone Version 4 TOTALe will decrease our margins. Rosetta Stone Version 4
TOTALe will also present new management and marketing challenges that differ from the challenges we face in our existing business. In addition, we will be required to defer recognition of a portion of
each sale of Version 4 TOTALe in connection with the subscription terms
of our on-line socialization services. We cannot assure you that Rosetta Stone Version 4 TOTALe will be introduced on the timetable publicly announced or that it will be successful or
profitable, or if it is profitable, that it will provide an adequate return on capital expended. If we are not successful in our launch of Rosetta Stone Version 4 TOTALe, our business, financial
results and reputation may be harmed.

Our introduction of the "Rosetta Stone Mini" and/or an introductory language learning software offering may not succeed and may harm our business, financial results and
reputation.

We have publicly announced plans to introduce an iPhone/iPod Touch/Mobile application, with the project name of Rosetta Stone Mini" to
be released in the second half of 2010 that will provide a sub-2 hour learning experience in a new language. In addition, we have publicly announced plans to release an introductory
offering at a sub-$200 price point, which we refer to as the introductory offering, with our launch of the full Rosetta Stone Version 4 TOTALe language learning solution. Both the Rosetta
Stone Mini and the introductory offering will carry lower price points than our full Rosetta Stone Version 4 TOTALe language learning solution and may cannibalize sales of our more expensive
solutions. We will devote significant capital, personnel and management attention to develop and launch the Rosetta Stone Mini and the introductory offering, including related research and development
expenses, and incurring significant marketing expenses relating to the launch. These new products will present new management and marketing challenges that differ from the challenges we

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face
in our existing business. We cannot assure you that the Rosetta Stone Mini or the introductory offering will be successful or that either offering will be profitable, or if it is profitable, that
it will provide an adequate return on capital expended. If we are not successful in our launch of the Rosetta Stone Mini or the introductory offering, our business, financial results and reputation
may be harmed.

Product returns could exceed our estimates, which would diminish our reported revenue.

We offer consumers who purchase our packaged software and audio practice products directly from us an unconditional full
money-back six-month guarantee. We also permit some of our retailers and distributors to return packaged products, subject to limitations. We establish revenue reserves for
packaged product returns based on historical experience, estimated channel inventory levels and the timing of new product introductions and other factors. If packaged product returns exceed our
reserve estimates, the excess would offset reported revenue, which could hurt our reported financial results.

If the recognition by schools and other institutions of the value of technology-based education does not continue to grow, our ability to generate revenue from institutions
could be impaired.

Our success depends in part upon the continued adoption by institutions and potential customers of technology-based education
initiatives. Some academics and educators oppose online education in principle and have expressed concerns regarding the perceived loss of control over the education process that can result from
offering courses online. If the acceptance of technology-based education does not grow our ability to continue to grow our institutional business could be impaired.

If there are changes in the spending policies or budget priorities for government funding of colleges, universities, schools, other education providers, armed forces or
government agencies, we could lose revenue.

Many of our institutional customers are colleges, universities, primary and secondary schools, other education providers, armed forces
and government agencies who depend substantially on government funding. Accordingly, any general decrease, delay or change in federal, state or local funding for colleges, universities, primary and
secondary schools, or other education providers or for armed forces or government agencies that use our products and services could cause our current and potential customers to reduce their purchases
of our products and services, to exercise their right to terminate licenses, or to decide not to renew licenses, any of which could cause us to lose revenue. In addition, a specific reduction in
governmental funding support for products such as ours would also cause us to lose revenue and could hurt our overall gross margins.

Some of our institutional business faces a lengthy and unpredictable sales cycle for our solutions, which could delay new sales.

We face a lengthy sales cycle between our initial contact with some potential institutional customers and the signing of license
agreements with these customers. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of such institutional sales. A delay in or failure to complete license
transactions could cause us to lose revenue, and could cause our financial results to vary significantly from quarter to quarter. Our sales cycle varies widely, reflecting differences in our potential
institutional customers' decision-making processes, procurement requirements and budget cycles, and is subject to significant risks over which we have little or no control,
including:



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If we are unable to continually enhance our products and services and adapt them to technological changes and customer needs, including the emergence of new computing
devices and more sophisticated online services, we may lose market share and revenue and our business could suffer.

We need to anticipate, develop and introduce new products, services and applications on a timely and cost-effective basis
that keeps pace with technological developments and changing customer needs. For example, the number of individuals who access the internet through devices other than a personal computer, such as
personal digital assistants, mobile telephones, televisions and set-top box devices, has increased dramatically, and this trend is likely to continue. Our products and services were
designed for high resolution, graphical environments such as those available on desktop and laptop computers. The lower resolution, functionality and memory associated with alternative devices
currently available may make the use of our products and services through such devices difficult. Because each manufacturer or distributor may establish unique technical standards for its devices, our
products and services may not work or be viewable on these devices. We have no experience to date in operating versions of our products and services developed or optimized for users of alternative
devices, and new devices and new platforms are continually being released. Accordingly, it is difficult to predict the problems we may encounter in developing versions of our products and services for
use on these alternative devices, and we may need to devote significant resources to the creation, support and maintenance of such versions. If we fail to develop or sell products and services that
respond to these or other technological developments and changing customer needs cost effectively, we may lose market share and revenue and our business could suffer.

If we fail to manage our growth effectively, we may experience difficulty in filling purchase orders, declines in product and service quality and customer satisfaction,
increased costs or disruption in our operations.

We have experienced rapid growth in our business in recent periods, which has strained our managerial, operational, financial and other
resources.

We
anticipate that continued growth of our operations will be required to satisfy increasing consumer and institutional demand and to avail ourselves of new market opportunities. The
expanding scope of our business and growth in the number of our employees, customers and sales locations will continue to place a significant strain on our management team, information technology
systems and other resources. To properly manage our growth, we need to hire and retain personnel, upgrade our existing operational, management and financial and reporting systems, including warehouse
management and inventory control, improve our business processes and controls and identify and develop relationships with additional retailers and distributors. We may also be required to expand our
distribution facilities and our operational facilities or add new facilities, which could require significant capital expenditures. Failure to effectively manage our growth in a
cost-effective manner could result in difficulty in filling purchase orders, declines in product and service quality and customer satisfaction, increased costs or disruption of our
operations.

Our
rapid growth also makes it difficult for us to adequately predict the expenditures we will need to make in the future. If we do not make the necessary overhead expenditures to
accommodate our future growth, we may not be successful in executing our growth strategy.

Our revenue is subject to seasonal and quarterly variations, which could cause our financial results to fluctuate significantly.

We have experienced, and we believe we will continue to experience, substantial seasonal and quarterly variations in our revenue and
net income. These variations are primarily related to increased sales of our products and services to consumers in the fourth quarter during the holiday selling season as well as higher sales to
governmental and educational institutions in the second and third quarters. We sell to a significant number of our retailers, distributors and institutional customers on a purchase

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order
basis and we receive orders when these customers need products and services. As a result, their orders are typically not evenly distributed throughout the year. Our quarterly results of
operations also may fluctuate significantly as a result of a variety of other factors, including the timing of holidays and
advertising initiatives, changes in our products, services and advertising initiatives and changes in those of our competitors. Budgetary constraints of our institutional customers may also cause our
quarterly results to fluctuate.

As
a result of these seasonal and quarterly fluctuations, we believe that comparisons of our results of operations between different quarters are not necessarily meaningful and that
these comparisons are not reliable as indicators of our future performance. In addition, these fluctuations could result in volatility and adversely affect our cash flows. As our business grows, these
seasonal fluctuations may become more pronounced. Any seasonal or quarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors. This could
cause the price of our common stock to fluctuate significantly.

Because a significant portion of our sales are made to or through retailers and distributors, none of which have any obligation to sell our products, the failure or
inability of these parties to sell our products effectively could hurt our revenue growth and profitability.

We rely on retailers and distributors, together with our direct sales force, to sell our products. Our sales to retailers are highly
concentrated on a small group, including Amazon.com, Apple, Barnes & Noble, Borders and Office Depot. We expect that our arrangements with these retailers and distributors will continue to
generate significant revenue for us. Sales to or through our retailers and distributors accounted for approximately 18% of our revenue for the year ended December 31, 2009.

We
have no control over the amount of products that these retailers purchase from us or sell on our behalf, we do not have long-term contracts with any of them, and they have
no obligation to offer or sell our products or to give us any particular shelf space or product placement within their stores. Thus, there is no guarantee that this source of revenue will continue at
the same level as it has in the past or that these retailers will not promote competitors' products over our products or enter into exclusive relationships with competitors. Any material adverse
change in the principal commercial terms, material decrease in the volume of sales generated by our larger retailers or distributors or major disruption or termination of a relationship with these
retailers and distributors could result in a potentially significant decline in our revenue and profitability. Furthermore, product display locations and promotional activities that retailers
undertake can affect the sales of our products. The fact that we also sell our products directly could cause retailers or distributors to reduce their efforts to promote our products or stop selling
our products altogether. In addition, if one or more of such retailers or distributors were unable to meet their obligations with respect to accounts payable to us, we could be forced to write off
such accounts. In addition, any bankruptcy, liquidation, insolvency or other failure of any of these retailers or distributors could result in significant financial loss and cause us to lose revenue
in future periods.

Substantially all of our inventory is located in one warehouse facility. Any damage or disruption at this facility could cause significant financial loss, including loss of
revenue and harm to our reputation.

Substantially all of our inventory is located in one warehouse facility. We could experience significant interruption in the operation
of this facility or damage or destruction of our inventory due to natural disasters, accidents, failures of the inventory locator or automated packing and shipping systems or other events. If a
material portion of our inventory were to be damaged or destroyed, we might be unable to meet our contractual obligations which could cause us significant financial loss, including loss of revenue and
harm to our reputation.

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The loss of key personnel or the failure to attract and retain highly qualified personnel could compromise our ability to effectively manage our business and pursue our
growth strategy.

Our future performance depends on the continued service of our key technical, development, sales, services and management personnel. We
rely on our executive officers and senior management to execute our existing business plans and to identify and pursue new opportunities. We rely on our technical and development personnel for product
innovation. We generally do not have employment agreements with our personnel and, therefore, they could terminate their employment with us at any time. The loss of key employees could result in
significant disruptions to our business, and the integration of replacement personnel could be costly and time consuming, could cause additional disruptions to our business, and could be unsuccessful.
We do not carry key person life insurance covering any of our employees.

Our
future success also depends on our continued ability to attract and retain highly qualified technical, development, sales, services and management personnel. Competition for such
personnel is intense, and we may fail to retain our key employees or attract or retain other highly qualified personnel in the future. Many of our employees are located in Harrisonburg, Virginia, a
city that does not have a large pool of qualified replacement personnel. The lack of qualified local replacement personnel may make it more difficult to quickly find replacement personnel and may
increase the costs of identifying and relocating replacement personnel to Harrisonburg, Virginia.

In
addition, wage inflation and the cost of retaining our key personnel in the face of competition for such personnel may increase our costs faster than we can offset these costs with
increased prices or increased sales volume.

If we are unable to hire, train, motivate and retain sales personnel to staff our kiosks, or to identify suitable locations and negotiate site licenses on acceptable terms,
we could lose revenue, our costs could increase and our profitability could decline.

In order to successfully grow our kiosk sales channel we must be able to hire, train, motivate and retain sales personnel to staff
these kiosks. Our kiosks are small and widely dispersed, and, as such, are operated without substantial hands-on management or oversight by us. As a result, we depend on our kiosk sales
personnel to effectively manage sales, customer issues and reporting of financial transactions from these kiosks. The opening and success of new kiosks will depend upon various additional factors,
including our ability to identify suitable locations and our ability to negotiate site licenses on acceptable terms and labor costs. Specifically, we must identify and negotiate
cost-effective site licenses for kiosk locations that will generate sufficient consumer demand. Many of these site licenses contain terms and conditions that are highly favorable to
licensors including allowing licensors to cancel them on short notice, sometimes as little as thirty days, and broad indemnification terms in favor of licensors. If competition for kiosk space
increases, license rates may increase and other terms may become even less favorable to us, resulting in lower profitability. Our failure to properly manage the expansion of this sales channel could
cause us to lose revenue and increase our expenses.

Failure to maintain the availability of the systems, networks, databases and software required to operate and deliver our internet-based products and services could damage
our reputation and cause us to lose revenue.

We rely on internal systems and external systems, networks and databases maintained by us and third-party providers to process customer
orders, handle customer service requests, and host and deliver our internet-based language learning solutions, including our online language courses andRosetta Stone
TOTALe, and ourSharedTalkonline peer-to-peer collaborative and interactive community. Any damage,
interruption or failure of our systems, networks and databases could prevent us from processing customer orders and result in degradation or interruptions in delivery of our products and services.
Notwithstanding our efforts to protect against interruptions in the availability of our e-commerce

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websites
and internet-based products and services, we do occasionally experience unplanned outages or technical difficulties. In addition, we do not have complete redundancy for all of our systems. We
do not maintain real-time back-up of all of our data, and in the event of system disruptions, we could experience loss of data which could cause us to lose customers and could
harm our reputation and cause us to face unexpected liabilities and expenses. If we continue to expand our business, we will put additional strains on these systems. We may also need to grow,
reconfigure or relocate our data centers in response to changing business needs, which may be costly and lead to unplanned disruptions of service.

We are subject to U.S. and foreign government regulation of online services which could subject us to claims, judgments, and remedies including monetary liabilities and
limitations on our business practices.

We are subject to regulations and laws directly applicable to providers of online services. The application of existing domestic and
international laws and regulations to us relating to issues such as user privacy and data protection, defamation, promotions, billing, consumer protection, accessibility, content regulation, quality
of services, and intellectual property ownership and infringement in many instances is unclear or unsettled. In addition, we will also be subject to any new laws and regulations directly applicable to
our domestic and international activities. Internationally, we may also be subject to laws regulating our activities in foreign countries and to foreign laws and regulations that are inconsistent from
country to country. We may incur substantial liabilities for expenses necessary to defend litigation in connection with such regulations and laws or to comply with these laws and regulations, as well
as potential substantial penalties for any failure to comply.

We may be subject to legal liability for new web-based online services.

Rosetta Stone TOTALeenables individuals to exchange information and engage in various
online activities on a domestic and an international basis. The law relating to the liability of providers of online services for activities of their users is currently unsettled both within the U.S.
and internationally. Claims may be brought against us for defamation, negligence, copyright or trademark infringement, unlawful activity, tort, including personal injury, fraud, or other theories
based on the nature and content of information that may be posted online or generated by our users. Defense of any such actions could be costly and involve significant time and attention of our
management and other resources and may require us to change our business in an adverse manner.

In
addition, the amount of data we store for our users on our servers (including personal information) will increase as we increase our web based services. Any systems failure or
compromise of our security that results in the release of our users' data could seriously limit the adoption of our products and services as well as harm our reputation and brand and, therefore, our
business. We may also need to expend significant resources to protect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we
expand the number of web based products and services we offer as well as increase the number of countries where we operate.

Further,
failure or perceived failure by us to comply with our policies, applicable requirements, or industry self-regulatory principles related to the collection, use,
sharing or security of personal information, or other privacy, data-retention or data-protection matters could result in a loss of user confidence in us, damage to our brands,
and ultimately in a loss of users, advertising partners, or affiliates which could adversely affect our business.

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Our possession and use of personal information presents risks and expenses that could harm our business. Unauthorized disclosure or manipulation of such data, whether
through breach of our network security or otherwise, could expose us to costly litigation and damage our reputation.

Maintaining our network security is of critical importance because our online e-commerce systems and our online
administration tools for our institutional business store proprietary and confidential customer, employee and other sensitive data, such as names, addresses, other personal information and credit card
numbers. We and our vendors use commercially available encryption technology to transmit personal information when taking orders. We use security and business controls to limit access and use of
personal information. However, third parties may be able to circumvent these security and business measures by developing and deploying viruses, worms and other malicious software programs that are
designed to attack or attempt to infiltrate our systems and networks. In addition, employee error, malfeasance or other errors in the storage, use or transmission of personal information could result
in a breach of customer or employee privacy. We employ contractors and temporary and part-time employees who may have access to the personal information of customers and employees. It is
possible such individuals could circumvent our controls, which could result in a breach of customer or employee privacy.

Possession
and use of personal information in conducting our business subjects us to legislative and regulatory burdens that could require notification of data breach, restrict our use
of personal information and hinder our ability to acquire new customers or market to existing customers. We have incurred, and will continue to incur, expenses to comply with privacy and security
standards and protocols imposed by law, regulation, industry standards or contractual obligations.

If
third parties improperly obtain and use the personal information of our customers or employees, we may be required to expend significant resources to resolve these problems. A major
breach of our network security and systems could have serious negative consequences for our businesses, including possible fines, penalties and damages, reduced customer demand for our products and
services, harm to our reputation and brand and loss of our ability to accept and process customer credit card orders.

We are exposed to risks associated with credit card and payment fraud and with credit card processing, which could cause us to lose revenue.

Many of our customers use credit cards or automated payment systems to pay for our products and services. We have suffered losses, and
may continue to suffer losses, as a result of orders placed with fraudulent credit cards or other fraudulent payment data. For example, under current credit card practices, we may be liable for
fraudulent credit card transactions if we do not obtain a cardholder's signature, a frequent practice in internet sales. We employ technology solutions to help us detect fraudulent transactions.
However, the failure to detect or control payment fraud could cause us to lose sales and revenue.

Any significant interruptions in the operations of our call center or third-party call centers could cause us to lose sales and disrupt our ability to process orders and
deliver our solutions in a timely manner.

We rely on both an in-house call center and third-party call centers to sell our solutions, respond to customer service and
technical support requests and process orders. Any significant interruption in the operation of these facilities, including an interruption caused by our failure to successfully expand or upgrade our
systems or to manage these expansions or upgrades, could reduce our ability to receive and process orders and provide products and services, which could result in lost and cancelled sales and damage
to our brand and reputation.

As
we grow, we will need more capacity from those existing call centers or we will need to identify and contract with new call centers. We may not be able to continue to locate and
contract for call

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center
capacity on favorable terms, or at all. Additionally, the rates those call centers charge us may increase or those call centers may not continue to provide service at the current levels.

We
structure our marketing and advertising to drive potential customers to our call centers and websites to purchase our solutions. If our call center operators do not convert inquiries
into sales at expected rates, our ability to generate revenue could be impaired. Training and retaining qualified call center operators is challenging due to the expansion of our product and service
offerings and the seasonality of our business. If we do not adequately train our call center operators, they will not convert inquiries into sales at an acceptable rate.

Our
call center employs a large number of personnel and historically has been subject to a high turnover rate among employees. We may have to terminate employees from time to time as our
business changes and labor demands shift among our facilities. Any significant increase in labor costs, deterioration of employee relations, slowdowns or work stoppages at any of our locations,
employee turnover or otherwise, could harm our business and profitability. In addition, high employee turnover could increase our exposure to employee-related litigation. Likewise, the third-party
call centers we utilize face similar issues.

If any of our products contain defects or errors or if new product releases or services are delayed, our reputation could be harmed, resulting in significant costs to us and
impairing our ability to sell our solutions.

If our products contain defects, errors or security vulnerabilities, our reputation could be harmed, which could result in significant
costs to us and impair our ability to sell our products in the future. In the past, we have encountered product development delays due to errors or defects. We would expect that, despite our testing,
errors will be found in new products and product enhancements in the future. Significant errors in our products or services could lead to, among other things:



In
addition, we could face claims for product liability, tort or breach of warranty. Our contracts with customers contain provisions relating to warranty disclaimers and liability
limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divert management's attention and adversely affect the market's perception of us and our products
and services. In addition, if our business liability insurance coverage proves inadequate or future coverage is unavailable on acceptable terms, or at all, we could face significant financial losses.

Our sales to U.S. government agencies and armed forces subject us to special risks that could adversely affect our business.

Government sales entail a variety of risks including:



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If we fail to effectively upgrade our information technology systems, we may not be able to accurately report our financial results or prevent fraud.

As part of our efforts to continue improving our internal control over financial reporting, we plan to continue to upgrade our existing
financial information technology systems in order to automate several controls that are currently performed manually. We may experience difficulties in transitioning to these upgraded systems,
including loss of data and decreases in productivity, as personnel become familiar with these new systems. In addition, our management information systems will require modification and refinement as
we grow and as our business needs change, which could prolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If we
experience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management information systems or
respond to changes in our business needs, we may not be able to effectively manage our business and we may fail to meet our reporting obligations. In addition, as a result of the automation of these
manual processes, the data produced may cause us to question the accuracy of previously reported financial results.

Our software products must interoperate with computer operating systems of our customers. If we are unable to ensure that our products interoperate properly with customer
systems, our business could be harmed.

Our products must interoperate with our customers' computer systems, including student learning management systems of our institutional
customers. As a result, we must continually ensure that our products interoperate properly with these systems. Changes in operating systems, the technologies we incorporate into our products or the
computer systems our customers use may damage our business. For example, our online Version 2 software subscriptions, which we offer in six languages, does not currently operate properly with
the newly released Microsoft Windows 7 and Mac OS X operating systems.

As our product and service offerings become more complex, our reported revenue may become less predictable.

Our planned expansion of products and services will generate more varied sources of revenue than our existing business. The accounting
policies that apply to these sources of revenue may be more complex than those that apply to our traditional products and services. In addition, we may change the manner in which we sell our software
licenses, and such change could cause delays in revenue recognition in accordance with accounting standards. Under these accounting standards, even if we deliver products and services to, and collect
cash from, a customer in a given fiscal period, we may be required to defer recognizing revenue from the sale of such product or service until a future period when all the conditions necessary for
revenue recognition have been satisfied. Conditions that can cause delays in revenue recognition include software arrangements that have undelivered elements for which we have not yet established
vendor specific objective evidence of fair value, requirements that we deliver services for significant enhancements or modifications to customize our software for a particular customer or material
customer acceptance criteria.

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Many of our expenses are fixed and many are based, in significant part, on our expectations of our future revenue and are incurred prior to the sale of our products and
services. Therefore, any significant decline in revenue for any period could have an immediate negative impact on our margins, net income and financial results for the period.

Our expense levels are based, in significant part, on our estimates of future revenue and many of these expenses are fixed in the short
term. As a result, we may be unable to adjust our spending in a timely manner if our revenue falls short of our expectations. Accordingly, any significant shortfall of revenue in relation to our
estimates could have an immediate negative effect on our profitability. In addition, as our business grows, we anticipate increasing our operating expenses to expand our product development, technical
support, sales and marketing and administrative organizations. Any such expansion could cause material losses to the extent we do not generate additional revenue sufficient to cover the additional
expenses.

We may need to raise additional funds to pursue our growth strategy or continue our operations, and we may be unable to raise capital when needed.

From time to time, we may seek additional equity or debt financing to provide for the capital expenditures required to finance working
capital requirements, continue our expansion, develop new products and services or make acquisitions or other investments. In addition, if our business plans change, general economic, financial or
political conditions in our markets change, or other circumstances arise that have a material effect on our cash flow, the anticipated cash needs of our business as well as our conclusions as to the
adequacy of our available sources of capital could change significantly. Any of these events or circumstances could result in significant additional funding needs, requiring us to raise additional
capital. We cannot predict the timing or amount of any such capital requirements at this time. If financing is not available on satisfactory terms, or at all, we may be unable to expand our business
or to develop new business at the rate desired and our results of operations may suffer.

Risks Related to Intellectual Property Rights

Protection of our intellectual property is limited, and any misuse of our intellectual property by others, including software piracy, could harm our business, reputation and
competitive position.

Our intellectual property is important to our success. We believe our trademarks, copyrights, trade secrets, pending patents, trade
dress and designs are valuable and integral to our success and competitive position. To protect our proprietary rights, we rely on a combination of copyrights, trademarks, trade secret laws,
confidentiality procedures, contractual provisions and technical measures.

We
have several patent applications on file. However, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination
process will require us to narrow our claims. Even if patents are issued from our patent applications, which is not certain, they may be contested, circumvented or invalidated in the future. Moreover,
the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as with any technology, competitors may be able to develop similar or
superior technologies now or in the future. In addition, we have not emphasized patents as a source of significant competitive advantage and have instead sought to primarily protect our proprietary
rights under laws affording protection for trade secrets, copyright and trademark protection of our products, brands, trademarks and other intellectual property where available and appropriate.
However, all of these measures afford only limited protection and may be challenged, invalidated or circumvented by third parties. In addition, these protections may not be adequate to prevent our
competitors or customers from copying or reverse-engineering our products. Third parties could copy all or portions of our products or otherwise obtain, use, distribute and sell our proprietary
information without authorization. Third parties may

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also
develop similar or superior technology independently by designing around our intellectual property, which would decrease demand for our products. In addition, our patents may not provide us with
any competitive advantages and the patents of others may seriously impede our ability to conduct our business.

We
protect our products, trade secrets and proprietary information, in part, by requiring all of our employees to enter into agreements providing for the maintenance of confidentiality
and the assignment of rights to inventions made by them while employed by us. We also enter into non-disclosure agreements with our technical consultants, customers, vendors and resellers
to protect our confidential and proprietary information. We cannot assure you that our confidentiality agreements with our employees, consultants and other third parties will not be breached, that we
will be able to effectively enforce these agreements, that we will have adequate remedies for any breach, or that our trade secrets and other proprietary information will not be disclosed or will
otherwise be protected.

We
rely on contractual and license agreements with third parties in connection with their use of our products and technology. There is no guarantee that such parties will abide by the
terms of such agreements or that we will be able to adequately enforce our rights, in part because we rely, in many instances, on "click-wrap" and "shrink-wrap" licenses, which
are not negotiated or signed by individual licensees. Accordingly, some provisions of our licenses, including provisions protecting against unauthorized use, copying, transfer, resale and disclosure
of the licensed software program, may be unenforceable under the laws of several jurisdictions.

Protection
of trade secret and other intellectual property rights in the markets in which we operate and compete is highly uncertain and may involve complex legal questions. The laws of
countries in which we operate may afford little or no protection to our trade secrets and other intellectual property rights. Although we defend our intellectual property rights and combat unlicensed
copying and use of software and intellectual property rights through a variety of techniques, preventing unauthorized use or infringement of our intellectual property rights is inherently difficult.
Despite our enforcement efforts
against software piracy, we lose significant revenue due to illegal use of our software. If piracy activities increase, it may further harm our business.

We
also expect that the more successful we are, the more likely that competitors will try to illegally use our proprietary information and develop products that are similar to ours,
which may infringe on our proprietary rights. In addition, we could potentially lose future trade secret protection for our source code if any unauthorized disclosure of such code occurs. The loss of
future trade secret protection could make it easier for third parties to compete with our products by copying functionality. In addition, any changes in, or unexpected interpretations of, the trade
secret and other intellectual property laws in any country in which we operate may compromise our ability to enforce our trade secret and intellectual property rights. Costly and
time-consuming litigation could be necessary to enforce and determine the scope of our confidential information and trade secret protection. If we are unable to protect our proprietary
rights or if third parties independently develop or gain access to our or similar technologies, our business, revenue, reputation and competitive position could be harmed.

Third-party use of our trademarks as keywords in internet search engine advertising programs may direct potential customers to competitors' websites, which could harm our
reputation and cause us to lose sales.

Competitors and other third parties purchase our trademarks and confusingly similar terms as keywords in internet search engine
advertising programs and in the header and text of the resulting sponsored link advertisements in order to divert potential customers to their websites. Preventing such unauthorized use is inherently
difficult. If we are unable to protect our trademarks and confusingly similar terms from such unauthorized use, competitors and other third parties may continue to drive potential online customers
away from our websites to competing websites, which could harm our reputation and cause us to lose sales.

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Our trademarks are limited in scope and geographic coverage and may not significantly distinguish us from our competition.

We own several federal trademark registrations, including theRosetta Stonemark, hold
common law trademark rights and have federal trademark applications pending in the United States and abroad for additional trademarks. Even if federal registrations are granted to us, our trademark
rights may be challenged. It is also possible that our competitors will adopt trademarks similar to ours, thus impeding our ability to build brand identity and possibly leading to customer confusion.
In fact, various third parties have registered trademarks that are similar to ours in the
United States and overseas. We could incur substantial costs in prosecuting or defending trademark infringement suits. If we fail to effectively enforce our trademark rights, our competitive position
and brand recognition may be diminished.

We have not registered copyrights for all our products, which may limit our ability to enforce them.

We have not registered our copyrights in all of our software, written materials, website information, designs or other copyrightable
works. The United States Copyright Act automatically protects all of our copyrightable works, but without a registration we cannot enforce those copyrights against infringers or seek certain statutory
remedies for any such infringement. Preventing others from copying our products, written materials and other copyrightable works is important to our overall success in the marketplace. In the event we
decide to enforce any of our copyrights against infringers, we will first be required to register the relevant copyrights, and we cannot be sure that all of the material for which we seek copyright
registration would be registrable in whole or in part, or that once registered, we would be successful in bringing a copyright claim against any such infringers.

We must monitor and protect our internet domain names to preserve their value. We may be unable to prevent third parties from acquiring domain names that are similar to,
infringe on or otherwise decrease the value of our trademarks.

We own several domain names that include the terms Rosetta Stone and Rosetta World. Third parties may acquire substantially similar
domain names that decrease the value of our domain names and trademarks and other proprietary rights which may hurt our business. Moreover, the regulation of domain names in the United States and
foreign countries is subject to change. Governing bodies could appoint additional domain name registrars or modify the requirements for holding domain names. Governing bodies could also establish
additional "top-level" domains, which are the portion of the Web address that appears to the right of the "dot," such as "com," "gov" or "org." As a result, we may not maintain exclusive
rights to all potentially relevant domain names in the United States or in other countries in which we conduct business, which could harm our business or reputation.

Claims that we misuse the intellectual property of others could subject us to significant liability and disrupt our business.

We may become subject to material claims of infringement by competitors and other third parties with respect to current or future
products, e-commerce and other web-related technologies, online business methods, trademarks or other proprietary rights. Our competitors, some of which may have substantially
greater resources than us and have made significant investments in competing products and technologies, may have, or seek to apply for and obtain, patents, copyrights or trademarks that will prevent,
limit or interfere with our ability to make, use and sell our current and future products and technologies, and we may not be successful in defending allegations of infringement of these patents,
copyrights or trademarks. Further, we may not be aware of all of the patents and other intellectual property rights owned by third parties that may be potentially adverse to our interests. We may need
to resort to litigation to enforce our proprietary rights or to determine the scope and validity of a third-party's patents or other proprietary rights, including whether any of our products,
technologies or processes infringe the patents or other proprietary rights of third parties. We may incur substantial

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expenses
in defending against third-party infringement claims regardless of the merit of such claims. The outcome of any such proceedings is uncertain and, if unfavorable, could force us to
discontinue sales of the affected products or impose significant penalties or restrictions on our business. We do not conduct comprehensive patent searches to determine whether the technologies used
in our products infringe upon patents held by others. In addition, product development is inherently uncertain in a rapidly evolving technological environment in which there may be numerous patent
applications pending, many of which are confidential when filed, with regard to similar technologies.

We do not own all of the software, other technologies and content used in our products and services.

Some of our products and services include intellectual property owned by third parties, including software that is integrated with
internally developed software and a portion of our voice recognition software, which we license from the University of Colorado. From time to time we may be required to renegotiate with these third
parties or negotiate with new third parties to include their technology or content in our existing products, in new versions of our existing products or in wholly new products. We may not be able to
negotiate or renegotiate licenses on commercially reasonable terms, or at all, and the third-party software may not be appropriately supported, maintained or enhanced by the licensors. If we are
unable to obtain the rights necessary to use or continue to use third-party technology or content in our products and services, the inability to support, maintain and enhance any software could result
in increased costs, or in delays or reductions in product shipments until equivalent software could be developed, identified, licensed and integrated.

Our use of open source software could impose limitations on our ability to commercialize our products.

We incorporate open source software into our products and may use more open source software in the future. The use of open source
software is governed by license agreements. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that these licenses could be construed in a manner that
could impose unanticipated conditions or restrictions on our ability to commercialize our products. In such event, we could be required to seek licenses from third parties in order to continue
offering our products, make generally available, in source code form, proprietary code that links to certain open source modules, re-engineer our products, discontinue the sale of our
products if re-engineering could not be accomplished on a cost-effective and timely basis, or become subject to other consequences. In addition, open source licenses generally
do not provide warranties or other contractual protections regarding infringement claims or the quality of the code. Thus, we may have little or no recourse if we become subject to infringement claims
relating to the open source software or if the open source software is defective in any manner.

Risks Related to Owning Our Common Stock

Some of our stockholders could together exert significant influence over our company.

As of December 31, 2009, funds affiliated with ABS Capital Partners beneficially owned in the aggregate shares representing
approximately 25% of our outstanding voting power. Two managing members of the general partner of ABS Capital Partners currently serve on our board of directors. Additionally, as of
December 31, 2009, Norwest Equity Partners VIII, LP, or Norwest, beneficially owned in the aggregate shares representing approximately 16% of our outstanding voting power. One managing
member of the general partner of Norwest currently serves on our board of directors. As a result, these stockholders could together potentially have significant influence over all matters presented to
our stockholders for approval, including election and removal of our directors and change of control transactions. The interests of these stockholders may not always coincide with the interests of the
other holders of our common stock.

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As a public company we incur additional cost and face increased demands on our management and key employees.

We have operated as a public company only since April 15, 2009. As a public company, we incur significant legal, accounting and
other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as rules implemented by the Securities and Exchange Commission, or SEC, and the New York
Stock Exchange, impose various requirements on public companies. Our management and other personnel devote substantial amounts of time to these requirements. Moreover, these requirements have
significantly increased our legal and financial compliance costs and have made some activities more time-consuming and costly. In addition, we incur additional costs associated with our
public company reporting requirements. These rules and regulations also make it more difficult and more expensive for us to obtain director and officer liability insurance. We estimate that the
incremental annual public company costs will be between $1.5 million and $2.0 million in fiscal 2010, which will primarily be reflected in general and administrative costs. However,
these estimates may prove to be inaccurate as many of these costs are beyond our control, and the actual incremental costs associated with our public company status could materially exceed our
estimates. If our profitability is harmed by these additional costs, it could have a negative effect on the trading price of our common stock.

In prior periods, we identified material weaknesses in our internal controls that could result in material misstatements in our financial statements. Although we have
remediated the weaknesses, if we do not maintain adequate internal controls over financial reporting, it could impair our ability to comply with the accounting and reporting requirements applicable to
public companies.

In relation to our consolidated financial statements for the year ended December 31, 2007, we identified material weaknesses in
our internal controls over financial reporting in accounting for inventory, income taxes and stock-based compensation, our general computer controls and controls within our enterprise resources
planning system. In addition, we identified a significant deficiency in our financial closing process. No material weaknesses or significant deficiencies in our internal controls were identified in
relation to our consolidated financial statements for the years ended December 31, 2008 and 2009. A material weakness is defined as a significant deficiency or combination of significant
deficiencies that result in a reasonable possibility that a material misstatement of our financial statements will not be prevented by our internal control over financial reporting. A significant
deficiency means a control deficiency, or combination of control deficiencies, that adversely affects our ability to initiate, record, process or report financial data reliably in accordance with
generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of our financial statements that is more than inconsequential will not be prevented or
detected by our internal control over financial reporting.

Our
independent registered public accounting firm's audit for the years ended December 31, 2008 and 2009 included consideration of internal control over financial reporting as a
basis for designing their audit procedures, but not for the purpose of expressing an opinion on the effectiveness of our internal controls over financial reporting. If such an evaluation had been
performed or when we are required to
have them perform such an evaluation, additional material weaknesses, significant deficiencies and other control deficiencies may have been or may be identified. Ensuring that we have adequate
internal financial and accounting controls and procedures in place to help produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be
evaluated frequently. We incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies relating to internal controls, which could
materially adversely affect our results of operations.

Because
of these material weaknesses, there is heightened risk that a material misstatement of our annual or quarterly financial statements relating to the periods that these material
weaknesses existed

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was
not prevented or detected. We have taken steps to remediate our material weaknesses, including hiring additional accounting and finance personnel and engaging consultants. Although we believe we
have remediated these material weaknesses and significant deficiencies and did not identify any new material weaknesses or significant deficiencies in relation to our consolidated financial statements
for the years ended December 31, 2008 or 2009, we cannot be certain that our efforts to remediate these internal control weaknesses were successful or that similar material weaknesses will not
recur.

Our
internal growth plans will also put additional strains on our internal controls if we do not augment our resources and adapt our procedures in response to this growth. As a public
company, we are required to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 regarding internal controls beginning with our fiscal year ending December 31,
2010. In the event that we have not adequately remedied these material weaknesses, and if we fail to maintain proper and effective internal controls in future periods, we could become subject to
potential review by the New York Stock Exchange, the SEC or other regulatory authorities, which could require additional financial and management resources, could result in our delisting by the New
York Stock Exchange, could compromise our ability to run our business effectively and could cause investors to lose confidence in our financial reporting.

If securities analysts do not publish research or reports about our business or if they publish negative evaluations of our stock, the price of our stock could decline.

The trading market for our common stock depends in part on the research and reports that industry or financial analysts publish about
us or our business. If one or more of the analysts covering our business downgrade their evaluations of or recommendations regarding our stock, or if one or more of the analysts cease providing
research coverage on our stock, the price of our stock could decline. If one or more of these analysts cease providing research coverage on our stock, we could lose visibility in the market for our
stock, which in turn could cause our stock price to decline.

Provisions in our organizational documents and in the Delaware General Corporation Law may prevent takeover attempts that could be beneficial to our stockholders.

Provisions in our second amended and restated certificate of incorporation and second amended and restated bylaws, and in the Delaware
General Corporation Law, may make it difficult and expensive for a third-party to pursue a takeover attempt we oppose even if a change in control of our company would be beneficial to the interests of
our stockholders. Any provision of our second amended and restated certificate of incorporation or second amended and restated bylaws or Delaware law that has the effect of delaying or deterring a
change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for
our common stock. Our board of directors has the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the powers, preferences and rights of each series
without stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisition proposals or make it more difficult for a third party to gain control of our company, or
otherwise could adversely affect the market price of our common stock. Further, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. This section
generally prohibits us from engaging in mergers and other business combinations with stockholders that beneficially own 15% or more of our voting stock, or with their affiliates, unless our directors
or stockholders approve the business combination in the prescribed manner. However, because funds affiliated with ABS Capital Partners and Norwest acquired their shares prior to our initial public
offering, Section 203 is currently inapplicable to any business combination or transaction with them or their affiliates. In addition, our second amended and restated certificate of
incorporation includes a classified board of directors and requires that any action to be taken by stockholders must be taken at a duly called meeting of stockholders and may not be taken by

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written
consent. Our second amended and restated bylaws require that any stockholder proposals or nominations for election to our board of directors must meet specific advance notice requirements and
procedures, which make it more difficult for our stockholders to make proposals or director nominations.

Item 2.Properties

Our corporate headquarters are located in Arlington, Virginia, where we sublease approximately 31,281 square feet of space. The term of
this sublease runs through December 31, 2013 and we have the right to extend that lease for an additional three years. We believe that our headquarters space will be adequate for the
foreseeable future.

We
continue to lease approximately 14,541 square feet of space in Arlington, Virginia, which was the site of our corporate headquarters until late 2008. This space consists of multiple
leased spaces with lease obligations with terms ending between December 31, 2009 and August 31, 2013. We intend to continue to attempt to sublease a portion of this space, but we cannot
assure you that we will be able to sublease any of this space or that, if we do, it will be on terms that will cover our rent expense related to the space.

We
currently own a facility with approximately 62,000 square feet of usable space in Harrisonburg, Virginia, that serves as our operations office, where we perform most of our product
development. In addition, we lease a facility with approximately 40,000 square feet in Harrisonburg, Virginia for use as a packing and distribution center for all of our U.S. and some of our
international fulfillment. We are seeking additional space in Harrisonburg to support our future growth.

We
also lease space for our three full service retail outlets in Missouri, New Jersey, and New York and for small offices in Boulder, Colorado, Tokyo, Japan, Seoul, South Korea, Munich,
Germany and London, United Kingdom. Our Boulder office serves as a research and development location while our Tokyo, Seoul and London offices serve as our regional sales offices.

As
of December 31, 2009, we also had site licenses for 242 kiosks. Most of our kiosk site licenses have terms of three to six months and provide for a minimum rent plus a
percentage rent based upon sales after certain minimum thresholds have been achieved. These site licenses generally require that we pay insurance, utilities, real estate taxes and repair and
maintenance expenses. Some of the site licenses also contain early termination options, which can be exercised by us or the licensor under certain conditions.

Item 3.Legal Proceedings

In July 2009, we filed a lawsuit in the United States District Court for the Eastern District of Virginia against Google Inc.,
seeking, among other things, to prevent Google from infringing upon our trademarks. In this lawsuit, we assert, among other things, that Google allows third parties, including individuals involved in
software piracy operations, to purchase the right to use our trademarks or other terms confusingly similar in Google's Adwords advertising program. This lawsuit seeks, among other things, injunctive
relief to prevent Google from selling our trademarks or other terms confusingly similar for use in Google's Adwords advertising program. To date, Google has not made any counterclaims for damages
against us, however, we expect to incur material legal fees and other costs and expenses in pursuit of our claims against Google.

From
time to time, we have been subject to various claims and legal actions in the ordinary course of our business. We are not currently involved in any legal proceeding the ultimate
outcome of which, in our judgment based on information currently available, would have a material adverse impact on our business, financial condition or results of operations.

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PART II

Item 5.Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market for Common Stock

Our common stock is listed on the New York Stock Exchange under the symbol "RST." The following table sets forth, for each of the
periods indicated, the high and low reported sales price of our common stock on the NYSE.

High

LowYear ended December 31, 2009Fourth Quarter

$
23.72

$
16.55Third Quarter


30.69


20.35Second Quarter (Beginning April 16)


31.67


22.10First Quarter





Year ended December 31, 2008Fourth Quarter





Third Quarter





Second Quarter





First Quarter








On
March 2, 2010, the last reported sales price of our common stock on the NYSE was $23.64 per share. As of that date, there were approximately 667 holders of record of our common
stock.

Dividends

We have not paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to
retain all available funds and any future earnings to support the operation of and to finance the growth and development of our business. We do not anticipate paying any cash dividends in the
foreseeable future.

Securities Authorized For Issuance Under Equity Compensation Plans

For information regarding securities authorized for issuance under equity compensation plans, see Part III
"Item 12Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."

Stockholder Return Performance Presentation

The following graph compares the change in the cumulative total stockholder return on our common stock during the period from
April 16, 2009 (the first day our stock began trading on the NYSE) through December 31, 2009, with the cumulative total return on the NYSE Composite Index and the SIC Code Index that
includes all U.S. public companies in the Standard Industrial Classification (SIC) Code 7372-Prepackaged Software. The comparison assumes that $100 was invested on April 16, 2009 in
our common stock and in each of the foregoing indices and assumes reinvestment of dividends, if any.

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COMPARISON OF 8 MONTH CUMULATIVE TOTAL RETURN*Among Rosetta Stone Inc., The NYSE Composite Index
And SIC code 7372 index

GRAPHIC



Use of Proceeds from Public Offering of Common Stock

On April 15, 2009, our registration statement (File No. 333-153632) was declared effective for our initial
public offering, pursuant to which we registered the offering and sale of 3,125,000 shares of common stock by Rosetta Stone Inc. and the associated sale of 3,125,000 shares of common stock by
funds associated with ABS Capital Partners and Norwest Equity Partners VIII, LP (collectively, the "Private Equity Funds") and the additional sale pursuant to the underwriters'
over-allotment option for an additional 937,500 shares of common stock by the Private Equity Funds, at a public offering price of $18.00 per share. The offering closed on April 21,
2009. The managing underwriters were Morgan Stanley & Co. Incorporated and William Blair & Company, LLC.

As
a result of the offering, we received net proceeds of approximately $49.0 million, after deducting underwriting discounts and commissions of $3.9 million and additional
offering-related expenses of approximately $3.3 million. In April 2009, we used $7.9 million to satisfy the federal, state and local withholding tax obligations associated with the "net
issuance" of stock grants we made to 10 of our key employees, including executive officers, on April 15, 2009. In April 2009, we used $9.9 million of the net proceeds to repay the
outstanding balances under our revolving line of credit with Wells Fargo. We anticipate that we will use the remaining net proceeds from our initial public offering for working
capital and other general corporate purposes, which may include the acquisition of other businesses, products or technologies. We do not, however, have agreements or commitments for any specific
acquisitions at this time. Pending such uses, we plan to invest the net proceeds in short-term, interest-bearing, investment grade securities.

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Item 6.Selected Consolidated Financial Data

The following table sets forth our selected consolidated statement of operations, balance sheet and other data for the periods
indicated. The selected consolidated statement of operations data for the years ended December 31, 2009, 2008 and 2007, and the period from January 4, 2006 through December 31,
2006, and the consolidated balance sheet data as of December 31, 2009, 2008, 2007 and 2006 have been derived from Rosetta Stone Inc., or the Successor, audited consolidated financial
statements. The selected consolidated statement of operations data for the period from January 1, 2006 through January 4, 2006 and the year ended December 31, 2005, represents the
operations of Fairfield & Sons, Ltd., or the Predecessor, which was acquired by Rosetta Stone Inc. on January 4, 2006 and have been derived from Predecessor audited
consolidated financial statements. The selected consolidated financial data as of December 31, 2005 has been derived from Predecessor audited financial statements. This information should be
read in conjunction "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements contained elsewhere in this Annual Report on
Form 10-K. Our historical results for any prior period are not necessarily indicative of results to be expected in any future period.

The
Predecessor incurred transaction-related expenses during the period from January 1, 2006 through January 4, 2006 relating to the acquisition by Rosetta
Stone Inc. on January 4, 2006. Included in the expenses were $5.9 million related to restricted common stock, $3.1 million in cash bonuses and $1.2 million in
acquisition-related bank fees.

Successor

PredecessorYear Ended
December 31,

Period from
January 4, through
December 31,

Period from
January 1, through
January 4,

Year Ended
December 31,2009

2008

2007

2006

2006

2005(in thousands, except per share data)Statements of Operations Data:Revenue

$
252,271

$
209,380

$
137,321

$
91,298

$
272

$
48,402Cost of revenue


33,427


28,676


20,687


12,541


203


8,242Gross profit


218,844


180,704


116,634


78,757


69


40,160Operating expenses:Sales and marketing


114,899


93,384


65,437


45,854


695


22,432Research and development


26,239


18,387


12,893


8,117


41


2,819Acquired in-process research and development











12,597





General and administrative


57,174


39,577


29,786


16,590


142


8,157Lease abandonment





1,831











Transaction-related expenses














10,315


Total operating expenses


198,312


153,179


108,116


83,158


11,193


33,408Income (loss) from operations


20,532


27,525


8,518


(4,401
)

(11,124
)

6,752Other income and expense:Interest income


159


454


673


613





38Interest expense


(356
)

(891
)

(1,331
)

(1,560
)




Other (expense) income


112


239


154


60


3


134Interest and other income (expense), net


(85
)

(198
)

(504
)

(887
)

3


172Income (loss) before income taxes


20,447


27,327


8,014


(5,288
)

(11,121
)

6,924Income tax expense (benefit)


7,084


13,435


5,435


(1,240
)




143Net income (loss)


13,363


13,892


2,579


(4,048
)

(11,121
)

6,781Preferred stock accretion








(80
)

(159
)




Income (loss) attributable to common stockholders

$
13,363

$
13,892

$
2,499

$
(4,207
)
$
(11,121
)
$
6,781Income (loss) per share attributable to common stockholders:Basic

$
0.89

$
7.29

$
1.47

$
(2.63
)
$
(37,194
)
$
24,658Diluted

$
0.67

$
0.82

$
0.15

$
(2.63
)
$
(37,194
)
$
24,658Common shares and equivalents outstanding:Basic weighted average shares


14,990


1,905


1,702


1,598


0.299


0.275Diluted weighted average shares


19,930


16,924


16,533


1,598


0.299


0.275


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Table of Contents

Successor

PredecessorYear Ended
December 31,

Period from
January 4, through
December 31,

Period from
January 1, through
January 4,

Year Ended
December 31,2009

2008

2007

2006

2006

2005(in thousands, except per share data)Other Data:Stock-based compensation included in:Cost of sales

$
34

$
2

$
2

$
1

$


$
Sales and marketing


999


153


189


59





Research and development


5,959


482


360


128





General and administrative


15,158


953


776


373





Transaction-related expenses














5,930


Total stock-based compensation expense

$
22,150

$
1,590

$
1,327

$
561

$
5,930

$
Intangible amortization included in:Cost of sales

$


$
13

$
1,227

$
1,213

$


$
Sales and marketing


42


3,003


3,596


4,113





Total intangible amortization expense

$
42

$
3,016

$
4,823

$
5,326

$


$





Sucessor

PredecessorYear Ended
December 31,

Year Ended
December 31,2009

2008

2007

2006

2005(in thousands)Consolidated Balance Sheet Data:Cash and cash equivalents

$
95,188

$
30,626

$
21,691

$
16,917

$
11,738Total assets


225,442


138,818


110,376


96,754


25,620Deferred revenue


26,106


15,744


12,939


8,105


6,231Notes payable and capital lease obligation





9,910


13,324


15,917


63Redeemable convertible preferred stock








5,000


4,920


Total stockholders' equity

$
156,435

$
79,071

$
58,125

$
53,548

$
8,985


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Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations

This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be
read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. Our actual results may differ materially
from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including those discussed under "Risk Factors" and elsewhere in this Annual Report
on Form 10-K.



We are a leading provider of technology-based language learning solutions. We develop, market and sell language learning solutions
consisting of software, online services and audio practice tools primarily under ourRosetta Stonebrand. Our teaching method, which we call Dynamic Immersion, is designed to leverage the innate, natural language learning ability that children use to learn their native language. Our courses
are based on our proprietary interactive technologies and pedagogical content and utilize a sophisticated sequencing of images, text and sounds to teach a new language without translation or grammar
explanation. We believe our award-winning solutions provide an effective, convenient and fun way to learn languages. We currently offer our self-study language learning solutions in 31
languages. Our customers include individuals, educational institutions, armed forces, government agencies and corporations.

The
strength and breadth of our solutions have allowed us to develop a business model that we believe distinguishes us from other language learning companies. Our scalable technology
platform and our proprietary content can be deployed across many languages, which have enabled us to cost-effectively develop a broad product portfolio. We have a multi-channel marketing
and distribution strategy that directly targets customers, utilizing print, online, television and radio advertising, public relations initiatives and our branded kiosks. Approximately 82% of our
revenue for the year ended December 31, 2009 was generated through our direct sales channels, which include our call centers, websites, institutional sales force and kiosks. We also distribute
our solutions through select retailers such as Amazon.com, Apple, Barnes & Noble, Borders and Office Depot.

We
generate revenue primarily from sales of packaged software and audio practice products and online software subscriptions. Our continued growth depends, in part, on our ability to
maintain strong brand recognition in order to generate sales from new customers. We continuously balance our need to achieve short-term financial goals with the equally critical need to
invest in our products, our brand and our infrastructure to ensure our future success. In making decisions about spending levels in our various functional organizations, we consider many factors,
including:



We
believe the primary factors that affect our financial performance include the following:



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We
believe that our multi-channel marketing and distribution models are fundamental to our success. Specifically, we focus on educating customers about the many benefits of our products
and services by leveraging our advertising and kiosk network in order to drive website and call center traffic.



We derive revenue from sales of language learning solutions consisting of packaged software and audio practice products and online
software subscriptions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements. Our audio practice products are normally combined with our
packaged software products and sold as a solution.

Product
revenue consists of revenue from sales of our packaged software and audio products. Subscription and service revenue consists primarily of revenue from our online software
subscriptions. The content of our packaged software and subscription offerings are the same. We simply offer our customers the ability to choose which format they prefer without differentiating the
learning experience. We intend to begin bundling time-based subscription licenses of our web-based TOTALe services with perpetual licenses of our Rosetta Stone Version 3
language learning solutions in the U.S. consumer market during the third quarter of 2010 as part of our Rosetta Stone Version 4 TOTALe launch. As a result, we anticipate that we will be deferring
approximately 20%-25% of each of these bundled sales. The deferred revenue will be recognized over the subscription term in accordance with Accounting Standards Codification subtopic
985-605,Software: Revenue Recognition.

We
sell our solutions directly to individuals, educational institutions, armed forces, government agencies and corporations. We distribute our consumer products predominantly through our
direct sales channels, primarily our websites and call centers, which we refer to as our direct-to-consumer channel. We also distribute our consumer products through our
kiosks, which we own, as well as through select retailers. The majority of our consumer customers purchase our packaged software and audio practice products. We sell to institutions primarily through
our direct institutional sales force. Many institutions elect to license our products on a subscription basis. For purposes of explaining variances in our revenue, we separately discuss changes in our
consumer and institutional sales channels because the customers and revenue drivers of these
channels are different. We anticipate that revenue growth in future periods will be less significant than we have experienced historically.

Our
consumer revenue is affected by seasonal trends associated with the holiday shopping season. As a result, our fourth quarter ended December 31, 2009 accounted for 31% of our
annual revenue in

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2009.
Our institutional revenue is seasonally stronger in the second and third quarters of the calendar year due to education, home school and government purchasing cycles. We expect these trends to
continue.



Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute our products. Such
costs include packaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty fees and inventory storage, obsolescence and
shrinkage. Cost of subscription and service revenue primarily represents costs associated with supporting our online language learning service, which includes hosting costs and depreciation. We also
include the cost of credit card processing and customer technical support in both cost of product revenue and cost of subscription and service revenue. We expect our cost of revenue to increase in
absolute dollars in future periods as our unit sales continue to grow. We also expect cost of revenue will increase as a percentage of revenue in future periods with the planned launch of Rosetta
Stone Version 4 TOTALe which includes services that have higher direct costs to deliver to customers than our existing software solutions.



We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative.

Our
operating expenses primarily consist of personnel costs, direct advertising and marketing expenses and professional fees associated with contract product development, legal,
accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses, stock-based compensation and employee benefit costs.

Sales and Marketing.Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print,
radio, online
and other direct marketing activities, personnel costs for our sales and marketing staff, rental payments for our kiosks and commissions paid to our sales personnel. Sales and marketing expenses also
include amortization expense of intangible assets related to customer relationships associated with the 2006 acquisition of Fairfield & Sons, Ltd. These intangible assets were fully
amortized by January 2009. In 2007, we began to make significant investments to expand our sales and marketing operations in Europe and Japan. In 2009, we began to make significant investments to
expand our sales and marketing operations in South Korea. In each case we established local sales offices and call centers, added employees and launched marketing and public relations campaigns within
the region. We intend to continue to expand our sales activities within these regions as well as to expand our presence into new countries, including Germany, in addition to expanding our media and
advertising campaigns in the United States. As a result, we expect sales and marketing expenses to increase in future periods.

Research and Development.Research and development expenses consist primarily of personnel costs and contract development fees
associated with the
development of our solutions. Our development efforts are primarily based in the United States and are devoted to expanding our product portfolio through the addition of new content and new
complimentary products and services to our language learning solutions. We expect our investment in research and development expenses to increase in future years but provide us with significant
benefits in the future.

General and Administrative.General and administrative expenses consist primarily of personnel costs of our executive, finance, legal,
human
resources and other administrative personnel, as well as accounting and legal professional services fees and other corporate expenses. We expect general and administrative expenses to increase in
future periods as we expect to continue to invest in corporate

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infrastructure
and incur additional expenses associated with being a public company, including increased legal and accounting costs, investor relations costs, independent director compensation,
exchange listing fees and stockholder related fees, higher insurance premiums and compliance costs in connection with Section 404 of the Sarbanes-Oxley Act of 2002. We also intend to increase
administrative expenses as a result of our planned international expansion.

Stock Compensation Charge.Included in the respective operating expense lines is an aggregate $18.8 million expense, consisting of
$18.5 million in stock-based compensation expense and $0.3 million in payroll tax expense, related to common stock grants awarded to key employees equal to a total of
591,491 shares in April 2009. This grant was net of the number of shares required to be withheld to satisfy the federal, state and local tax withholding obligations. The aggregate grant date fair
value of the awards was $18.5 million, which we recognized as stock-based compensation expense on the grant date, as the awards were immediately vested. We allocated this $18.8 million
aggregate expense among the operating expense line items in accordance with the functions performed by the respective employees who received the grants.



Other income (expense) primarily consists of interest income and interest expense. Interest expense is related to our
long-term debt, the outstanding balance of which was zero as of December 31, 2009. Interest income represents interest received on our cash and cash equivalents.



Income tax expense consists of federal and state income taxes in the United States. For the year ended December 31, 2009, our
worldwide effective tax rate was approximately 35%-38%. We expect our worldwide rate to be approximately 35% in 2010 and beyond assuming no general increase in U.S. federal or state income tax rates
applicable to companies such as ours. However, we expect our income tax expense to increase in absolute dollars as our income continues to grow.



In presenting our financial statements in conformity with accounting principles generally accepted in the United States, or GAAP, we
are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures.

Some
of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on
historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and
assumptions. Our
future estimates may change if the underlying assumptions change. Actual results may differ significantly from these estimates.

We
believe that the critical accounting policies listed below involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact
on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understand and evaluate the consolidated financial statements contained in this
annual report on Form 10-K.



Revenue is primarily derived from the sale of packaged software and audio practice products, online software subscriptions and
professional services. Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta Stone TOTALe,

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which
was released in July 2009. Revenue is recognized for software products and related services in accordance with Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition("ASC
985-605").

Revenue
is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee
is fixed and determinable; and collectability is probable. Revenues from packaged software and audio practice products and online software subscriptions are recorded net of discounts.

Revenue
is recognized from the sale of packaged software and audio practice products when the product has been delivered, assuming the remaining revenue recognition criteria have been
met. Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale of the software to the end user and is recorded
in the same manner as all other product sales. Revenue from sales of packaged software products are recognized as the products are shipped and title passes. A limited amount of packaged software
products are sold to resellers on a consignment basis. Revenue is recognized for these consignment transactions once the end-user sale has occurred, assuming the remaining revenue
recognition criteria have been met. In accordance with Accounting Standards Codification subtopic 985-605-50,Software: Revenue Recognition: Customer
Payments and Incentives("ASC 985-605-50"), price protection for changes in the manufacturer suggested retail value granted to resellers for the
inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue. We offer customers the
ability to make payments for packaged software purchases in installments over a period of time, which typically ranges between three and five months. Given that these installment payment plans are for
periods less than twelve months and a successful collection history has been established, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met.
For the years ended December 31, 2009, 2008 and 2007, installment sales represented 8%, 4% and 3% respectively. Packaged software is provided to customers who purchase directly from us with a
six-month right of return. We also allow our retailers to return unsold products, subject to some limitations. In accordance with Accounting Standards Codification subtopic
985-605-15,Software: Revenue Recognition: Products("ASC 985-605-15"), product revenue is reduced for
estimated returns, which are based on historical return rates.

Revenue
for software license agreements sold via online software subscriptions as hosting agreements are recognized in accordance with Accounting Standards Codification subtopic
985-605-05,Software: Revenue Recognition: Background("ASC 985-605-05"). Revenue for online software
subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria have been met, which typically ranges between three and twelve months. Some
online licensing arrangements include a specified number of licenses that can be activated over a period of time, which typically ranges between twelve and twenty-four months. Revenue for
these arrangements is recognized on a per license basis ratably over the term of the individual license subscription period, assuming all revenue recognition criteria have been met, which typically
ranges between three and twelve months. Revenue for set-up fees related to online licensing arrangements is recognized ratably over the term of the online licensing arrangement, assuming
all revenue recognition criteria have been met. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement and the subscription services
are made available to the customer. In connection with packaged software product sales and online software subscriptions, technical support is provided to customers, including customers of resellers,
at no additional charge. As the fee for technical support is included in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of
providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenues are recognized together with the software product and license revenue.
Costs associated with the technical support are accrued at the time of sale.

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Revenue
from the sale of packaged software products with specific upgrade rights is recognized in accordance with ASC 985-605. Revenue recognition for these sales is deferred
until the earlier of the point at which sufficient vendor-specific objective evidence ("VSOE") exist for the specific upgrade right or all elements of the arrangement have been delivered.

In
accordance with ASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identified benefit is
identified and the fair value is reasonably determinable.

We
have been engaged to develop language learning software for certain endangered languages under fixed fee arrangements. These arrangements also include contractual periods of
post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue for multi-element contracts will be recognized ratably once the PCS and online hosting
periods begin, over the longer of the PCS or online hosting period. When the current estimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for
the entire loss on the contract is recorded.



We account for stock-based compensation in accordance with Accounting Standards Codification topic 718, CompensationStock Compensation("ASC 718"), which was adopted by us effective January 1, 2006. Under ASC 718, all stock-based
awards, including employee stock option grants, are recorded at fair value as of the grant date and recognized as expense in the statement of operations on a straight-line basis over the
requisite service period, which is the vesting period.

As
of December 31, 2009 and 2008, there were approximately $5.3 million and $4.4 million of unrecognized stock-based compensation expense related to
non-vested stock option awards that is expected to be recognized over a weighted average period of 2.49 and 2.21 years, respectively.

The
following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statement line items (in thousands):

Years Ended December 31,2009

2008

2007Included in cost of revenue:Cost of product revenue

$
34

$
2

$
2Cost of subscription and service revenue








Total included in cost of revenue


34


2


2Included in operating expenses:Sales and marketing


999


153


189Research and development


5,959


482


360General and administrative


15,158


953


776Total included in operating expenses


22,116


1,588


1,325Total

$
22,150

$
1,590

$
1,327


In
accordance with ASC topic 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expense is then recognized on a
straight-line basis over the requisite service period of the award. We use the Black-Scholes pricing model to value our stock options, which requires the use of estimates, including future
stock price volatility, expected term and forfeitures. Stock-based compensation expense recognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates
were applied in the expense calculation.

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The
fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model as follows:

Year Ended December 31,2009

2008

2007Expected stock price volatility

61%

57%-62%

62%-70%Expected term of options

6 years

6 years

6 yearsExpected dividend yield





Risk-free interest rate

1.71%-2.46%

2.08%-3.36%

3.50%-4.96%


Prior
to the completion of our initial public offering in April 2009, our stock was not publicly quoted and we had a limited history of stock option activity, so we reviewed a group of
comparable industry-related companies to estimate our expected volatility over the most recent period commensurate with the estimated expected term of the awards. In addition to analyzing data from
the peer group, we also considered the contractual option term and vesting period when determining the expected option life and forfeiture rate. Subsequent to the initial public offering, we continue
to review a group of comparable industry-related companies to estimate volatility, but also review the volatility of our own stock since the initial public offering. We consider the volatility of the
comparable companies to be the best estimate of future volatility. For the risk-free interest rate, we use a U.S. Treasury Bond rate consistent with the estimated expected term of the
option award.

The
following table sets forth all stock option grants since the date of plan inception, through the date of this Annual Report on Form 10-K:

Grant Date

Number of
Options Granted

Exercise Price

Common Stock
Fair Value
Per Share
at Grant
DateMay 22, 2006


1,366,456

$
3.85

$
4.57August 16, 2006


29,861


3.85


5.10August 21, 2006


149,500


3.85


5.14September 5, 2006


130,000


3.85


5.25December 8, 2006


29,133


3.85


5.92February 2, 2007(1)


20,423


3.85


6.35March 21, 2007


221,559


6.08


6.73April 20, 2007(1)


31,330


6.08


6.98June 5, 2007


59,800


7.31


7.31August 3, 2007(1)


18,824


7.31


9.60August 22, 2007


27,911


10.60


10.60November 28, 2007


34,229


11.19


11.19December 17, 2007(1)


22,178


10.60


11.30February 8, 2008(1)


57,447


11.19


11.64April 29, 2008(1)


99,346


11.64


10.36May 28, 2008


110,916


10.36


10.36August 19, 2008


36,075


14.22


14.22November 19, 2008


99,021


17.49


17.49April 15, 2009


441,911


18.00


18.00May 28, 2009


15,000


22.30


22.30August 19, 2009


1,974


20.35


20.35November 18, 2009


12,445


16.74


16.74December 7, 2009


1,259


18.05


18.05


(1)The
exercise price for these stock options was established at the fair value of our common stock on the date of grant approval by the board of directors.
However, in accordance with ASC 718, because all of the key terms of the stock option grants were not communicated to employees on a timely


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basis,
we established the option grant date, the interpolated common stock fair value and stock option fair value as of the date on which all key option terms were communicated to the employees, which
is the date reflected above.




We made stock grants, restricted stock grants and stock option grants to our employees on April 15, 2009. In connection with
these grants, we recorded an aggregate expense of approximately $18.5 million in the second quarter of 2009, and an additional $6.3 million that will be recorded over the
four-year vesting period of the stock options and restricted stock grants.



Accounts receivable consist of amounts due to us from our normal business activities. We provide an allowance for doubtful accounts to
reflect the expected
non-collection of accounts receivable based on past collection history and specific risks identified.



Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and
trademark and other intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives in accordance with Accounting
Standards Codification topic 350,Goodwill and Other Intangible Assets("ASC 350"). On an annual basis, we review our indefinite lived intangible assets
for impairment based on the fair value of indefinite lived intangible assets as compared to the carrying value in accordance with ASC 350. In the event the carrying value exceeds the fair value of the
assets, the assets are written down to their fair value. There has been no impairment of intangible assets during any of the periods presented.



In accordance with ASC 350, goodwill is not amortized and is tested for impairment annually on June 30th and whenever
events and circumstances occur indicating goodwill might be impaired. The first step is a screen for potential impairment by comparing the fair value of our one reporting unit with its carrying
amount. The second step measures the amount of impairment loss, if any. As of June 30, 2009 and 2008, we reviewed the goodwill for impairment and determined that no impairment of goodwill was
identified during any of the periods presented, nor is the reporting unit at risk of failing step one of the goodwill impairment test.



In accordance with Accounting Standards Codification topic 360,Accounting for the Impairment or Disposal of
Long-lived Assets("ASC 360"), we evaluate the recoverability of our long-lived assets. ASC 360 requires recognition of impairment of
long-lived assets in the event that the net book value of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the
period of identification to the extent the carrying amount of an asset exceeds the fair value of such asset. Based on our analysis, we believe that no impairment of our long-lived assets
was indicated as of December 31, 2009 and 2008.

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For the years ended December 31, 2009, 2008 and 2007, we accounted for income taxes in accordance with Accounting Standards
Codification topic 740,Income Taxes("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred tax assets
and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax bases of assets and liabilities.
Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred tax liabilities are recognized for taxable
temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will
not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted.

In
June 2006, the Financial Accounting Standards Board ("FASB") issued certain provisions in the Accounting Standards Codification topic 740-10-25, Income Taxes: Overall: Recognition,("ASC 740-10-25"),
which clarify the accounting for uncertainty in income taxes recognized
in an enterprise's financial statements in accordance with ASC 740 and prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. These
provisions also provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. We adopted these recognition
provisions of ASC 740-10-25 effective January 1, 2007. The adoption of ASC 740-10-25 did not have a material impact on our financial condition,
results of operations or cash flows.

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Results of Operations

The following table sets forth our consolidated statement of operations for the periods indicated.

Year Ended December 31,2009

2008

2007(in thousands, except per share data)Statements of Operations Data:Revenue

$
252,271

$
209,380

$
137,321Cost of revenue


33,427


28,676


20,687Gross profit


218,844


180,704


116,634Operating expenses:Sales and marketing


114,899


93,384


65,437Research and development


26,239


18,387


12,893General and administrative


57,174


39,577


29,786Lease abandonment





1,831


Total operating expenses


198,312


153,179


108,116Income from operations


20,532


27,525


8,518Other income and expense:Interest income


159


454


673Interest expense


(356
)

(891
)

(1,331
)Other (expense) income


112


239


154Interest and other income (expense), net


(85
)

(198
)

(504
)Income before income taxes


20,447


27,327


8,014Income tax expense (benefit)


7,084


13,435


5,435Net income


13,363


13,892


2,579Preferred stock accretion








(80
)Income attributable to common stockholders

$
13,363

$
13,892

$
2,499Income per share attributable to common stockholders:Basic

$
0.89

$
7.29

$
1.47Diluted

$
0.67

$
0.82

$
0.15Common shares and equivalents outstanding:Basic weighted average shares


14,990


1,905


1,702Diluted weighted average shares


19,930


16,924


16,533Stock-based compensation included in:Cost of sales

$
34

$
2

$
2Sales and marketing


999


153


189Research and development


5,959


482


360General and administrative


15,158


953


776Transaction-related expenses








$
22,150

$
1,590

$
1,327Intangible amortization included in:Cost of sales

$


$
13

$
1,227Sales and marketing


42


3,003


3,596$
42

$
3,016

$
4,823


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Comparison of the Year Ended December 31, 2009 and the Year Ended December 31, 2008

Year Ended December 31,2009

2008

Change

% Change(dollars in thousands)Product revenue

$
218,549


86.6
%
$
184,182


88.0
%
$
34,367


18.7
%Subscription and service revenue


33,722


13.4
%

25,198


12.0
%
$
8,524


33.8
%Total revenue

$
252,271


100.0
%
$
209,380


100.0
%
$
42,891


20.5
%Revenue by sales channel:Direct-to-consumer

$
114,002


45.2
%
$
96,702


46.2
%
$
17,300


17.9
%Kiosk


40,418


16.0
%

36,314


17.3
%
$
4,104


11.3
%Retail


44,850


17.8
%

34,638


16.5
%
$
10,212


29.5
%Total consumer


199,270


79.0
%

167,654


80.1
%

31,616


18.9
%Institutional


53,001


21.0
%

41,726


19.9
%
$
11,275


27.0
%Total revenue

$
252,271


100.0
%
$
209,380


100.0
%
$
42,891


20.5
%




Total revenue for the year ended December 31, 2009 was $252.3 million, an increase of $42.9 million, or 21%, from
the year ended December 31, 2008.



Consumer revenue was $199.3 million for the year ended December 31, 2009 an increase of $31.6 million, or 19%,
from the year ended December 31, 2008. The increase in consumer revenue was attributable to a 14% increase in unit sales, which resulted in a $23.8 million increase in revenue, combined
with a 4% increase in the average selling price of each unit, which accounted for a $7.8 million increase in revenue. Unit growth was driven by the planned expansion of our direct marketing
programs, as well as growth in our retail distribution network. Direct advertising expenses increased 25% to $42.4 million during the year ended December 31, 2009, while the number of
kiosks increased from 150 to 242 from December 31, 2008 to December 31, 2009. Our 2008 revenue includes a $2.6 million initial stocking order we received from Barnes &
Noble in June 2008 to support their expansion of our product line to over 650 of their stores nationally. We did not have any such large initial stocking orders in 2009.

Product
revenue represented 96% of total consumer revenue for the year ended December 31, 2009, with the balance attributable to subscription and service revenue. We intend to
begin bundling time-based subscription licenses of our web-based TOTALe services with perpetual licenses of our Rosetta Stone Version 3 language learning solutions in the U.S.
consumer market during the third quarter of 2010 with the planned launch of Rosetta Stone Version 4 TOTALe. As a result, we will be deferring approximately 20% - 25% of each of these bundled
sales. We will recognize the deferred revenue over the term of the subscription license in accordance with Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition.



Institutional revenue was $53.0 million for the year ended December 31, 2009, an increase of $11.3 million, or
27%, compared to the year ended December 31, 2008. The increase in institutional revenue was primarily due to the expansion of our direct sales force. As a result, we had a $4.8 million
increase in education revenue, a $3.9 million increase in government revenue and a $2.0 million increase in corporate revenue.

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Product
revenue represented 52% of total institutional revenue for the year ended December 31, 2009, and subscription and service revenue represented 48% for the same period.



Year Ended
December 31,2009

2008

Change

% Change(dollars in thousands)Revenue:Product

$
218,549

$
184,182

$
34,367


18.7
%Subscription and service


33,722


25,198

$
8,524


33.8
%Total revenue

$
252,271

$
209,380

$
42,891


20.5
%Cost of revenue:Cost of product revenue

$
30,264

$
26,539

$
3,725


14.0
%Cost of subscription and service revenue


3,163


2,137

$
1,026


48.0
%Total cost of revenue


33,427


28,676


4,751


16.6
%Gross profit

$
218,844

$
180,704

$
38,140Gross margin percentages


86.7
%

86.3
%

0.4
%


Cost
of revenue for the year ended December 31, 2009 was $33.4 million, an increase of $4.8 million, or 17%, from the year ended December 31, 2008. As a
percentage of total revenue, cost of revenue decreased to 13% for the year ended December 31, 2009 compared to 14% for the year ended December 31, 2008. The dollar increase in cost of
revenue was primarily attributable to expansion of our product offering combined with a change in our sales mix, offset in part by a reduction in affiliate commissions and the absence in the 2009
period of intangible amortization related to core technology associated with the acquisition of Fairfield & Sons, Ltd., which was fully amortized in 2008. Cost of subscription and
service revenue increased by $1.0 million or 48% as we releasedRosetta Stone TOTALe, our new web-based service offering that
includes a component of dedicated language conversation coaching. We expect our cost of revenue will increase as a percent of revenue as we begin bundling time-based subscription licenses
of our web-based TOTALe services with perpetual licenses of our Rosetta Stone Version 3 language learning solutions in the U.S. consumer market with the planned launch of Rosetta Stone
Version 4 during the third quarter of 2010.



Year Ended
December 31,2009

2008

Change

% Change(dollars in thousands)Sales and marketing

$
114,899

$
93,384

$
21,515


23.0
%Research and development


26,239


18,387


7,852


42.7
%General and administrative


57,174


39,577


17,597


44.5
%Lease abandonment





1,831


(1,831
)

(100.0
)%Total operating expenses

$
198,312

$
153,179

$
45,133


29.5
%




Sales and marketing expenses for the year ended December 31, 2009 were $114.9 million, an increase of
$21.5 million, or 23%, from the year ended December 31, 2008. As a percentage of total

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revenue,
sales and marketing expenses were 46% for the year ended December 31, 2009, compared to 45% for the year ended December 31, 2008. The dollar and percentage increase in sales and
marketing expenses were primarily attributable to the continued expansion of our direct marketing activities. Advertising expenses grew by $8.6 million and were primarily related to television
and radio media and internet marketing. We also expanded the number of our kiosks from 150 as of December 31, 2008 to 242 as of December 31, 2009, which resulted in $6.2 million
of additional kiosk operating expenses, including rent and sales compensation related expenses. Personnel costs related to growth in our institutional sales channel and marketing and sales support
activities also increased by $6.4 million. The stock compensation charge related to a common stock grant to key employees in connection with our initial public offering resulted in a
$0.4 million increase in sales and marketing expense in 2009 compared to the prior year period. Completion in January 2009 of the amortization of the intangible assets associated with the 2006
acquisition of Fairfield & Sons, Ltd. resulted in a $3.0 million reduction in amortization expense in 2009 when compared to the prior year period.

Sales
and marketing expenses without consideration of the stock compensation charge associated with the common stock grant to key employees in connection with our initial public offering
would have been $114.5 million, an increase of $21.1 million or 23% from the prior year. As a percentage of revenue, sales and marketing expenses would have remained the same at 45% for
the year ended December 31, 2009 compared to the prior year period.



Research and development expenses were $26.2 million for the year ended December 31 2009, an increase of
$7.9 million, or 43%, from the year ended December 31, 2008. As a percentage of total revenue, research and development expenses increased to 10% for the year ended December 31,
2009 compared to 9% for the year ended December 31, 2008. The dollar and percentage increase were primarily attributable to a stock compensation charge related to common stock awarded to key
employees which resulted in a $5.0 million increase in research and development expense in 2009 when compared to the prior year period. In addition, research and development expenses increased
$3.0 million due to the addition of new product development personnel associated with the development of new products and services that are complementary to our existing solutions.

Research
and development expenses without consideration of the stock compensation charge associated with the common stock grant to key employees in connection with our initial public
offering would have been $21.2 million, an increase of $2.9 million or 16% from the prior year. As a percentage of revenue, research and development expenses would have decreased to 8%
for the year ended December 31, 2009 from 9% for the prior year period.



General and administrative expenses for the year ended December 31, 2009 were $57.2 million, an increase of
$17.6 million, or 45%, from the year ended December 31, 2008. As a percentage of revenue, general and administrative expenses increased to 23% for the year ended December 31, 2009
compared to 19% for the year ended December 31, 2008. The dollar and percentage increase was primarily attributable to a stock compensation charge related to common stock awarded to key
employees in connection with our initial public offering resulting in a $13.4 million increase in general and administrative expense. In addition, general and administrative expenses increased
due to greater personnel related costs as we expanded our finance, legal, information technology and other administrative functions to support the overall growth in our business. Personnel-related
costs increased $4.2 million with a corresponding increase in communications, training, recruitment, travel and other support costs of $0.6 million and new office space and equipment
depreciation costs of $0.9 million. Legal fees also increased $0.4 million related to intellectual property protection matters, and liability insurances for directors and officers
increased $0.3 million. This increase was partially offset by

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decreased
professional service expenses of $1.5 million as we replaced contract staff with employees and a decrease in bad debt expense $0.7 million during the year ended
December 31, 2009 as a result of improved collection efforts.

General
and administrative expenses without consideration of the stock compensation charge associated with the common stock grant to key employees in connection with our initial public
offering would have been $43.8 million, an increase of $4.2 million or 11% from the prior year. As a percentage of revenue, general and administrative expenses would have decreased to
17% for the year ended December 31, 2009 from 19% for the prior year period.



Included in each of the respective operating expense lines for the year ended December 31, 2009 is a portion of the
$18.8 million charge related to the total of 591,491 shares of common stock awarded to 10 of our key employees in April 2009. The following table presents the stock-based compensation charge by
operating expense line item:

Year Ended
December 31,2009

2008

Change

% Change(dollars in thousands)Sales and marketing

$
377

$


$
377


100
%Research and development


5,033




$
5,033


100
%General and administrative


13,393





13,393


100
%Total

$
18,803

$


$
18,803


100
%




We incurred no lease abandonment expense for the year ended December 31, 2009; however, with respect to the year ended
December 31, 2008, we incurred lease abandonment expense associated with the relocation of our headquarters of $1.8 million consisting of accrued exit costs and liabilities under
operating lease agreements.



Year Ended
December 31,2009

2008

Change

% Change(dollars in thousands)Interest income

$
159

$
454

$
(295
)

(65.0
)%Interest expense


(356
)

(891
)
$
535


(60.0
)%Other income


112


239

$
(127
)

(53.1
)%Total

$
(85
)
$
(198
)
$
113


(57.1
)%


Interest
income represents interest earned on our cash and cash equivalents. Interest income for the year ended December 31, 2009 was $0.2 million, a decrease of
$0.3 million, or 65%, from the year ended December 31, 2008. Interest expense is primarily related to our long-term debt, the outstanding balance of which was zero as of
December 31, 2009. Interest expense for the year ended December 31, 2009 was $0.4 million, a decrease of $0.5 million, or 60% from the year ended December 31, 2008.
The decrease was primarily due to the retirement of our previous Madison Capital term loan. Other Income for the year ended December 31, 2009 was $0.1 million, a decrease of
$0.1 million, or 53% and is primarily due to foreign currency fluctuations.

56

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Table of Contents



Year Ended
December 31,2009

2008

Change

% Change(dollars in thousands)Income tax expense

$
7,084

$
13,435

$
(6,351
)

(47.3
)%


Income
tax expense for the year ended December 31, 2009 was $7.1 million, a decrease of $6.4 million, or 47%, compared to the year ended December 31, 2008.
The decrease was the result of a decrease of $6.9 million in pre-tax income for the year ended December 31, 2009 and a lower effective tax rate, compared to the year ended
December 31, 2008. Our effective tax rate decreased to 35% for the year ended December 31, 2009 compared to 49% for the year ended December 31, 2008. The reduction in our
effective tax rate was a result of changes in the geographic distribution of our income and a change in our transfer pricing agreements.

We
determine the pricing among our associated entities on the basis of detailed functional and economic analysis involving benchmarking against transactions among entities that are not
under common control. Based on our analysis, we made changes to the transfer pricing agreements effective January 1, 2009. The resulting change in geographic distributions of income contributed
to a lower effective tax rate as compared to the year ended December 31, 2008.

We
do not currently record income tax on the results of our U.K., Japan or German subsidiaries. Despite enacting certain tax planning strategies during the year ended December 31,
2009, no subsidiary has produced sustainable pretax profits as of December 31, 2009 and each remains in a three-year cumulative loss position. Accordingly we continue to carry a
full valuation allowance on net operating loss carryforwards and other deferred tax assets for these jurisdictions. As we continue operations in accordance with the revised transfer pricing
agreements, we will monitor actual results and updated projections on a quarterly basis. When and if the subsidiaries realize or
realistically anticipate sustainable profitability, we will assess the appropriateness of releasing the valuation allowance in whole or in part.

Comparison of the Year Ended December 31, 2008 and the Year Ended December 31, 2007

Year Ended December 31,2008

2007

Change

% Change(dollars in thousands)Product revenue

$
184,182


88.0
%
$
119,897


87.3
%
$
64,285


53.6
%Subscription and service revenue


25,198


12.0
%

17,424


12.7
%
$
7,774


44.6
%Total revenue

$
209,380


100.0
%
$
137,321


100.0
%
$
72,059


52.5
%Revenue by sales channel:Direct-to-consumer

$
96,702


46.2
%
$
61,950


45.1
%
$
34,752


56.1
%Kiosk


36,314


17.3
%

23,947


17.4
%
$
12,367


51.6
%Retail


34,638


16.5
%

21,206


15.4
%
$
13,432


63.3
%Total consumer


167,654


80.1
%

107,103


78.0
%

60,551


56.5
%Institutional


41,726


19.9
%

30,218


22.0
%
$
11,508


38.1
%Total revenue

$
209,380


100.0
%
$
137,321


100.0
%
$
72,059


52.5
%




Total revenue for the year ended December 31, 2008 was $209.4 million, an increase of $72.1 million, or 53%, from
the year ended December 31, 2007.

57

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Table of Contents



Consumer revenue was $167.7 million for the year ended December 31, 2008, an increase of $60.6 million, or 57%,
from the year ended December 31, 2007. The increase in consumer revenue was attributable to a 22% increase in unit sales, which resulted in a $23.7 million increase in revenue, combined
with a 28% increase in the average selling price of each unit, which accounted for a $36.9 million increase in revenue. Unit growth was driven by the expansion of our direct advertising
campaign as well as growth in our retail distribution network. Direct advertising expenses increased 38% to $33.9 million during the year ended December 31, 2008, while the number of
kiosks increased from 86 to 150 from December 31, 2007 to December 31, 2008. We also received a $2.6 million initial stocking order from Barnes & Noble in June 2008 to
support their expansion of our product line to over 650 of their stores nationally.

In
August 2007, we released our Version 3 solution for ten of our best selling languages. All Version 3 solutions include three course levels, while our Version 2 solutions only include
one or two course levels. Upon the release of a language in Version 3, we discontinue selling that language in Version 2 and, as a result, sales of Version 3 products replace sales of Version 2
products for that language. Our solutions are often purchased in sets including all available course levels for a language. The additional levels included in Version 3 enabled us to offer additional
languages with three course levels, resulting in a greater number of available products at our highest price point for a complete set. In March 2008,
we released Version 3 in four additional languages and, in June 2008, we released seven additional Version 3 languages. Also in June 2008, we released ourAudio
Companionpractice tool product for all 14 then-available Version 3 languages. In September 2008, we released Version 3 and ourAudio
Companionin seven additional languages. This expansion of our product portfolio with higher price point options has resulted in the 28% increase in average selling price per
unit for the year ended December 31, 2008.

Product
revenue represented 94% of total consumer revenue for the year ended December 31, 2008, with the balance attributable to subscription and service revenue.



Institutional revenue was $41.7 million for the year ended December 31, 2008, an increase of $11.5 million, or
38%, compared to the year ended December 31, 2007. The increase in institutional revenue was primarily due to the expansion of our direct sales force. As a result, we had a $9.4 million
increase in education and home school revenue and a $1.6 million increase in corporate revenue.

Product
revenue represented 65% of total institutional revenue for the year ended December 31, 2008, and subscription and service revenue represented 35% for the same period.

58

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Table of Contents



Year Ended December 31,2008

2007

Change

% Change(dollars in thousands)Revenue:Product

$
184,182

$
119,897

$
64,285


53.6
%Subscription and service


25,198


17,424

$
7,774


44.6
%Total revenue

$
209,380

$
137,321

$
72,059


52.5
%Cost of revenue:Cost of product revenue

$
26,539

$
19,055

$
7,484


39.3
%Cost of subscription and service revenue


2,137


1,632

$
505


30.9
%Total cost of revenue


28,676


20,687


7,989


38.6
%Gross profit

$
180,704

$
116,634

$
64,070Gross margin percentages


86.3
%

84.9
%

1.4
%


Cost
of revenue for the year ended December 31, 2008 was $28.7 million, an increase of $8.0 million, or 39%, from the year ended December 31, 2007. As a
percentage of total revenue, cost of revenue was 14% for the year ended December 31, 2008 compared to 15% for the year ended December 31, 2007. The dollar increase in cost of revenue was
attributable to growth in unit sales. The increase in gross margin percentage was due to a $0.9 million write down of inventory in the 2007 period associated with the transition from
Version 2 to Version 3 product and packaging.



Year Ended December 31,2008

2007

Change

% Change(dollars in thousands)Sales and marketing

$
93,384

$
65,437

$
27,947


42.7
%Research and development


18,387


12,893

$
5,494


42.6
%General and administrative


39,577


29,786

$
9,791


32.9
%Lease abandonment


1,831




$
1,831


100.0
%Total operating expenses

$
153,179

$
108,116

$
45,063


41.7
%




Sales and marketing expenses for the year ended December 31, 2008 were $93.4 million, an increase of
$27.9 million, or 43%, from the year ended December 31, 2007. As a percentage of total revenue, sales and marketing expenses were 45% for the year ended December 31, 2008,
compared to 48% for the year ended December 31, 2007. The dollar increase in sales and marketing expenses was primarily attributable to the continued expansion of our direct marketing
activities. Advertising expenses grew by $9.3 million and were primarily related to the purchase of additional television media. We also expanded the number of our kiosks from 86 as of
December 31, 2007 to 150 as of December 31, 2008, which resulted in $7.9 million of additional kiosk operating expenses, including sales compensation related expenses. Personnel
costs related to growth in our institutional sales channel and marketing and sales support activities also increased by $7.7 million.

59

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Research and development expenses were $18.4 million for the year ended December 31, 2008, an increase of
$5.5 million, or 43%, from the year ended December 31, 2007. As a percentage of total revenue, research and development expenses were 9% for the years ended December 31, 2008 and
2007. The dollar increase was primarily attributable to additional personnel and contract development costs associated with the transition of Version 2 languages to Version 3, as well as
the development of new products and services that are complementary to our existing solutions.



General and administrative expenses for the year ended December 31, 2008 were $39.6 million, an increase of
$9.8 million, or 33%, from the year ended December 31, 2007. As
a percentage of revenue, general and administrative expenses decreased to 19% for the year ended December 31, 2008 compared to 22% for the year ended December 31, 2007. The dollar
increase was primarily attributable to a $4.3 million increase in personnel-related costs as we expanded our finance, information technology and other administrative functions to support the
overall growth in our business, and a corresponding increase in communications, travel and other support costs of $4.4 million. Depreciation expense also increased $0.9 million and bad
debt expense increased $0.8 million during the year ended December 31, 2008 as a result of greater capital expenditures and credit sales. We also incurred an additional
$1.0 million in legal fees related to intellectual property protection matters. This increase was partially offset by decreased professional service expenses of $0.2 million as we
replaced contract staff with employees.



Lease abandonment expense associated with the relocation of our headquarters was $1.8 million for the year ended
December 31, 2008, consisting of accrued exit costs and liabilities under operating lease agreements.



Year Ended December 31,2008

2007

Change

% Change(dollars in thousands)Interest income

$
454

$
673

$
(219
)

(32.5
)%Interest expense


(891
)

(1,331
)
$
440


(33.1
)%Other income


239


154

$
85


55.2
%Total

$
(198
)
$
(504
)
$
306


(60.7
)%


Interest
expense for the year ended December 31, 2008 was $0.9 million, a decrease of $0.4 million, or 33%, from the year ended December 31, 2007. The
decrease was due to a reduction in the outstanding balance of our long-term debt as a result of $3.4 million in principal payments during the period



Year Ended December 31,2008

2007

Change

% Change(dollars in thousands)Income tax expense

$
13,435

$
5,435

$
8,000


147.2
%


60

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Table of Contents

Income
tax expense for the year ended December 31, 2008 was $13.4 million, an increase of $8.0 million, or 147%, compared to the year ended December 31, 2007.
The increase was the result of an increase of $19.3 million in pre-tax income for the year ended December 31, 2008, compared to the year ended December 31, 2007. Our
effective tax rate decreased to 49.2% for the year ended December 31, 2008 compared to 67.8% for the year ended December 31, 2007 as a result of a decline in the percentage of foreign
losses relative to total consolidated income before tax. We do not currently recognize income tax benefits on losses in our foreign subsidiaries.

Liquidity and Capital Resources

Our primary operating cash requirements include the payment of salaries, incentive compensation, employee benefits and other
personnel-related costs, as well as direct advertising expenses, costs of office facilities and costs of information technology systems.

Since
our inception, we have financed our operations solely through cash flow from operations with the exception of the acquisition of Fairfield & Sons, Ltd., which was
funded in part through the sale of preferred and common stock and a $17.0 million term loan from Madison Capital Funding LLC. At December 31, 2009, our principal sources of
liquidity were cash and cash equivalents totaling $95.2 million and available borrowings under our credit facility.

On
January 16, 2009, we entered into a new secured credit agreement with Wells Fargo Bank, N.A., or Wells Fargo, that provides us with a $12.5 million revolving line of
credit. This revolving credit facility has a two-year term and the applicable interest rate is 2.5% above one month LIBOR, or approximately 2.73% as of December 31, 2009. On
January 16, 2009, we borrowed approximately $9.9 million under this revolving credit facility and used these funds to repay the entire outstanding principal and interest of the term loan
we had with Madison Capital. As a result, we have no borrowings owed to Madison Capital under either their term loan or revolving credit facility, and we have terminated these credit agreements. In
April 2009, we completed our initial public offering and received net proceeds of $49.0 million after deducting the underwriters discount and initial public offering expenses. We used
$9.9 million to repay Wells Fargo the outstanding principal and interest of the revolving credit facility. The full $12.5 million under the Wells Fargo revolving credit facility remains
available to us for borrowing, subject to specified conditions.

We
expect that our future growth will continue to require additional working capital. Our future capital requirements will depend on many factors, including development of new products,
market acceptance of our products, the levels of advertising and promotion required to launch additional products and improve our competitive position in the marketplace, the expansion of our sales,
support and marketing organizations, the establishment of additional offices in the United States and worldwide and building the infrastructure necessary to support our growth, the response of
competitors to our products and our relationships with suppliers and clients. We have experienced increases in our expenditures consistent with the growth in our operations and personnel, and we
anticipate that our expenditures will continue to increase in the future. We believe that anticipated cash flows from operations and available sources of funds, including available borrowings under
our revolving credit facility, will provide sufficient liquidity to fund our business and meet our obligations in the foreseeable future.

In
April 2009, we completed an initial public offering. After deducting the payment of underwriters' discounts and commissions and offering expenses, our net proceeds from the sale of
shares in the offering were $49.0 million. The net proceeds from the offering were used to repay a $9.9 million balance on our revolving credit facility with Wells Fargo and
$7.9 million to satisfy the federal, state and local withholding tax obligations associated with the net issuance of common stock to certain of our key employees.

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Table of Contents

Cash Flow Analysis



Net cash provided by operating activities was $41.2 million for the year ended December 31, 2009. Net cash provided by
operating activities was primarily generated from net income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $13.4 million for the year ended
December 31, 2009. Depreciation, amortization and stock compensation expense for the period totaled $27.6 million. A decrease in amortization resulting from the full amortization of
intangible assets in January 2009 was partially offset by increases in depreciation on tangible assets associated with the expansion of the business. The increase in stock-based compensation expense
was primarily the result of $18.5 million in expense associated with the issuance of common stock to key employees in April 2009. Additionally, a $10.3 million increase in deferred
revenue resulting from greater sales of subscription licenses contributed to net cash provided by operations.

Net
cash provided by operating activities was $18.3 million for the year ended December 31, 2008. Net cash provided by operating activities was primarily generated from net
income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $13.9 million for the year ended December 31, 2008. Depreciation, amortization and
stock compensation expense for the period totaled $8.7 million. Increases in deferred revenue resulting from greater sales of subscription licenses also contributed to net cash provided by
operations; the increase represented $3.1 million for the year ended December 31, 2008. As a result of the growth in our retail channel and institutional sales, accounts receivable
increased by $16.5 million. This increase in accounts receivable was offset in part by increases in net liabilities associated with the expansion of our business.

Net
cash provided by operating activities was $15.8 million for the year ended December 31, 2007. Net cash provided by operating activities was primarily generated from net
income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $2.6 million for the year ended December 31, 2007. Depreciation and amortization
and stock compensation expense for the period aggregated to $9.1 million. Increases in deferred revenue resulting from greater sales of subscription licenses also contributed to net cash
provided by operations; the increase represented $4.8 million for the year ended December 31, 2007. As a result of the growth in our business, we had increases in accounts receivable and
inventory, offset in part by increases in net liabilities.



Net cash used in investing activities was $8.6 million, $7.0 million, and $9.2 million for the years ended
December 31, 2009, 2008 and 2007, respectively. Our investing activities during these periods primarily related to the purchase of property and equipment associated with the expansion of our
information technology systems and our facilities as a result of our growth.



Net cash provided by financing activities was $32.0 million for the year ended December 31, 2009 primarily related to
$49.0 million in net proceeds from our initial public offering, offset by the $9.9 million payment of the balance outstanding under our revolving credit facility with Wells Fargo and the
$7.9 million payment of taxes associated with the common stock grant to some of our key employees.

Net
cash used in financing activities was $4.6 million and $1.8 million for the years ended December 31, 2008 and 2007, respectively. Net cash used in financing
activities during these periods was primarily related to principal payments on our long-term debt. Additionally, for the year ended December 31, 2008, net cash used in financing
activities also included payments associated with our planned initial public offering.

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Table of Contents

We
believe that our current cash and cash equivalents and funds generated from our operations will be sufficient to meet our working capital and capital expenditure requirements through
2010. Thereafter, we may need to raise additional funds through public or private financings or increased borrowings to develop or enhance products, to fund expansion, to respond to competitive
pressures or to acquire complementary products, businesses or technologies. If required, additional financing may not be available on terms that are favorable to us, if at all. If we raise additional
funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and these securities might have rights, preferences and privileges
senior to those of our current stockholders. No assurance can be given that additional financing will be available or that, if available, such financing can be obtained on terms favorable to our
stockholders and us.

During
the last three years, inflation and changing prices have not had a material effect on our business and we do not expect that inflation or changing prices will materially affect
our business in the foreseeable future.

Off-Balance Sheet Arrangements

We do not engage in any off-balance sheet financing arrangements. We do not have any interest in entities referred to as
variable interest entities, which include special purpose entities and other structured finance entities.

Contractual Obligations

The following table summarizes our contractual obligations at December 31, 2009 and the effect such obligations are expected to
have on our liquidity and cash flow in future periods.

Total

Less than 1 Year

1 - 3 Years

3 - 5 Years

More than 5 Years(in thousands)Long-term debt

$


$


$


$


$
Operating lease obligations


12,720


5,593


5,128


1,911


88Total

$
12,720

$
5,593

$
5,128

$
1,911

$
88


On
January 4, 2006, we entered into a credit agreement for a $17.0 million term loan, or term loan, and a $4.0 million revolving credit facility, or revolver. The
credit agreement was amended on August 2, 2007 and April 23, 2008 to amend some covenants, terms, and definitions. The term loan and revolver accrue interest at the base rate plus the
applicable margin or the LIBOR rate plus the applicable margin, as specified by us. As of December 31, 2008, the interest rate on the term loan was 4.65%.

On
January 16, 2009, we entered into a new credit agreement with Wells Fargo Bank, N.A., or Wells Fargo, that provides us with a $12.5 million revolving line of credit.
This revolving credit facility has a two-year term and the applicable interest rate is 2.5% above one month LIBOR, or approximately 2.73% as of December 31, 2009. On
January 16, 2009, we borrowed approximately $9.9 million under this revolving credit facility and used these funds to repay the entire outstanding principal and interest of the term loan
we had with Madison Capital. As a result, we have no borrowings owed to Madison Capital under either their term loan or revolving credit facility, and we have terminated these credit agreements. With
a portion of the net proceeds from our April 2009 initial public offering, we repaid the $9.9 million of borrowing under the Wells Fargo revolving credit facility, which had been used to prepay
the borrowings made under the Madison Capital credit facility. As a consequence, the remaining balance of approximately $12.5 million under the Wells Fargo credit facility is available to us
for borrowing, subject to specified conditions.

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Table of Contents

The
operating lease obligations reflected in the table above include our corporate office leases and site licenses for our kiosks.

Recent Accounting Pronouncements

In February 2008, the FASB issued Accounting Standards Codification topic 820,Fair Value Measurements and
Disclosures("ASC 820"). The provisions of ASC 820, which provide guidance for, among other things, the definition of fair value and the methods used to measure
fair value, were adopted January 1, 2008 for financial instruments. The provisions adopted in 2008 did not have an impact on the Company's financial statements. The effective date of
ASC 820 for all nonrecurring fair value measurements of nonfinancial assets and liabilities (except for those that are recognized or disclosed at fair value in the financial statements on a
recurring basis) was fiscal years beginning after November 15, 2008. On January 1, 2009 we adopted the provisions in ASC 820 for nonrecurring fair value measurements of
nonfinancial assets and liabilities. We applied the provisions adopted in the first quarter of 2009 to the accounting for the acquisition of SGLC International Co. Ltd. See
note 4.

In
December 2007, the FASB issued Accounting Standards Codification topic 805,Business Combinations("ASC 805"), which establishes
principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the business combination. ASC 805 is to be applied prospectively to business combinations for
which the acquisition date is on or after an entity's fiscal year that begins after December 15, 2008. We applied the provisions adopted in the first quarter of 2009 to the fair value
measurements recorded as part of the acquisition of SGLC International Co. Ltd. See note 4.

In
December 2007, the FASB issued Accounting Standards Codification topic 810,Consolidation("ASC 810"), which establishes new
accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a
noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent's equity. The amount of net income attributable to the noncontrolling
interest will be included in consolidated net income on the face of the income statement. ASC 810 clarifies that changes in a parent's ownership interest in a subsidiary that do not result in
deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a
subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. ASC 810 also includes expanded
disclosure requirements regarding the interests of the parent and its noncontrolling interest. ASC 810 is effective for fiscal years, and interim periods within those fiscal years, beginning on
or after December 15, 2008. Earlier adoption is prohibited. The adoption of ASC 810 did not have a material impact on our financial position, results of operations or cash flows.

In
March 2008, the FASB issued Accounting Standards Codification topic 815,Derivatives and Hedging("ASC 815"), which requires
enhanced disclosures about an entity's derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after
November 15, 2008. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related
hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows. The adoption of
ASC 815 did not have a significant impact on our financial position, results of operations or cash flows.

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In
May 2008, the FASB issued Accounting Standards Codification topic ASC 105,Generally Accepted Accounting Principles,
("ASC 105"), which identifies the sources of accounting principles and provides the framework for selecting the principles used in the preparation of financial statements of nongovernmental
entities that are presented in conformity with generally accepted accounting principles in the United States. ASC 105 is effective for financial statements issued for fiscal years and interim
periods beginning after November 15, 2008. The adoption of ASC 105 did not have significant impact on our financial position, results of operation, or cash flows.

On
October 10, 2008, the FASB issued Accounting Standards Codification topic 820,Fair Value Measurements and Disclosures("ASC 820"), which was effective upon issuance, including periods for
which financial statements have not been issued. ASC 820 provided an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial
asset is inactive. The adoption of ASC 820 did not have a material impact on our consolidated financial position and the results of operations.

In
April 2009, the FASB issued Accounting Standards Codification topic 820-10-65-4,Fair Value Measurements and
Disclosures("ASC 820"), which provides guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or
liability has significantly decreased. ASC 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly. In addition, ASC 820 requires disclosure in
interim and annual periods of the inputs and valuation methods used in determining fair value and a discussion of any changes in those valuation methods. ASC 820 is effective for annual and
interim periods ending on or after June 15, 2009. The adoption of ASC 820 did not have a material impact on our consolidated financial position and the results of operations.

On
May 28, 2009, the FASB issued Accounting Standards Codification topic 855,Subsequent Events("ASC 855"). Although
ASC 855 does not significantly change current practice surrounding the disclosure of subsequent events, it provides guidance on management's assessment of subsequent events and the requirement
to disclose the date through which subsequent events have been evaluated. ASC 855 became effective for the quarter ended June 30, 2009. The adoption of ASC 855 did not have any
impact on our consolidated financial position or results of operations.

On
June 12, 2009, the FASB issued Statement No. 167,Amendments to FASB Interpretation No. 46(R)("SFAS
No. 167"). SFAS No. 167 modifies the existing quantitative guidance used in determining the primary beneficiary of a variable interest entity ("VIE") by requiring entities to
qualitatively assess whether an enterprise is a primary beneficiary, based on whether the entity has (i) power over the significant activities of the VIE, and (ii) an obligation to
absorb losses or the right to receive benefits that could be potentially significant to the VIE. SFAS No. 167 becomes effective for all new and existing VIEs on January 1, 2010. The
adoption of SFAS No. 167 will not have any impact on our consolidated financial position or results of operations.

On
June 29, 2009, the FASB issued Accounting Standards Codification topic ASC 105,Generally Accepted Accounting Principles("ASC 105"), which establishes the FASB Accounting Standards Codification (the "Codification") as the primary source of authoritative GAAP recognized by the FASB to be applied by
nongovernmental entities. Rules and interpretive releases of the SEC are also sources of authoritative GAAP for SEC registrants. ASC 105 and the Codification become effective on
September 30, 2009. When effective, the Codification will supersede all existing non-SEC accounting and reporting standards and the FASB will not issue new standards in the form of
Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification;
(b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The adoption of ASC 105 and the Codification
on September 30, 2009 did not have a material effect on our consolidated financial statements.

65

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Table of Contents

In October 2009, the FASB issued Accounting Standards Update ("ASU") 2009-13, which amended the accounting requirements under the Revenue Recognition
Topic, ASC 605-25Multiple-Element Arrangements. The objective of
this update is to address the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. The
amendments establish a hierarchy for determining the selling price of a deliverable and will allow for the separation of products and services in more instances than previously permitted. The guidance
provided within ASU 2009-13 is effective for fiscal years beginning on or after June 15, 2010 and allows for either prospective or retrospective application, with early
adoption permitted. We are currently evaluating the impact that adoption of this guidance will have on our consolidated financial statements.

In
October 2009, the FASB issued ASU 2009-14 which amended the accounting requirements under theSoftware Topic,
ASC 985-605Revenue Recognition. The objective of this update is to address the accounting for revenue arrangements that contain
tangible products and software. Specifically, products that contain software that is "more than incidental" to the product as a whole will be removed from the scope of ASC
subtopic 985-605 (previously AICPA Statement of Position 97-2). The amendments align the accounting for these revenue transaction types with the amendments under
ASU 2009-13 mentioned above. The guidance provided within ASU 2009-14 is effective for fiscal years beginning on or after June 15, 2010 and allows for
either prospective or retrospective application, with early adoption permitted. We are currently evaluating the impact that adoption of this guidance will have on our consolidated financial
statements.

Item 7A.Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Risk

The functional currency of our foreign subsidiaries is their local currency. Accordingly, our results of operations and cash flows are
subject to fluctuations due to changes in foreign currency exchange rates. The volatility of the prices and applicable rates are dependent on many factors that we cannot forecast with reliable
accuracy. In the event our foreign sales and expenses increase, our operating results may be more greatly affected by fluctuations in the exchange rates of the currencies with which we do business. At
this time we do not, but we may in the future, invest in derivatives or other financial instruments in an attempt to hedge our foreign currency exchange risk.

Interest Rate Sensitivity

Interest income and expense are sensitive to changes in the general level of U.S. interest rates. However, based on the nature and
current level of our marketable securities, which are primarily short-term investment grade and government securities and our notes payable, we believe that there is no material risk of
exposure.

Item 8.Financial Statements and Supplementary Data

Our consolidated financial statements, together with the related notes and the report of independent registered public accounting firm,
are set forth on the pages indicated in Item 15.

Item 9.Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None.

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Item 9A.Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of
our disclosure controls and procedures as of December 31, 2009. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under
the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's
management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the
cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2009, our Chief Executive Officer
and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting identified in connection with the evaluation required by
Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the period covered by this report that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

Management's Annual Report on Internal Control over Financial Reporting and Attestation Report of the Registered Accounting Firm

This annual report does not include a report of management's assessment regarding internal control over financial reporting or an
attestation report of the company's registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newly public companies.

Item 9B.Other Information

None.

PART III

Certain information required by Part III is omitted from this Annual Report as we intend to file our definitive Proxy Statement
for the 2010 Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 days after the end of the fiscal year
covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein by reference.

Item 10.Directors, Executive Officers and Corporate Governance

The information required by this Item is incorporated herein by reference to the information provided under the headings "Election of
Directors," "Section 16(A) Beneficial Ownership Reporting Compliance," "Corporate GovernanceBoard of Directors," "Corporate GovernanceCommittees,"

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Table of Contents

"Corporate
GovernanceAudit Committee," "Corporate GovernanceNominating & Corporate Governance Committee" and "Stockholder Proposals for 2011 Annual Meeting and
Director Nominations" in our definitive proxy statement for the 2010 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days after the
fiscal year ended December 31, 2009 (the "2010 Proxy Statement").

Code of Ethics and Business Conduct

We have adopted a code of ethics and business conduct ("code of conduct") that applies to all of our employees, officers and directors,
including without limitation our principal executive officer, principal financial officer and controller or principal accounting officer. Copies of both the code of conduct, as well as any waiver of a
provision of the code of conduct granted to any senior officer or director or material amendment to the code of conduct, if any, are available, without charge, under the "Corporate
GovernanceHighlights" tab on our website atwww.rosettastone.com.

Item 11.Executive Compensation

The information required by this Item is incorporated herein by reference to the information provided under the headings
"Compensation & Management Development Committee Report", "Executive Compensation," "Non-Employee Director Compensation" and "Compensation Committee Interlocks and Insider
Participation" in the 2010 Proxy Statement.

Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by this Item is incorporated herein by reference to the information provided under the headings "Security
Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plan Information" in the 2010 Proxy Statement.

Item 13.Certain Relationships and Related Transactions, and Director Independence

The information required by this Item is incorporated herein by reference to the information provided under the headings "Corporate
GovernanceBoard of Directors," "Corporate GovernanceCommittees" and "Interests of Management and Others in Certain Transactions" in the 2010 Proxy Statement.

Item 14.Principal Accounting Fees and Services

The information required by this Item is incorporated herein by reference to the information provided under the heading "Principal
Accountant Fees and Services" in the 2010 Proxy Statement.

PART IV

Item 15.Exhibits and Financial Statement Schedules

(a)Consolidated Financial Statements



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(b)   Exhibits

The
exhibits listed in the Index to Exhibits are filed as part of this Annual Report on Form 10-K.

69

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Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

ROSETTA STONE INC.By:

/s/ TOM P.H. ADAMS Tom P.H. Adams Chief Executive Officer


Date:
March 9, 2010

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in
the capacities on the 9th day of March, 2010.

Signature

Title/s/ TOM P.H. ADAMS Tom P.H. Adams

Chief Executive Officer and Director
(Principal Executive Officer)/s/ BRIAN D. HELMAN Brian D. Helman

Chief Financial Officer
(Principal Financial Officer)/s/ LAURA L. WITT Laura L. Witt

Chairman of the Board, Director/s/ PHILLIP A. CLOUGH Phillip A. Clough

Director/s/ JOHN T. COLEMAN John T. Coleman

Director/s/ LAURENCE FRANKLIN Laurence Franklin

Director/s/ PATRICK W. GROSS Patrick W. Gross

Director/s/ THEODORE J. LEONSIS Theodore J. Leonsis

Director/s/ JOHN E. LINDAHL John E. Lindahl

Director


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Table of Contents

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageReport of Independent Registered Public Accounting Firm

F-2Consolidated Balance Sheets

F-3Consolidated Statements of Operations

F-4Consolidated Statements of Changes in Stockholders' Equity

F-5Consolidated Statements of Cash Flows

F-6Notes to Consolidated Financial Statements

F-7


F-1

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Stockholders of
Rosetta Stone Inc.
Arlington, VA

We
have audited the accompanying consolidated balance sheets of Rosetta Stone Inc. and subsidiaries (the "Company") as of December 31, 2009 and 2008, and the related
consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits.

We
conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the
results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States
of America.

As
discussed in Notes 2 and 15 to the consolidated financial statements, effective January 1, 2007, the Company adopted the uncertain tax position related accounting
provisions of Accounting Standards Codification 740,Income Taxes(formerly FIN No. 48).

/s/
DELOITTE & TOUCHE LLP

McLean,
Virginia
March 9, 2010

F-2

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Table of Contents

ROSETTA STONE INC.        CONSOLIDATED BALANCE SHEETS        (in thousands, except per share amounts)

As of December 31,2009

2008AssetsCurrent assets:Cash and cash equivalents

$
95,188

$
30,626Restricted cash


50


34Accounts receivable (net of allowance for doubtful accounts of $1,349 and $1,103, respectively)


37,400


26,497Inventory, net


8,984


4,912Prepaid expenses and other current assets


7,447


6,598Deferred income taxes


6,020


2,282Total current assets


155,089


70,949Property and equipment, net


18,374


15,727Goodwill


34,838


34,199Intangible assets, net


10,704


10,645Deferred income taxes


5,565


6,828Other assets


872


470Total assets

$
225,442

$
138,818Liabilities and stockholders' equityCurrent liabilities:Accounts payable

$
1,605

$
3,207Accrued compensation


10,463


8,570Other current liabilities


25,638


20,021Deferred revenue


24,291


14,382Income tax payable


4,184


1,332Current maturities of long-term debtrelated party (Note 9)





4,250Total current liabilities


66,181


51,762Long-term debtrelated party (Note 9)





5,660Deferred revenue


1,815


1,362Other long-term liabilities


1,011


963Total liabilities


69,007


59,747Commitments and contingencies (Note 14)Stockholders' equity:Class A, Series A-1 Convertible Preferred Stock, $0.001 par value; zero and 269 shares authorized; zero and 269 shares issued and outstanding,
liquidation preference of zero and $26,876 at December 31, 2009 and December 31, 2008, respectively





26,876Class A, Series A-2 Convertible Preferred Stock, $0.001 par value; zero and 178 shares authorized; zero and 178 shares issued and outstanding,
liquidation preference of zero and $17,820 at December 31, 2009 and December 31, 2008, respectively





17,820Class B Convertible Preferred Stock, $0.001 par value; zero and 115 shares authorized; zero and 111 issued and outstanding, liquidation preference of
zero and $11,341 at December 31, 2009 and 2008, respectively





11,341Preferred Stock, $0.001 par value; 10,000 and zero shares authorized; zero and zero shares issued and outstanding at December 31, 2009 and
December 31, 2008, respectively





Class A Convertible Common Stock, $0.00005 par value; zero and 900 shares authorized; zero and zero shares issued and outstanding at December 31,
2009 and 2008, respectively





Class B Convertible Common Stock,$0.00005 par value; zero and 20,000 shares authorized; zero and zero shares issued and outstanding at December 31,
2009 and 2008, respectively





Non-designated common stock, $0.00005 par value, 190,000 and 39,100 shares authorized, 20,440 and 1,936 shares issued and outstanding at December 31,
2009 and December 31, 2008, respectively


2


1Additional paid-in capital


130,872


10,814Accumulated income


25,785


12,422Accumulated other comprehensive loss


(224
)

(203
)Total stockholders' equity


156,435


79,071Total liabilities and stockholders' equity

$
225,442

$
138,818


See accompanying notes to consolidated financial statements.

F-3

---





Table of Contents

ROSETTA STONE INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        (in thousands except per share amounts)

Year Ended December 31,2009

2008

2007Revenue:Product

$
218,549

$
184,182

$
119,897Subscription and service


33,722


25,198


17,424Total revenue


252,271


209,380


137,321Cost of revenue:Cost of product revenue


30,264


26,539


19,055Cost of subscription and service revenue


3,163


2,137


1,632Total cost of revenue


33,427


28,676


20,687Gross profit


218,844


180,704


116,634Operating expensesSales and marketing


114,899


93,384


65,437Research and development


26,239


18,387


12,893General and administrative


57,174


39,577


29,786Lease abandonment





1,831


Total operating expenses


198,312


153,179


108,116Income from operations


20,532


27,525


8,518Other income and expense:Interest income


159


454


673Interest expense


(356
)

(891
)

(1,331
)Other income


112


239


154Total other income (expense)


(85
)

(198
)

(504
)Income before income taxes


20,447


27,327


8,014Income tax provision


7,084


13,435


5,435Net income


13,363


13,892


2,579Preferred stock accretion








(80
)Net income attributable to common shareholders

$
13,363

$
13,892

$
2,499Net income per share attributable to common stockholders:Basic

$
0.89

$
7.29

$
1.47Diluted

$
0.67

$
0.82

$
0.15Common shares and equivalents outstanding:Basic weighted average shares


14,990


1,905


1,702Diluted weighted average shares


19,930


16,924


16,533


See
accompanying notes to consolidated financial statements.

F-4

---



Table of Contents

ROSETTA STONE INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

(in thousands)

Class A, Series A-1
Convertible Preferred Stock

Class A, Series A-2
Convertible Preferred Stock

Class B Convertible
Preferred Stock

Class A Convertible
Common Stock

Class B Convertible
Common Stock

Non-Designated
Common Stock





Accumulated
Other
Comprehensive
Income
(loss)Additional
Paid-in
Capital

Accumulated
Income
(loss)

Total
Stockholders'
EquityShares

Amount

Shares

Amount

Shares

Amount

Shares

Amount

Shares

Amount

Shares

AmountBalanceJanuary 1, 2007


269

$
26,876


178

$
17,820


63

$
6,341




$





$



1,612

$
1

$
6,601

$
(4,049
)
$
(42
)
$
53,548Stock issued upon the exercise of stock options
































225





765








765Stock-based compensation expense






































1,327








1,327Accretion of Redeemable Convertible Class B Preferred Stock to redemption value






































(80
)







(80
)Comprehensive income (loss):Net income









































2,579





2,579Foreign currency translation loss, net of tax of $6












































(14
)

(14
)Total comprehensive income















































2,565BalanceDecember 31, 2007


269


26,876


178


17,820


63


6,341














1,837


1


8,613


(1,470
)

(56
)

58,125Stock issed upon the exercise of stock options
































99





365








365Stock-based compensation expense






































1,590








1,590Tax benefit on stock options exercised






































246








246Expiration of redemption rights of Class B Redeemable Convertible Preferred Stock














48


5,000





























5,000Comprehensive income:Net income









































13,892





13,892Foreign currency translation loss, net of tax of $52












































(147
)

(147
)Total comprehensive income















































13,745BalanceDecember 31, 2008


269

$
26,876


178

$
17,820


111

$
11,341




$





$



1,936

$
1

$
10,814

$
12,422

$
(203
)
$
79,071Stock issed upon the exercise of stock options
































89





386








386Stock issued to employees
































591





10,647








10,647Stock-based compensation expense






































3,616








3,616Tax benefit on stock options exercised






































336








336Conversion of preferred stock


(269
)

(26,876
)

(178
)

(17,820
)

(111
)

(11,341
)













14,508


1


56,036








Sale of common stock
































3,125





49,037








49,037Comprehensive income:Net income









































13,363





13,363Foreign currency translation loss, net of tax of $(8)












































(21
)

(21
)Total comprehensive income















































13,342BalanceDecember 31, 2009




$





$





$





$





$



20,249

$
2

$
130,872

$
25,785

$
(224
)
$
156,435


See accompanying notes to consolidated financial statements.

F-5

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Table of Contents

ROSETTA STONE INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        (in thousands)

Year Ended December 31,2009

2008

2007Cash Flows From Operating Activities:Net income

$
13,363

$
13,892

$
2,579Adjustments to reconcile net income to cash provided by operating activities, net of business acquisitionsStock-based compensation expense


22,150


1,590


1,327Compensation expense related to put-options








(7
)Bad debt expense


911


1,611


828Depreciation and amortization


5,428


7,075


7,769Amortization of deferred financing costs


209


104


104Gain on embedded derivative





(4
)

(29
)Deferred income tax benefit


(2,475
)

(2,177
)

(1,299
)Loss on disposal of equipment


42


17


193Net change in:Restricted cash


(16
)

359


(383
)Accounts receivable


(11,779
)

(16,494
)

(4,010
)Inventory


(3,916
)

(1,092
)

(2,563
)Prepaid expenses and other current assets


(1,006
)

(1,041
)

(139
)Other assets


(429
)

(91
)

(169
)Accounts payable


(1,604
)

(1,430
)

2,630Accrued compensation


1,905


3,933


1,348Other current liabilities


5,678


7,393


2,108Income tax payable


3,188


925


652Excess tax benefit from stock options exercised


(336
)

(246
)

Other long-term liabilities


(463
)

963


Deferred revenue


10,300


3,051


4,830Net cash provided by operating activities


41,150


18,338


15,769Cash Flows From Investing Activities:Purchases of property and equipment


(8,455
)

(7,019
)

(9,167
)Acquisition, net of cash acquired


(100
)




Proceeds from employee and stockholder loans








2Net cash used in investing activities


(8,555
)

(7,019
)

(9,165
)Cash Flows From Financing Activities:Proceeds from common stock issuance, net of issuance costs


49,037





Proceeds from the exercise of stock options


473


365


765Tax benefit of stock options exercised


336


246


Costs incurred for intended initial public offering





(1,801
)

Payment of payroll taxes on net common stock issuance


(7,887
)




Payment of payroll taxes on stock options exercised


(89
)




Proceeds from long-term debt


9,929





Principal payments under long-term debt


(19,839
)

(3,402
)

(2,550
)Payments under capital lease obligations


(3
)

(12
)

(16
)Net cash provided by (used in) financing activities


31,957


(4,604
)

(1,801
)Increase in cash and cash equivalents


64,552


6,715


4,803Effect of exchange rate changes in cash and cash equivalents


10


2,220


(29
)Net increase in cash and cash equivalents


64,562


8,935


4,774Cash and cash equivalentsbeginning of year


30,626


21,691


16,917Cash and cash equivalentsend of year

$
95,188

$
30,626

$
21,691Supplemental Cash Flow Disclosure:Cash paid during the periods for:Interest

$
104

$
936

$
1,259Income taxes, net

$
6,364

$
14,642

$
4,821Noncash financing and investing activities:Accrued liability for purchase of property and equipment

$
546

$
1,076

$
455Equipment acquired under capital lease

$
14

$


$
Contingent liability for acquisition

$
850

$


$



See accompanying notes to consolidated financial statements.

F-6

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Table of Contents

ROSETTA STONE INC.        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF OPERATIONS

Rosetta Stone Inc. and subsidiaries ("Rosetta Stone," the "Company" or the "Successor") develops, markets and supports a suite of language learning software products under the Rosetta Stonebrand name. The Company's software products are sold on a direct basis and through select retailers. The Company provides its software
applications to customers through the sale of CD-ROM's and on line subscriptions. Rosetta Stone Inc. was incorporated on December 23, 2005 in the state of Delaware and
acquired Rosetta Stone Holdings Inc., a Delaware corporation, on January 4, 2006. Rosetta Stone Holdings Inc. acquired Rosetta Stone Ltd. (formerly Fairfield &
Sons, Ltd.) and Rosetta Stone (UK), Limited (formerly Fairfield & Sons UK Limited), on January 4, 2006. Rosetta Stone Inc. has six wholly owned operating
subsidiariesRosetta Stone Holdings Inc., a Delaware corporation, Rosetta Stone Ltd., a Virginia corporation, Rosetta Stone International Inc., a Delaware corporation,
Rosetta Stone (UK), a corporation incorporated under the laws of England and Wales, Rosetta Stone Japan Inc., a company incorporated under the laws of Japan, and Rosetta Stone GmbH, a
company incorporated under the laws of Germany.

On
November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd., headquartered in Seoul, South Korea, see
Note 4Acquisitions.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Initial Public Offering

In April 2009, the Company completed an initial public offering consisting of 7,187,500 shares of common stock at $18.00 per share. The
total shares sold in the offering included 4,062,500 sold by selling stockholders and 3,125,000 shares sold by the Company.

After
deducting the payment of underwriters' discounts and commissions and offering expenses, the net proceeds to the Company from the sale of shares in the offering were
$49.0 million. The net proceeds from the offering were used to repay a $9.9 million balance on the revolving credit facility and $7.9 million to satisfy the federal, state and
local withholding tax obligations associated with the net issuance of stock grants made to key employees.

Principles of Consolidation

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of
America and include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America
requires that management make certain estimates and assumptions. Significant estimates and assumptions have been made regarding the allowance for doubtful accounts, estimated sales returns,
stock-based compensation, fair value of assets and liabilities acquired, lease abandonment accrual, fair value of intangibles and goodwill, fair value of stock issued, inventory reserve, disclosure of
contingent assets and liabilities and disclosure of contingent litigation. Actual results may differ from these estimates.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue Recognition

Revenue is primarily derived from the sale of packaged software and audio practice products, online software subscriptions and
professional services. Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta Stone TOTALe, which was released in July 2009.
Rosetta Stone TOTALe is currently sold only as an online software subscription. Revenue is recognized for software products and related services in accordance with Accounting Standards Codification
subtopic 985-605,Software: Revenue Recognition("ASC 985-605").

Revenue
is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee
is fixed and determinable; and collectability is probable. Revenues from packaged software and audio practice products and online software subscriptions are recorded net of discounts.

Revenue
is recognized from the sale of packaged software and audio practice products when the product has been delivered, assuming the remaining revenue recognition criteria have been
met. Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale of the software to the end user and is recorded
in the same manner as all other product sales. Revenue from sales of packaged software products are recognized as the products are shipped and title passes. A limited amount of packaged software
products are sold to resellers on a consignment basis. Revenue is recognized for these consignment transactions once the end-user sale has occurred, assuming the remaining revenue
recognition criteria have
been met. In accordance with Accounting Standards Codification subtopic 985-605-50,Software: Revenue Recognition: Customer Payments and Incentives("ASC
985-605-50"), price protection for changes in the manufacturer suggested retail value
granted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue. The Company offers customers the ability to make
payments for packaged software purchases in installments over a period of time, which typically ranges between three and five months. Given that these installment payment plans are for periods less
than twelve months and a successful collection history has been established, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met. For the years
ended December 31, 2009, 2008 and 2007, installment sales represented 8%, 4% and 3% of revenue, respectively. Packaged software is provided to customers who purchase directly from us with a
six-month right of return. The Company also allows its retailers to return unsold products, subject to some limitations. In accordance with Accounting Standards Codification subtopic
985-605-15,Software: Revenue Recognition: Products("ASC 985-605-15"), product revenue is reduced for
estimated returns, which are based on historical return rates.

Revenue
for software license agreements sold via online software subscriptions as hosting agreements are recognized in accordance with Accounting Standards Codification subtopic
985-605-05,Software: Revenue Recognition: Background("ASC 985-605-05"). Revenue for online software
subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria have been met, which typically ranges between three and twelve months. Some
online licensing arrangements include a specified number of licenses that can be activated over a period of time, which typically ranges between twelve and twenty-four months. Revenue for
these arrangements is recognized on a per license basis ratably over the term of the individual license subscription period, assuming all revenue recognition criteria have been met, which typically
ranges between three and twelve months. Revenue for set-up fees related to online licensing arrangements is

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

recognized
ratably over the term of the online licensing arrangement, assuming all revenue recognition criteria have been met. Accounts receivable and deferred revenue are recorded at the time a
customer enters into a binding subscription agreement and the subscription services are made available to the customer. In connection with packaged software product sales and online software
subscriptions, technical support is provided to customers, including customers of resellers, at no additional charge. As the fee for technical support is included in the initial licensing fee, the
technical support and services are generally provided within one year, the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered,
technical support revenues are recognized together with the software product and license revenue. Costs associated with the technical support are accrued at the time of sale.

Revenue
from the sale of packaged software products with specific upgrade rights is recognized in accordance with ASC 985-605. Revenue recognition for these sales is deferred
until the earlier of the point at which sufficient vendor-specific objective evidence ("VSOE") exist for the specific upgrade right or all elements of the arrangement have been delivered.

In
accordance with ASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identified benefit is
identified and the fair value is reasonably determinable.

The
Company has been engaged to develop language learning software for certain endangered languages under fixed fee arrangements. These arrangements also include contractual periods of
post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue for multi-element contracts will be recognized ratably once the PCS and online hosting
periods begin, over the longer of the PCS or online hosting period. When the current estimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for
the entire loss on the contract is recorded.

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and demand deposits
with financial institutions.

Restricted Cash

Restricted cash is restricted for the reimbursement of funds to employees under the Company's flexible benefit plan and security for a
credit card processing vendor.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable consist of amounts due to the Company from its normal business activities. The Company provides an allowance for
doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified.

Inventories

Inventories are stated at the lower of cost, determined on a first-in first-out basis, or market. The Company
reviews inventory for excess quantities and obsolescence based on its best estimates of future

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

demand,
product lifecycle status and product development plans. The Company uses historical information along with these future estimates to reserve for obsolete and potential obsolete inventory.

Concentrations of Credit Risk

Accounts receivable and cash and cash equivalents subject the Company to its highest potential concentrations of credit risk. The
Company reserves for credit losses and does not require collateral on its trade accounts receivable. In addition, the Company maintains cash and investment balances in accounts at various banks and
brokerage firms. The Company is insured by the Federal Deposit Insurance Corporation for up to $250,000 at each bank. The Company's cash and cash equivalents may exceed the insured limits at times.
The Company has not experienced any losses on cash and cash equivalent accounts to date and the Company believes it is not exposed to any significant credit risk related to cash. The Company sells
products to retailers, resellers, government agencies, and individual consumers and extends credit based on an evaluation of the customer's financial condition, without requiring collateral. Exposure
to losses on receivables is principally dependent on each customer's financial condition. The Company monitors its exposure for credit losses and maintains allowances for anticipated losses. No
customer accounted for more than 10% of the Company's revenue during the years ended December 31, 2009, 2008 or 2007. The Company had 3 customers that accounted for 47% of accounts receivable
at December 31, 2009, and two customers that accounted for 38% of accounts receivable at December 31, 2008.

Fair Value of Financial Instruments

The carrying value of the Company's financial instruments, which include cash and cash equivalents, restricted cash, accounts
receivable, accounts payable, and other accrued expenses, approximate their fair values due to their short maturities. Based on borrowing rates currently available to the Company for loans with
similar terms, the carrying value of debt approximates fair value at December 31, 2009 and 2008.

Property, Equipment and Software

Property, equipment, and software are stated at cost, less accumulated depreciation and amortization. Depreciation on property,
leasehold improvements, equipment, and software is computed on a straight-line basis over the estimated useful lives of the assets, as follows:

Software

3 yearsComputer equipment

3 - 5 yearsAutomobiles

5 yearsFurniture and equipment

5 - 7 yearsBuilding

39 yearsBuilding improvements

15 yearsLeasehold improvements

4 - 7 yearsAssets under capital leases

lesser of lease term or economic life


Expenses
for repairs and maintenance that do not extend the life of equipment are charged to expense as incurred. Expenses for major renewals and betterments, which significantly extend
the useful lives of existing property and equipment, are capitalized and depreciated. Upon retirement or

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

disposition
of property and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized.

Intangible Assets

Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and
trademark and other intangible assets. Those
intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives in accordance with Accounting Standards Codification topic 350, Goodwill and Other Intangible
Assets("ASC 350"). On an annual basis, the Company reviews its indefinite lived intangible assets for impairment based on
the fair value of indefinite lived intangible assets as compared to the carrying value in accordance with ASC 350. In the event the carrying value exceeds the fair value of the assets, the assets are
written down to their fair value. There has been no impairment of intangible assets during any of the periods presented.

Goodwill

In accordance with ASC 350, goodwill is not amortized and is tested for impairment annually on June 30th and whenever
events and circumstances occur indicating goodwill might be impaired. As of June 30, 2009 and 2008, the Company reviewed the goodwill for impairment and determined that no impairment of
goodwill was identified during any of the periods presented.

Valuation of Long-Lived Assets

In accordance with Accounting Standards Codification topic 360,Accounting for the Impairment or Disposal of
Long-lived Assets("ASC 360"), the Company evaluates the recoverability of its long-lived assets. ASC 360 requires recognition of impairment of
long-lived assets in the event that the net book value of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the
period of identification to the extent the carrying amount of an asset exceeds the fair value of such asset. Based on its analysis, the Company believes that no impairment of its
long-lived assets was indicated as of December 31, 2009 and 2008.

Financial Instruments with Characteristics of Both Liabilities and Equity

The Company issues financial instruments that have characteristics of both liabilities and equity. The Company accounts for these
arrangements in accordance with Accounting Standards Codification topic 480,Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and
Equity("ASC 480"), as well as related interpretations of this standard.

Derivative Instruments

The Company enters into financing arrangements that consist of freestanding derivative instruments or are hybrid instruments that
contain embedded derivative features. The Company accounts for these arrangements in accordance with Accounting Standards Codification topic 815,Accounting for Derivative
Instruments and Hedging Activities("ASC 815") as well as related interpretation of this standard. In accordance with this standard, derivative instruments are recognized as
either assets or liabilities in the balance sheet and are measured at fair values with gains or losses recognized in earnings. Embedded derivatives that are not clearly and closely related to the host

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

contract
are bifurcated and are recognized at fair value with changes in fair value recognized as either a gain or loss in earnings. The Company determines the fair value of derivative instruments and
hybrid instruments based on available market data using appropriate valuation models, giving consideration to all of the rights and obligations of each instrument.

Stock Split

On March 23, 2009, in connection with the Company's initial public offering of common stock, the Board of Directors approved a
1.3-to-1 split of common stock to stockholders of record as of such date. All references to the number of common shares and per share amounts have been restated as appropriate
to reflect the effect of the split for all periods presented.

Guarantees

Indemnifications are provided of varying scope and size to certain institutional customers against claims of intellectual property
infringement made by third parties arising from the use of its products. The Company has not incurred any costs or accrued any liabilities as a result of such obligations.

Cost of Revenue

Cost of revenue consists of the direct and indirect costs to produce and distribute Rosetta Stone software. Inventory related costs
include materials purchasing, inbound freight, inventory receiving, production assembly of boxed products, product royalty fees, storage of inventory, inventory obsolescence and inventory shrinkage.
Distribution related costs include out-bound freight, fulfillment partner fees, internal shipping labor and packaging materials. Other costs included in cost of revenue include credit card
processing fees, amortization of certain intangible assets, depreciation of fixed assets used, and the cost of technical support for customers.

Research and Development

Research and development expenses include employee compensation costs, professional services fees and overhead costs associated with
product development. Software products are developed for sale to external customers. The Company considers technological feasibility to be established when all planning, designing, coding, and testing
has been completed according to design specifications. The Company has determined that technological feasibility for its software products is reached shortly before the products are released to
manufacturing. Costs incurred after technological feasibility is established have not been material, and accordingly, the Company has expensed all research and development costs when incurred.

Software Developed for Internal Use

Product development also includes certain software products for internal use. Development costs for internal use software are expensed
as incurred until the project reaches the application development stage, in accordance with Accounting Standards Codification topic 350,Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use("ASC 350"). Internal-use software is defined to have the following characteristics: (a) the software is
internally developed, or modified solely to meet the entity's internal needs, and (b) during the software's development or modification, no substantive

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

plan
exists or is being developed to market the software externally. Internally developed software is amortized over a three-year useful life.

For
the years ended December 31, 2009, 2008 and 2007, the Company capitalized zero, $0.2 million and $1.1 million in internal-use software, respectively.

For
the years ended December 31, 2009, 2008 and 2007, the Company recorded amortization expense relating to internal-use software of $0.5 million,
$0.5 million and $0.4 million, respectively.

Income Taxes

For the years ended December 31, 2009, 2008 and 2007, the Company accounted for income taxes in accordance with Accounting
Standards Codification topic 740,Income Taxes("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred
tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax bases of assets and
liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred liabilities are recognized for
taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted.

In
June 2006, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Codification topic 740-10-25,Accounting for
Uncertainty in Income Taxes("ASC 740-10-25"), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial
statements in accordance with ASC 740 and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. The
Company adopted ASC 740-10-25 effective January 1, 2007. The adoption of ASC 740-10-25 did not have a material impact on the Company's financial
condition, results of operations or cash flows.

Stock-Based Compensation

The Company accounts for its stock-based compensation in accordance Accounting Standards Codification topic 718, CompensationStock
Compensation("ASC
718"), which was adopted by the Company effective January 1, 2006. Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date
and recognized as expense in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period.

Net Income Per Share

Net income per share is computed under the provisions of Accounting Standards Codification topic 260,Earnings
Per Share. Basic income per share is computed using net income and the weighted average number of common shares outstanding. Diluted earnings per share reflect the weighted
average number of common shares outstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exercise of stock
options (using

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

the
treasury stock method), restricted stock awards, restricted stock units and conversion of preferred shares (using the as-converted method). Common equivalent shares are excluded from
the diluted computation if their effect is anti-dilutive.

The
following table sets forth the computation of basic and diluted net income per common share (in thousands, except per share amounts):

Years Ended December 31,2009

2008

2007Numerator:Net income

$
13,363

$
13,892

$
2,579Accretion of redeemable convertible preferred stock








(80
)Net income attributable to common stockholders

$
13,363

$
13,892

$
2,499Denominator:Weighted average number of common shares:Basic


14,990


1,905


1,702Diluted


19,930


16,924


16,533Income per common share:Basic

$
0.89

$
7.29

$
1.47Diluted

$
0.67

$
0.82

$
0.15


The
following table sets forth common stock equivalent shares included in the calculation of the Company's diluted net income per share (in thousands):

Years Ended December 31,2009

2008

2007Equity instruments:Convertible preferred stock


4,134


14,508


14,508Restricted common stock units


7





Restricted common stock


93





Stock options


706


511


322Total common stock equivalent shares


4,940


15,019


14,830


Share-based
awards to purchase approximately 15,000, 135,000 and 103,000 shares of common stock that had an exercise price in excess of the average market price of the common stock
during the years ended December 31, 2009, 2008 and 2007, respectively, were not included in the calculation of diluted earnings per share because they were anti-dilutive.

Comprehensive Income (Loss)

Comprehensive income consists of net income and other comprehensive income. Other comprehensive income refers to revenues, expenses,
gains, and losses that are not included in net income, but rather are recorded directly in stockholders' equity. For the years ended December 31, 2009, 2008 and 2007, the Company's
comprehensive income consisted of net income and foreign currency translation gains (losses).

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Foreign Currency Translation and Transactions

The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the
foreign subsidiaries are translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation
adjustments are recorded as a component of other comprehensive income in stockholders' equity.

Cash
flows of consolidated foreign subsidiaries, whose functional currency is the local currency, are translated to U.S. dollars using average exchange rates for the period. The Company
reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item in the reconciliation of the changes in cash and cash equivalents during the period.

Gains
and losses resulting from foreign currency transactions are included in other income and expense. Foreign currency transaction gains (losses) were $(44,000), $0.2 million
and $0.1 million for the years ended December 31, 2009, 2008 and 2007, respectively.

Recently Issued Accounting Standards

In February 2008, the FASB issued Accounting Standards Codification topic 820,Fair Value Measurements and
Disclosures("ASC 820"). The provisions of ASC 820, which provide guidance for, among other things, the definition of fair value and the methods used to measure fair value,
were adopted January 1, 2008 for financial instruments. The provisions adopted in 2008 did not have an impact on the Company's financial statements. The effective date of ASC 820 for all
nonrecurring fair value measurements of nonfinancial assets and liabilities (except for those that are recognized or disclosed at fair value in the financial statements on a recurring basis) was
fiscal years beginning after November 15, 2008. On January 1, 2009 the Company adopted the provisions in ASC 820 for nonrecurring fair value measurements of nonfinancial assets and
liabilities. The Company applied the provisions adopted in the first quarter of 2009 to the fair value measurements recorded as part of the acquisition of SGLC International Co. Ltd. See
note 4.

In
December 2007, the FASB issued Accounting Standards Codification topic 805,Business Combinations("ASC 805"), which establishes
principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the business combination. ASC 805 is to be applied prospectively to business combinations for which the acquisition date is on or
after an entity's fiscal year that begins after December 15, 2008. The Company applied the provisions adopted in the first quarter of 2009 to the accounting for the acquisition of SGLC
International Co. Ltd. See note 4.

In
December 2007, the FASB issued Accounting Standards Codification topic 810,Consolidation("ASC 810"), which establishes new accounting
and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest
(minority interest) as equity in the consolidated financial statements and separate from the parent's equity. The amount of net income attributable to the noncontrolling interest will be included in
consolidated net income on the face of the income

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

statement.
ASC 810 clarifies that changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial
interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the
noncontrolling equity investment on the deconsolidation date. ASC 810 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. ASC 810 is
effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The adoption of ASC 810 did not have a
material impact on the Company's financial position, results of operations or cash flows.

In
March 2008, the FASB issued Accounting Standards Codification topic 815,Derivatives and Hedging("ASC 815"), which requires enhanced
disclosures about an entity's derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15,
2008. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are
accounted for and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows. The adoption of ASC 815 did not have a
significant impact on the Company's financial position, results of operations or cash flows.

In
May 2008, the FASB issued Accounting Standards Codification topic ASC 105,Generally Accepted Accounting Principles, ("ASC 105"), which
identifies the sources of accounting principles and provides the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented
in conformity with generally accepted accounting principles in the United States. ASC 105 is effective for financial statements issued for fiscal years and interim periods beginning after
November 15, 2008. The adoption of ASC 105 did not have significant impact on the Company's financial position, results of operation, or cash flows.

On
October 10, 2008, the FASB issued Accounting Standards Codification topic 820,Fair Value Measurements and Disclosures("ASC
820"), which was effective upon issuance, including periods for which financial statements have not been issued. ASC 820 provided an illustrative example to demonstrate how the fair value of a
financial asset is determined when the market for that financial asset is inactive. The adoption of ASC 820 did not have a material impact on the Company's consolidated financial position and the
results of operations.

In
April 2009, the FASB issued Accounting Standards Codification topic 820-10-65-4,Fair Value Measurements and
Disclosures("ASC 820"), which provides guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability
has significantly decreased. ASC 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly. In addition, ASC 820 requires disclosure in interim and annual
periods of the inputs and valuation methods used in determining fair value and a discussion of any changes in those valuation methods. ASC 820 is effective for annual and interim periods ending on or
after June 15, 2009. The adoption of ASC 820 did not have a material impact on the Company's consolidated financial position and the results of operations.

On
May 28, 2009, the FASB issued Accounting Standards Codification topic 855,Subsequent Events("ASC 855"). Although ASC 855 does
not significantly change current practice surrounding the disclosure of subsequent events, it provides guidance on management's assessment of subsequent events and the requirement to disclose the date
through which subsequent events have been evaluated.

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2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

ASC 855
became effective for the quarter ended June 30, 2009. The adoption of ASC 855 did not have any impact on the Company's consolidated financial position or results of
operations.

On
June 12, 2009, the FASB issued Statement No. 167,Amendments to FASB Interpretation No. 46(R)("SFAS
No. 167"). SFAS No. 167 modifies the existing quantitative guidance used in determining the primary beneficiary of a variable interest entity ("VIE") by requiring entities to
qualitatively assess whether an enterprise is a primary beneficiary, based on whether the entity has (i) power over the significant activities of the VIE, and (ii) an obligation to
absorb losses or the right to receive benefits that could be potentially significant to the VIE. SFAS No. 167 becomes effective for all new and existing VIEs on January 1, 2010. The
adoption of SFAS No. 167 will not have any impact on the Company's consolidated financial position or results of operations.

On
June 29, 2009, the FASB issued Accounting Standards Codification topic ASC 105,Generally Accepted Accounting Principles("ASC
105"), which establishes the FASB Accounting Standards Codification (the "Codification") as the primary source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities.
Rules and interpretive releases of the SEC are also sources of authoritative GAAP for SEC registrants. ASC 105 and the Codification become effective on September 30, 2009. When effective, the
Codification will supersede all existing non-SEC accounting and reporting standards and the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging
Issues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification; (b) provide background information about
the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The adoption of ASC 105 and the Codification on September 30, 2009 did not have a material
effect on the Company's consolidated financial statements.

In
October 2009, the FASB issued Accounting Standards Update ("ASU") 2009-13, which amended the accounting requirements under theRevenue Recognition
Topic, ASC 605-25Multiple-Element Arrangements. The objective of this update is to address the accounting for
multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. The amendments establish a hierarchy for determining
the selling price of a deliverable and will allow for the separation of products and services in more instances than previously permitted. The guidance provided within ASU 2009-13 is
effective for fiscal years beginning on or after June 15, 2010 and allows for either prospective or retrospective application, with early adoption permitted. The Company is currently evaluating
the impact that adoption of this guidance will have on its consolidated financial statements.

In
October 2009, the FASB issued ASU 2009-14 which amended the accounting requirements under theSoftware Topic, ASC
985-605Revenue Recognition. The objective of this update is to address the accounting for revenue arrangements that contain tangible
products and software. Specifically, products that contain software that is "more than incidental" to the product as a whole will be removed from the scope of ASC subtopic 985-605
(previously AICPA Statement of Position 97-2). The amendments align the accounting for these revenue transaction types with the amendments under ASU 2009-13 mentioned above.
The guidance provided within ASU 2009-14 is effective for fiscal years beginning on or after June 15, 2010 and allows for either prospective or retrospective application, with early
adoption permitted. The Company is currently evaluating the impact that adoption of this guidance will have on its consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. INVENTORY

Inventory consisted of the following (in thousands):

As of December 31,2009

2008Raw materials

$
4,053

$
3,023Finished goods


5,696


2,3599,749


5,382Reserve for obsolete inventory


(765
)

(470
)Inventory, net

$
8,984

$
4,912


4. ACQUISITIONS

On November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd., a software reseller headquartered in Seoul, South Korea. As the assets
acquired constituted a business, this transaction was accounted for under Accounting Standards Codification topic 805,Business Combination("ASC 805"). The purchase price consisted of an initial cash payment of $100,000, followed
by three annual cash installment payments, based on revenue performance in South Korea. The terms of the acquisition agreement provide for additional consideration to be paid by the Company in each of
the following three years, if the acquired company's revenues exceed certain targeted levels each of these years. The amount is calculated as the lesser of a percentage of the revenue generated or a
fixed amount for each year, based on the terms of the agreement.

Based
on these terms, the minimum additional cash payment is zero if none of the minimum revenue targets are met, and the maximum additional payment is $1.1 million. Management
determined that the total contingent consideration for inclusion in the purchase price was the maximum of $1.1 million, the fair value of which is $850,000. Including the cash paid upon the
acquisition date of $100,000, the total purchase price was $950,000.

Under
the purchase method of accounting, the total purchase price was allocated to the tangible and intangible assets acquired on the basis of their respective estimated fair values at
the date of acquisition. The valuation of the identifiable intangible assets and their useful lives acquired reflects management's estimates.

The
summary of fair value of assets acquired in the asset acquisition is as follows (in thousands):

Tangible assets:Inventory

$
135Property and equipment


95Intangible assets:Customer relationships


100Goodwill


620Total assets acquired

$
950


A
total of $100,000 was allocated to amortizable intangible assets consisting of customer relationships, and a total of $620,257 was allocated to goodwill. Goodwill represents the excess
of the

F-18

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4. ACQUISITIONS (Continued)

purchase
price over the fair value of tangible and amortizable intangible assets acquired. No liabilities were assumed in this acquisition, and proforma requirements were immaterial to the
presentation.

5. PROPERTY AND EQUIPMENT

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

As of December 31,2009

2008Land

$
390

$
390Buildings and improvements


7,952


5,437Leasehold improvements


1,453


1,166Computer equipment


7,617


6,134Software


11,327


8,251Furniture and equipment


2,589


2,06031,328


23,438Less: accumulated depreciation


(12,954
)

(7,711
)Property and equipment, net

$
18,374

$
15,727


The
Company leases certain computer equipment, software and machinery under capital lease agreements, with bargain purchase options at the end of the lease term. As of
December 31, 2009 and
2008, leased computer equipment and software included in property and equipment above was $56,000 and $44,000, respectively.

The
Company recorded depreciation expense for the years ended December 31, 2009, 2008 and 2007 in the amount of $5.4 million, $4.0 million and $2.9 million,
respectively.

6. GOODWILL

The value of goodwill is primarily derived from the acquisition of Rosetta Stone, Ltd. in January 2006 and the acquisition of certain assets of SGLC
International Co. Ltd. in November 2009, as detailed in Note 4. The Company tests goodwill for impairment annually on June 30 of each year at the reporting unit level using
a fair value approach, in accordance with the provisions of Accounting Standards Codification topic 350,IntangiblesGoodwill and Other("ASC 350"). If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for
impairment between annual tests. The Company's annual testing resulted in no impairments of goodwill since the dates of acquisition. For income tax purposes, the goodwill balance is amortized over a
period of 15 years.

F-19

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. GOODWILL (Continued)

The
following table represents the balance and changes in goodwill for the years ended December 31, 2009, 2008, 2007 and 2006 (in thousands):

Balance as of January 1, 2006

$
Rosetta Stone Ltd. acquisition


34,199Balance as of December 31, 2006

$
34,199No acquisition activity


Balance as of December 31, 2007

$
34,199No acquisition activity


Balance as of December 31, 2008

$
34,199SGLC International Co. LTD. acquisition


620Balance as of December 31, 2009

$
34,819Effect of change in foreign currency rate


19Balance as of December 31, 2009

$
34,838


7. INTANGIBLE ASSETS

Intangible assets consisted of the following items as of the dates indicated (in thousands):

December 31, 2009

December 31, 2008Gross
Carrying
Amount

Accumulated
Amortization

Net
Carrying
Amount

Gross
Carrying
Amount

Accumulated
Amortization

Net
Carrying
AmountTrade name / trademark

$
10,607

$


$
10,607

$
10,607

$


$
10,607Core technology


2,453


(2,453
)




2,453


(2,453
)

Customer relationships


10,842


(10,747
)

95


10,739


(10,706
)

33Website


12


(10
)

2


12


(7
)

5Total

$
23,914

$
(13,210
)
$
10,704

$
23,811

$
(13,166
)
$
10,645


The
Company recorded intangible assets of $23.8 million, associated with the acquisition of Rosetta Stone Ltd. in January 2006, and $100,000 with the acquisition of certain
assets of SGLC International Co. Ltd. in November 2009. The Company did not record any additions to intangible assets during 2008. The estimated lives of the acquired core technology and
customer relationships are between 18 to 36 months. The intangible asset associated with the trade name and trademark has an indefinite useful life. The estimated life of the website rights is
60 months. The Company computes

F-20

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. INTANGIBLE ASSETS (Continued)

amortization
of intangible assets on a straight-line basis over the estimated useful life. Below are the estimated useful lives of the intangible assets acquired:

Weighted
Average
LifeTrade name / trademark

IndefiniteCore technology

24 monthsCustomer relationships

33 monthsWebsite

60 months


Amortization
expense consisted of the following (in thousands):

Years Ended December 31,2009

2008

2007Included in cost of revenue:Cost of product revenue

$


$
13

$
1,227Cost of subscription and service revenue








Total included in cost of revenue





13


1,227Included in operating expenses:

$
42

$
3,003

$
3,596Total

$
42

$
3,016

$
4,823


The
following table summarizes the estimated future amortization expense related to intangible assets as of December 31, 2009 (in thousands):

As of
December 31,
20092010

$
542011


43Thereafter


Total

$
97


8. OTHER CURRENT LIABILITIES

The following table summarizes other current liabilities (in thousands):

December 31,2009

2008Marketing expenses

$
8,746

$
4,803Professional and consulting fees


2,720


2,249Sales return reserve


4,708


3,229Taxes payable


2,043


1,527Other


7,421


8,213$
25,638

$
20,021


F-21

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. BORROWING AGREEMENT

On January 4, 2006, the Company entered into a Credit Agreement with Madison Capital, which provided the Company a $4.0 million revolving credit facility ("Revolver") and a
$17.0 million term loan ("Term Loan"). The Credit Agreement was amended on August 2, 2007 and April 23, 2008 to amend certain covenants, terms, and definitions. Under the Credit
Agreement, all amounts outstanding under the Revolver and the Term Loan accrued interest at the Base Rate plus the Applicable Margin or the LIBOR Rate plus the Applicable Margin, as specified by the
Company. As of December 31, 2008, the interest rate on the term loan was 4.65%.

On
January 16, 2009, the Company entered into a new credit agreement with Wells Fargo Bank, N.A. ("Wells Fargo"), which provides the Company with a $12.5 million revolving
line of credit. This revolving credit facility has a two-year term and the applicable interest rate is 2.5% above one month LIBOR, or approximately 2.73% as of December 31, 2009. On
January 16, 2009, the Company borrowed approximately $9.9 million under this revolving credit facility and used these funds to repay the entire outstanding principal and interest of the
Term Loan the Company had with Madison Capital. As a result, the Company has no borrowings owed to Madison Capital under either their Term Loan or Revolver, and the Company has terminated these credit
agreements. As a result of the early repayment of the Madison Capital Loan, the Company wrote-off the remaining unamortized capitalized financing costs associated with this loan. The
amount of the write-off was approximately $0.2 million. Upon completion of the Company's initial public offering, the Company repaid the $9.9 million balance of its revolving
credit facility with Wells Fargo during the three months ended June 30, 2009, and a total of $12.5 million under revolving credit facility is available to the Company for borrowing
thereunder.

Long-term
borrowings consist of the following (in thousands):

December 31,2009

2008Term loan, Madison Capital

$


$
9,910Revolver, Wells Fargo Bank N.A.








9,910Less current portion





(4,250
)Total

$


$
5,660


Certain
of the Company's assets are pledged as collateral to secure any borrowings by the Company under the credit agreement with Wells Fargo. The line of credit contains financial
covenants tested on a quarterly basis and is applicable for the term of the loan. The primary covenants under the line of credit are limitations on liens and encumbrances, restrictions on investments,
limitations on the sale of certain assets, and a minimum liquidity threshold. In addition, the Company is required to provide a quarterly report to the lender within 45 days following the end
of a quarter, and an audited annual report 120 days following the close of the fiscal year. Non-compliance with debt covenants are considered events of default and could result in
the line of credit becoming immediately due and/or being terminated.

Interest
expense for the twelve months ended December 31, 2009 and 2008 was $0.4 million and $0.9 million, respectively.

F-22

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCK-BASED COMPENSATION



On January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under
which the Company's Board of Directors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The plan initially authorized the grant
of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized the grant of additional stock options for up to 195,000 shares of common stock
under the plan, resulting in total stock options available for grant under the 2006 Plan of 2,137,200 as of December 31, 2008. The stock options granted under the Stock Plan generally expire at
the earlier of a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date.
Stock issued as a result of exercises of stock options will be issued from the Company's authorized available stock.



On February 27, 2009, the Company's Board of Directors approved a new Stock Incentive and Award Plan (the "2009 Plan") that
provides for the ability of the Company to grant up to 2,437,744 new stock incentive awards or options including Incentive and Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock,
Restricted Stock Units, Performance Units, Performance Shares, Performance based Restricted Stock, Share Awards, Phantom Stock and Cash Incentive Awards. The stock incentive awards and options granted
under the 2009 Plan generally expire at the earlier of a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more
than ten years from such grant date.

Concurrent
with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants. At December 31, 2009 there were 1,960,958 shares available for future
grant under the 2009 Plan.

In
accordance with Accounting Standards Codification topic 718,CompensationStock Compensation("ASC 718"), the fair value of
stock-based awards to employees is calculated as of the date of grant. Compensation expense is then recognized on a straight-line basis over the requisite service period of the award. The
Company uses the Black-Scholes pricing model to value its stock options, which requires the use of estimates, including future stock price volatility, expected term and forfeitures. Stock-based
compensation expense recognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation.The fair value of each
option grant is estimated on the date of grant using the Black Scholes option pricing model as follows:

Year Ended December 31,2009

2008

2007Expected stock price volatility

61%

57% - 62%

62% - 70%Expected term of options

6 years

6 years

6 yearsExpected dividend yield





Risk-free interest rate

1.71% - 2.46%

2.08% - 3.36%

3.50% - 4.96%


F-23

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCK-BASED COMPENSATION (Continued)

Prior to the completion of the Company's initial public offering in April 2009, the Company's stock was not publicly quoted and the Company had a limited history of stock option
activity, so the Company reviewed a group of comparable industry-related companies to estimate its expected volatility over the most recent period commensurate with the estimated expected term of the
awards. In addition to analyzing data from the peer group, the Company also considered the contractual option term and vesting period when determining the expected option life and forfeiture rate.
Subsequent to the initial public offering, the Company continues to review a group of comparable industry-related companies to estimate volatility, but also reviews the volatility of its own stock
since the initial public offering. The Company considers the volatility of the comparable companies to be the best estimate of future
volatility. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.

Stock OptionsThe following table summarizes the Company's stock option activity for the years ended December 31, 2009, 2008 and 2007:

Options
Outstanding

Weighted
Average
Exercise
Price

Weighted
Average
Contractual
Life (years)

Aggregate
Intrinsic
ValueBalance at January 1, 2007


1,531,231

$
3.85


9.46

$
3,415,823Options granted


415,574


7.28Options exercised


(238,735
)

3.85Options cancelled


(214,367
)

4.53Balance at December 31, 2007


1,493,703


4.70


8.70


9,695,391Options granted


402,805


12.89Options exercised


(103,506
)

3.96Options cancelled


(135,203
)

7.97Balance at December 31, 2008


1,657,799


6.48


8.05


18,268,386Options granted


472,589


18.11Options exercised


(93,505
)

5.10Options cancelled


(60,654
)

12.48Balance at December 31, 2009


1,976,229


9.14


7.58


17,511,103Vested and expected to vest at December 31, 2008


1,572,720


6.23


7.99


17,722,546Vested and expected to vest at December 31, 2009


1,878,917


8.73


7.5


17,396,124


F-24

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCK-BASED COMPENSATION (Continued)

The
following tables summarize the status of options outstanding under the Company's stock option plan as of December 31, 2009:

Outstanding

ExercisableRange of Exercise Prices

Number Outstanding as of 12/31/09

Weighted Average Remaining Contractual Life (in years)

Weighted Average Exercise Price

Number Exercisable as of 12/31/09

Weighted Average Exercise Price$3.85 - $3.85


909,725


6.50

$
3.85


762,478

$
3.85$6.08 - $10.36


323,040


7.47


7.33


192,345


6.99$11.19 - $17.49


298,591


8.46


13.76


102,329


12.83$18.00 - $18.00


426,640


9.24


18.00


15,187


18.00$18.05 - $20.35


3,233


9.75


19.45


498


20.35$22.30 - $22.30


15,000


9.41


22.30





$3.85 - $22.30


1,976,229


7.58


9.14


1,072,837


5.47


As
of December 31, 2009 and 2008, there were approximately $5.3 million and $4.4 million of unrecognized stock-based compensation expense related to
non-vested stock option awards that is expected to be recognized over a weighted average period of 2.49 and 2.21 years, respectively.

The
weighted average remaining contractual term and the aggregate intrinsic value for options outstanding at December 31, 2009 was 7.58 years and $17.5 million,
respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options exercisable at December 31, 2009 was 6.84 years and $13.4 million,
respectively. As of December 31, 2009, options were vested and exercisable as to a total of 1,072,837 shares of common stock with a weighted average exercise price per share of $5.47.

The
weighted average grant-date fair value per share of stock options granted was $10.32, $7.19 and $5.04 for the years ended December 31, 2009, 2008 and 2007,
respectively.

The
aggregate intrinsic value disclosed above represents the total intrinsic value (the difference between the fair market value of the Company's common stock as of December 31,
2009, and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their
options on December 31, 2009. This amount is subject to change based on changes to the fair market value of the Company's common stock.

F-25

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCK-BASED COMPENSATION (Continued)

Restricted StockThe following table summarizes the Company's restricted stock activity for the year ended December 31, 2009:

Nonvested
Outstanding

Weighted
Average
Grant Date
Fair Value

Aggregate
Fair
ValueNonvested Awards, January 1, 2009







$
Awards granted


191,468


18.72Awards vested


Awards cancelled


(11,666
)

19.55Nonvested Awards, December 31, 2009


179,802


18.67


3,356,903


During
2009, 191,468 shares of restricted stock were granted. The aggregate grant date fair value of the awards was $3.6 million, which will be recognized as expense on a
straight-line basis over the requisite service period of the awards, which is also the vesting period. The Company's restricted stock grants are accounted for as equity awards. The grant
date fair value is based on the market price of the Company's common stock at the date of grant. The Company did not grant any restricted stock prior to April 2009.

Restricted
stock awards are considered outstanding at the time of grant as the stock holders are entitled to voting rights and to receive any dividends declared subject to the loss of
the right to receive accumulated dividends if the award is forfeited prior to vesting. Unvested restricted stock awards are not considered outstanding in the computation of basic earnings per share.

Restricted Stock UnitsDuring 2009, 9,858 restricted stock units were granted. The aggregate grant date fair value of the awards was $180,000,
which
was recognized as expense on the grant date, as the awards were immediately vested. The Company's restricted stock units are accounted for as equity awards. The grant date fair value is based on the
market price of the Company's common stock at the date of grant. The Company did not grant any restricted stock units prior to April 2009.

Common Stock GrantIn May 2006, the Company adopted the Rosetta Stone Inc. Liquidity Performance Award Plan. The Company amended this plan by
resolution dated December 31, 2008. This plan provides a bonus to its key employees in the event of an acquisition of the Company, an acquisition of substantially all of the assets of the
Company, a liquidation of the Company or any other transaction resulting in liquidating distributions to any holders of its preferred stock. This plan terminates upon completion of an initial public
offering. In April 2009, the Company's Board of Directors awarded 10 of the Company's key employees a total of 591,491 shares of common stock. This grant is net of the number of shares required to be
withheld to satisfy the federal, state and local tax withholding obligations, which were paid by the Company to the respective taxing authorities in cash. Thus, the grant is referred to as a "net
issuance." The aggregate grant date fair value of the awards was $18.5 million, which was recognized as expense on the grant date, as the grants were immediately vested.

F-26

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCK-BASED COMPENSATION (Continued)

The
following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statement line items (in thousands):

Years Ended December 31,2009

2008

2007Included in cost of revenue:Cost of product revenue

$
34

$
2

$
2Cost of subscription and service revenue








Total included in cost of revenue


34


2


2Included in operating expenses:Sales and marketing


999


153


189Research and development


5,959


482


360General and administrative


15,158


953


776Total included in operating expenses


22,116


1,588


1,325Total

$
22,150

$
1,590

$
1,327


11. COMMON STOCK

At December 31, 2008, the Company had the authority to issue 60,000,000 shares of common stock, of which 900,000 shares were designated as Class A Convertible Common Stock,
20,000,000 shares are designated Class B Convertible Common Stock and 39,100,000 are non-designated, collectively referred to as "Common Stock." On February 28, 2008, the
Company changed the par value of its Class A Convertible Common Stock, Class B Convertible Common Stock and Non-Designated Common Stock from $0.001 to $0.00005 per share. At
December 31, 2008, 1,935,654 shares of Non-Designated Common Stock were issued and outstanding, respectively.

On
March 23, 2009, in connection with the Company's initial public offering of common stock, the Board of Directors approved a 1.3-to-1 split of common
stock to stockholders of record as of such date. All references to the number of common shares and per share amounts have been restated as appropriate to reflect the effect of the split for all
periods presented.

On
April 15, 2009, the Company completed an initial public offering consisting of 7,187,500 shares of common stock at $18.00 per share. The total shares sold in the offering
included 4,062,500 sold by selling stockholders and 3,125,000 shares sold by the Company.

On
April 21, 2009, in conjunction with the Company's qualified underwritten initial public offering of common stock, its total outstanding preferred shares in the amount of
557,989 automatically converted at a ratio of 26:1 into 14,507,714 shares of Common Stock.

At
December 31, 2009, the Company's Board of Directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 were designated as Common Stock, with a par
value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001 per share. At December 31, 2009, 20,440,181 shares of Common Stock were issued and
outstanding.

F-27

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMON STOCK (Continued)

Dividends

Holders of each class of Common Stock are entitled to dividends, in cash or stock in the same form and per share amount as declared by
the Board of Directors.

Liquidation

In the event of any dissolution, liquidation, or winding up of the Company, whether voluntary or involuntary, the holders of the Common
Stock are entitled to participate in the distribution of assets of the Company remaining after the provision for payment of all debts and liabilities of the Company and after the Company has paid or
set aside for payment on behalf of any class of stock having preference over the common stock in the event of dissolution, liquidation or winding up.

Voting Rights

Each holder of Common Stock is entitled to cast one vote for each outstanding share of common stock on any matter properly considered
and acted upon by the
stockholders, except in a vote for the election or removal of one or more directors of the Company for which the Common Stock may be voted, at which each holder of one share of Common Stock is
entitled to cast 0.653775 votes, and one vote for each outstanding share of Class B Convertible Common Stock.

12. CONVERTIBLE PREFERRED STOCK

At December 31, 2008, the Company had outstanding 268,758 shares of Class A, Series A-1 Convertible Preferred Stock, 178,200 shares of Class A
Series A-2 Convertible Preferred Stock and 111,031 shares of Class B Convertible Preferred Stock, $0.001 par value per share.

On
April 21, 2009, in conjunction with the Company's qualified underwritten initial public offering of common stock, its total outstanding preferred shares in the amount of
557,989 automatically converted at a ratio of 26:1 into 14,507,714 shares of Common Stock and the then-existing classes of preferred stock ceased to exist. At December 31, 2009, the
Company had no preferred shares outstanding and the authorized preferred stock was undesignated blank check preferred.

13. EMPLOYEE BENEFIT PLAN

The Company maintains a defined contribution 401(k) Plan (the "Plan"). The Company matches employee contributions to the Plan up to 4% of their compensation that vest immediately. The
Company recorded expenses for the Plan totaling $1.1 million and $0.9 million for the years ended December 31, 2009 and 2008, respectively.

14. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company leases many kiosks, copiers, parking spaces, buildings, a warehouse and office space under operating lease and site license
arrangements, some of which contain renewal options. The rental payments under some kiosk site licenses are based on a minimum rental plus a percentage of the kiosk's sales in excess of stipulated
amounts. Kiosk site licenses range from a period of one month to

F-28

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. COMMITMENTS AND CONTINGENCIES (Continued)

five
years. Building, warehouse and office space leases range from three months to 85 months. Certain leases also include lease renewal options.

The
following table summarizes future minimum operating lease payments as of December 31, 2009 and the years thereafter (in thousands):

As of
December 31,
2009Periods Ending December 31,2010

$
5,5932011


3,1852012


1,9432013


1,7522014


1592015 and thereafter


88$
12,720


Total
expenses under operating leases were $11.6 million and $9.8 million during the years ended December 31, 2009 and 2008, respectively.

The
Company accounts for its leases under the provisions of Accounting Standards Codification topic 840,Accounting for Leases("ASC 840"), and subsequent amendments, which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes. Certain operating leases
contain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the difference between the rent paid and the straight-line
rent recorded as either a deferred rent asset or liability depending on the calculation. Lease incentives received from landlords are recorded as deferred rent liabilities and are amortized on a
straight-line basis over the lease term as a reduction to rent expense. The deferred rent liability was $0.5 million and $0.3 million at December 31, 2009 and 2008,
respectively. The deferred rent asset was $0.5 million and $0.3 million at December 31, 2009 and 2008, respectively. The deferred rent asset is classified in prepaid and other
assets as all associated leases have less than one year remaining on their term.

On
October 6, 2008, the Company entered into an operating sublease agreement (the "Lease") for additional office space in Arlington, Virginia. The Lease is for a five year period
terminating on December 31, 2013 with total rental payments of $7.5 million. Rents range from $117,000 per month for the first year of the Lease term to $132,000 per month in the final
year of the Lease term. The Company provided the landlord a security deposit of $352,000 in the form of a letter of credit. The Company has the option to renew this Lease for an additional
three-year period.

The
Company exited its facility at 1101 Wilson Boulevard, Arlington, Virginia in December 2008 as a result of a relocation of its headquarters to 1919 North Lynn, Arlington, Virginia.
The Company estimated its liability under operating lease agreements and accrued exit costs in accordance with Accounting Standards Codification topic 420,Exit or Disposal
Cost Obligations("ASC 420"), as the leases associated with this facility do not terminate until December 31, 2009 and August 31, 2013, respectively.
Accrued exit costs associated with the headquarters relocation were charged to lease

F-29

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. COMMITMENTS AND CONTINGENCIES (Continued)

abandonment
expense in December 2008. The following table summarizes the accrued exit costs for the 1101 Wilson Boulevard facility (in thousands):

As of
December 31,
2009

As of
December 31,
2008Accrued exit costs, beginning of period

$
1,676

$
Costs incurred and charged to expense


(8
)

1,676Principal reductions


(649
)

Accrued exit costs, end of period

$
1,019

$
1,676Accrued exit cost liabilityShort-term

$
504

$
713Long-term


515


963Total

$
1,019

$
1,676


Royalty Agreement

On December 28, 2006 the Company entered into an agreement to license software from a vendor for incorporation in software
products that the Company is developing. The agreement required a one-time, non-refundable payment of $0.3 million, which was expensed in full as research and
development costs during 2006 because the products in which the licensed software were to be incorporated into had not yet reached technological feasibility. In addition, the agreement specifies that,
in the event the software is incorporated into specified Company software products, royalties will be due at a rate of 20% of sales for those products up to an additional amount totaling
$0.4 million. There were no additional royalty payments made under this agreement in 2009 or 2008.

Employment Agreements

The Company has agreements with certain of its executives and key employees which provide guaranteed severance payments upon
termination of their employment without cause. The severance payments range from six to fifteen months of base salary.

Litigation

In July 2009, the Company filed a lawsuit in the United States District Court for the Eastern District of Virginia against
Google Inc., seeking, among other things, to prevent Google from infringing upon its trademarks. In this lawsuit, the Company asserts, among other things, that Google allows third parties,
including individuals involved in software piracy operations, to purchase the right to use its trademarks or other terms confusingly similar in Google's Adwords advertising program. This lawsuit
seeks, among other things, injunctive relief to prevent Google from selling the Company's trademarks or other terms confusingly similar for use in Google's Adwords advertising program. To date, Google
has not made any counterclaims for damages against us, however, the Company expects to incur material legal fees and other costs and expenses in pursuit of its claims against Google.

The
Company is involved in various litigation matters arising out of the normal course of business. In the opinion of management, the amount of liability, if any, resulting from the
final resolution of these matters will not have a material adverse impact on the Company's results of operations, financial position and cash flows.

F-30

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. INCOME TAXES

The following table summarizes the significant components of the Company's deferred tax assets and liabilities as of December 31, 2009 and 2008 (in thousands):

As of
December 31,2009

2008Deferred tax assets:Inventory

$
290

$
183Amortization and depreciation


3,521


5,068Net operating loss carryforwards


4,359


5,112Deferred revenue


663


528Accrued liabilities


6,456


3,118Stock-based compensation


2,266


965Bad debt reserve


425


33817,980


15,312Valuation allowance


(5,012
)

(5,263
)12,968


10,049Deferred tax liabilities:Prepaid expenses


1,328


876Foreign currency translation loss


50


58Other


5


51,383


939Net deferred tax assets

$
11,585

$
9,110Net deferred tax assets as of December 31 are classified as follows:Current

$
6,020

$
2,282Non-current


5,565


6,828Total

$
11,585

$
9,110


At
December 31, 2009, the Company had $7.8 million of net operating loss ("NOL") carryforwards for United Kingdom income tax purposes that do not expire,
with a tax value of $2.2 million. The Company also had $5.2 million of NOL carryforwards for Japanese income tax purposes which expire in 2014 and 2015, with a tax value of
$2.2 million. Accounting Standards Codification topic 740,Income Taxes("ASC 740") requires that a valuation allowance be established
when it is more likely than not that all or a portion of a deferred tax asset will not be realized. As a result of the losses incurred for the years ended December 31, 2008 and 2007, both the
United Kingdom and Japanese operations remain in cumulative loss positions providing sufficient negative evidence under the provisions of ASC 740 for the Company to determine that a valuation
allowance of $5.0 million against the deferred tax assets associated with its foreign operations is appropriate. The decrease of $0.3 million in the valuation allowance is attributable
to utilization of net deferred tax assets, primarily operating losses, in the United Kingdom and Japan in the year ended December 31, 2009 and changes year over year in the value of deferred
tax assets when translated from local currency to U.S. dollars. The valuation allowance will offset assets associated with future foreign tax deductions as well as carryforward items.

F-31

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. INCOME TAXES (Continued)

Despite
enacting certain tax planning strategies during the year ended December 31, 2009, neither subsidiary has produced sustainable pretax profits as of December 31, 2009. Company
management will monitor actual results and updated projections on a quarterly basis. When and if the subsidiaries realize or realistically anticipate sustainable profitability, the Company will assess
the appropriateness of releasing the valuation allowance in whole or in part. Although management believes that these assets could ultimately be fully utilized, future performance cannot be assured.

The
components of income (loss) before income taxes are as follows (in thousands):

Year Ended December 31,2009

2008

2007United States

$
19,030

$
36,109

$
14,825Foreign


1,417


(8,782
)

(6,811
)Income before income taxes

$
20,447

$
27,327

$
8,014


The
provision for taxes on income consists of the following (in thousands):

Year Ended December 31,2009

2008

2007Current:Federal

$
7,555

$
12,842

$
5,311State


1,864


2,788


1,429Foreign


140


34


Total current

$
9,559

$
15,664

$
6,740Deferred:Federal

$
(1,917
)
$
(1,946
)
$
(944
)State


(430
)

(283
)

(361
)Foreign


(128
)




Total deferred


(2,475
)

(2,229
)

(1,305
)Provision for income taxes

$
7,084

$
13,435

$
5,435


F-32

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. INCOME TAXES (Continued)

Reconciliation
of income tax expense computed at the U.S. federal statutory rate to income tax expense is as follows (in thousands):

Year Ended December 31,2009

2008

2007Income tax expense at statutory federal rate

$
7,157

$
9,565

$
2,805State income tax expense, net of federal income tax effect


809


1,529


568Domestic production activities deduction


(481
)

(811
)

(348
)Nondeductible intercompany interest


205


174


122Other nondeductible expenses


143


101


92Tax rate differential on foreign operations


(192
)

90


(53
)Increase (decrease) in valuation allowance


(566
)

2,791


2,293Other


9


(4
)

(44
)Income tax expense

$
7,084

$
13,435

$
5,435


The
Company adopted Accounting Standards Codification topic 740-10-25,Income Taxes: Overall: Recognition,("ASC 740-10-25") on January 1, 2007, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in
accordance with Accounting Standards Codification topic 740,Income Taxes. ASC 740-10-25 prescribes a recognition
threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.
ASC 740-10-25 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

At
the adoption date and as of December 31, 2009, the Company had no material unrecognized tax benefits and no adjustments to liabilities or operations were required under
ASC 740-10-25. The Company's practice is to recognize interest and penalty expense related to uncertain tax positions in income tax expense, which were zero at the
adoption date and for the year ended December 31, 2009.

The
Company is subject to taxation in the United States and various states and foreign jurisdictions. The Company's tax years 2008, 2007 and 2006 are subject to examination by the tax
authorities. There were no income tax examinations in process as of December 31, 2009. While the ultimate results cannot be predicted with certainty, the Company's management believes that
examinations, if any, will not have a material adverse effect on its consolidated financial condition or results of operations, and that the accrued tax liabilities are adequate for all years.

The
Company made income tax payments of $6.4 million, $14.6 million and $4.8 million in 2009, 2008 and 2007, respectively.

16. SEGMENT INFORMATION

The Company operates as one operating segment as the principal business activity relates to developing and selling language learning software. The chief operating decision maker, the
Chief Executive Officer, evaluates the performance of the Company based upon software revenues.

Products
and services are sold primarily in the United States, but are also sold through direct and indirect sales channels in other countries, primarily in Japan, South Korea and
Europe. Less than 5%

F-33

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

16. SEGMENT INFORMATION (Continued)

of
the Company's revenues were generated from sales outside of the United States for the years ended December 31, 2008 and 2007, and approximately 8% of the Company's revenue was generated from
sales outside the United States for the year ended December 31, 2009. As of December 31, 2009 and 2008, the Company had $1.0 million and $0.4 million, respectively, of
long-lived assets held outside of the United States.

No
single customer accounted for more than 10% of the Company's revenue for the years ended December 31, 2009, 2008 and 2007, respectively.

17. RELATED PARTIES

As of December 31, 2009 and 2008, the Company had outstanding receivables from stockholders of $74,000 and $0.2 million, respectively, and outstanding receivables from
employees in the amount of $8,000 and zero, respectively.

18. VALUATION AND QUALIFYING ACCOUNTS

The following table includes the Company's valuation and qualifying accounts for the respective periods (in thousands):

Year Ended December 31,2009

2008

2007Allowance for doubtful accounts:Beginning balance

$
1,103

$
627

$
267Charged to costs and expenses


911


1,611


828Deductionsaccounts written off


(665
)

(1,135
)

(468
)Ending balance


1,349


1,103


627Sales return reserve:Beginning balance


3,229


1,688


858Charged to costs and expenses


18,340


14,337


10,413Deductionsreserves utilized


(16,861
)

(12,796
)

(9,583
)Ending balance


4,708


3,229


1,688Reserve for excess and obsolete inventory:Beginning balance


470


478


190Charged to costs and expenses


1,090


2,093


1,677Deductionsreserves utilized


(795
)

(2,101
)

(1,389
)Ending balance

$
765

$
470

$
478Deferred income tax asset valuation allowance:Beginning balance


5,263


2,980


687Charged to costs and expenses





2,283


2,293Deductions


(251
)




Ending balance

$
5,012

$
5,263

$
2,980


F-34

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Table of Contents

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

19. SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (Unaudited)

Summarized quarterly supplemental consolidated financial information for 2009 and 2008 are as follows (in thousands, except per share amounts):

Quarter EndedMarch 31,

June 30,

September 30,

December 31,2009Revenue

$
50,284

$
56,460

$
67,216

$
78,311Gross profit

$
43,857

$
48,758

$
58,208

$
68,021Net income (loss)(a)

$
3,195

$
(7,292
)
$
5,303

$
12,157Basic income per share(a)

$
1.65

$
(0.42
)
$
0.26

$
0.60Shares used in basic per share computation


1,939


17,370


20,177


20,216Diluted income per share(a)

$
0.19

$
(0.42
)
$
0.25

$
0.58Shares used in diluted per share computation


17,095


17,370


20,988


20,9682008Revenue

$
35,585

$
47,742

$
59,803

$
66,250Gross profit

$
31,049

$
41,197

$
51,227

$
57,231Net income (loss)

$
(432
)
$
3,361

$
6,021

$
4,942Basic income per share

$
(0.23
)
$
1.77

$
3.13

$
2.55Shares used in basic per share computation


1,864


1,899


1,921


1,936Diluted income per share

$
(0.23
)
$
0.20

$
0.36

$
0.29Shares used in diluted per share computation


1,864


16,827


16,931


17,043


(a)The
second quarter of 2009 contained an IPO-related $18.8 million expense, consisting of $18.5 million in stock-based compensation
expense and $0.3 million in payoll tax expense, related to common stock grants awarded to key employees equal to a total of 591,491 shares.


F-35

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Table of Contents

EXHIBIT INDEX

Index to exhibits2.1(1)

Stock Purchase Agreement dated as of January 4, 2006, by and among Fairfield & Sons, Ltd., Rosetta Stone Inc., Rosetta Stone Holdings Inc., the Shareholders of Fairfield & Sons,
 Ltd., Tom Adams, and Eugene Stoltzfus3.1(1)

Second Amended and Restated Certificate of Incorporation3.2(1)

Second Amended and Restated Bylaws4.1(1)

Specimen certificate evidencing shares of common stock4.2(1)

Subscription Agreement dated as of January 4, 2006, by and among Rosetta Stone Inc., ABS Capital Partners IV, L.P., ABS Capital Partners IV A, L.P., ABS Capital Partners Offshore, L.P., ABS
Capital Partners Special Offshore, L.P., Norwest Equity Partners VIII, L.P., Madison Capital Funding LLC, and Tom Adams4.3(1)

Registration Rights Agreement dated as of January 4, 2006 among Rosetta Stone Inc. and the Investor Shareholders and other Shareholders listed on Exhibit A Thereto10.1+(1)

2006 Incentive Option Plan10.2+(1)

2009 Omnibus Incentive Plan10.3+(1)

Director Form of Option Award Agreement under the 2006 Plan10.4+(1)

Executive Form of Option Award Agreement under the 2006 Plan10.5+(1)

Standard Form of Option Award Agreement under the 2006 Plan10.6+(1)

Form of Option Award Agreement under the 2009 Plan10.7(1)

Form of Indemnification Agreement entered into with each director and executive officer10.8+(1)

Executive Employment Agreement between Rosetta Stone Ltd. and Tom Adams dated February 20, 200910.9(1)

Lease Agreement dated as of February 26, 2006, by and between Premier Flex Condos, LLC and Fairfield Language Technologies, Inc., as amended10.10(1)

Sublease Agreement dated as of October 6, 2008, by and between The Corporate Executive Board Company and Rosetta Stone Ltd.10.11(1)

Software License Agreement by and between The Regents of the University of Colorado and Fairfield & Sons, Ltd. dated as of December 22, 2006***10.12+(1)

Form of Restricted Stock Award under the 2009 Plan10.13(1)

Credit Agreement dated as of January 16, 2009 between Rosetta Stone Ltd. and Wells Fargo Bank N.A.10.14+(1)

Executive Employment Agreement between Rosetta Stone Ltd. and Brian Helman dated February 20, 200910.15+(1)

Executive Employment Agreement between Rosetta Stone Ltd. and Eric Eichmann dated February 20, 200910.16+(1)

Executive Employment Agreement between Rosetta Stone Ltd. and Gregory Long dated February 20, 200910.17+(1)

Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu dated February 20, 200921.1

Subsidiaries of the Registrant23.1

Consent of Deloitte & Touche LLP, independent registered public accounting firm24.1

The Power of Attorney with Board of Directors' Signatures31.1

Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2

Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1

Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2

Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


***Portions
of this exhibit have been omitted pursuant to a request for confidential treatment.+Identifies
management contracts and compensatory plans or arrangements.(1)Incorporated
by reference to exhibit filed with Registrant's registration statement on Form S-1 (File No. 333-153632),
as amended.


---