10-K 1 scil-20121231x10k.htm 10-K 1027e632f0f5414


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2012

or

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

COMMISSION FILE NO. 000-24547

SCIENTIFIC LEARNING CORPORATION

(Exact name of registrant as specified in its charter)

DELAWARE

94-3234458

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification Number)

300 Frank H. Ogawa Plaza, Suite 600

Oakland, CA 94612

510-444-3500

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

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

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

Common Stock, par value $0.001 per share

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

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

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

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

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

Indicate by check mark whether the registrant is 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  Accelerated filer  Non-accelerated filer  Smaller reporting company x

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing sale   price of the Common Stock on June 29, 2012 as reported on the Nasdaq Global Market was approximately $24,380,916. Shares of Common Stock held by each director and executive officer and certain persons who owned 5% or more of the registrant's outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.



 

As of March 25, 2013 the Registrant had outstanding 23,578,752 shares of Common Stock.

 

 


 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant's 2012 Annual Meeting of Stockholders are incorporated by reference in Part III.

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TABLE OF CONTENTS

 

 

 

PART I

 

PAGE NO.

 

 

 

Item 1.

Business

Item 1A.

Risk Factors

Item 1B.

Unresolved Staff Comments

13 

Item 2.

Properties

13 

Item 3.

Legal Proceedings

13 

Item 4.

Mine Safety Disclosures

13 

 

 

 

PART II

 

 

 

 

 

Item 5.

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

15 

Item 6.

Selected Financial Data

17 

Item 7.

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

18 

Item 8.

Financial Statements and Supplementary Data

32 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

59 

Item 9A.

Controls and Procedures

59 

Item 9B.

Other Information

59 

 

 

 

PART III

 

 

 

 

 

Item 10.

Directors and Executive Officers and Corporate Governance

60 

Item 11.

Executive Compensation

60 

Item 12.

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

60 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

60 

Item 14.

Principal Accountant Fees and Services

60 

 

 

 

PART IV

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

61 

 

 

 

SIGNATURES

 

62 

 

 

 

 

 

 


 

Forward Looking Statements

 

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

 

PART I

ITEM 1.BUSINESS

 

Overview

 

We are an education company that accelerates learning by applying proven research on how the brain learns in online and on-premise software solutions. Our results show that learners who use our products can realize achievement gains of up to 2 years in as little as 3 months and maintain an accelerated rate of learning even after product use ends. We provide our learning solutions primarily to U.S. K-12 schools in traditional brick-and-mortar, virtual or blended learning settings and also to parents and learning centers, in approximately 45 countries around the world.

 

We are highly differentiated because of our continuous focus on the “science of learning” - combining advances in the field of brain research with standards-based learning objectives to achieve dramatic student gains.  At December 31, 2012, proof that our products produce substantial academic gains was demonstrated in 273 efficacy studies, including randomized controlled trials and longitudinal studies, representing results from approximately 130,000 aggregate participants. These studies show gains for students at all K-12 grade levels, for at-risk, special education, English language, Title I (low income, under achieving), and a variety of other students. Gains have been demonstrated throughout the United States and in ten other countries. The studies show that these gains endure over time.

 

In 2011, we began to transition to a software as a service (SaaS) model. Our easy-to-use and easy-to-access web-based platforms are able to effectively deliver individualized learning opportunities to a large number of students simultaneously. Our Fast ForWord and Reading Assistant educational software products are now available on our browser-based SciLEARN Enterprise software platform and our on-demand platform MySciLEARN On Demand. The SciLEARN Enterprise and MySciLEARN platforms meet the needs of institution and district-wide installations by providing scalability, remote access, centralized reporting, asynchronous online professional development, and ease of administration for multiple campuses.

 

Markets

 

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

 

United States K-12 Market

 

Our sales are concentrated in K-12 schools in the United States, which in 2012 were estimated to total over 114,000 schools serving approximately 48 million students in almost 14,000 school districts. In the last three fiscal years, the U.S. K-12 sector has represented approximately 83% of our sales.

 

Historically, we have focused our selling efforts on district-level administrators.  While we continue to sell at the district level, our new SaaS technology and pricing allows us to expand our selling efforts to building-level principals and lead teachers for smaller initial purchases. After these initial implementations, we then seek to expand throughout the school and/or district based on the demonstrated efficacy of the products.

 

We market our products primarily as learning acceleration solutions, to be used in a blended model with existing teaching and curriculum materials, at both the elementary and secondary school levels. Despite a national focus on reading and increased school district accountability, independent evaluations of student performance have demonstrated little improvement in reading results. According to the U.S. Department of Education (USDE), in 2011, 67% of fourth graders in the United States were not “proficient” in reading and 34% performed below the “basic” level. Between 2009 and 2011, there was no measurable change in average 4th grade

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reading scores.  United States K-12 public schools are funded primarily through state and local tax revenues, but also receive funding from the federal government through a variety of programs, many of which target children who are poor and/or are struggling academically. The funding for a substantial portion of our K-12 sales has historically come from federal sources, in particular IDEA (special education) and Title I funding.  The National Education Association estimates that the federal sequestration that went into effect on March 1, 2013 will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year, but it is not yet clear what level of impact this will have on our sales. The amount of this funding varies from time to time, as do the rules governing the use of this funding; the temporary additional American Recovery and Reinvestment Act (ARRA) education funding expired in 2011.  There has been much recent discussion about changes to the federal No Child Left Behind Act, and the administration has granted 34 states and the District of Columbia waivers from certain requirements, but there has been no legislative agreement on significant changes.  State and local funding for schools continues to be significantly impacted by decreases in tax revenues due to the recent recession. While education spending remains an important priority, over half the states have reduced their funding to schools compared to 2008, resulting in teacher layoffs, program restrictions and overall expense reductions.

 

Other Markets

 

In addition to selling to K-12 schools, we also sell to and through private practice professionals and learning centers. These speech and language and other professionals recommend the use of our products to appropriate clients and then supervise the use of the software, often in connection with their other services. In 2012, over 400 non-school professionals and entities in the United States and Canada (North America) offered our products.

 

We also sell web-based products and tutoring services directly to parents. These products are designed to meet the needs of learners who want to “catch up” and are delivered via a SaaS (software as a service) model.

 

Sales to countries other than the United States and Canada are a small but growing part of our business, which we serve through a network of value-added resellers (VARs). During 2012, products were marketed to customers in approximately 45 countries. As of December 31, 2012, we were represented by 22 VARs.

 

Our strategy for international markets thus far has been conservative, so that we do not divert resources from the U.S. K-12 market. However, we believe the potential international opportunity is significant. Outside of North America, our products are used in three primary applications: (1) assisting in the acquisition of English as a second language, (2) by clinical professionals with impaired children, and (3) in tutoring and learning centers to strengthen academic skills.  About one-fourth to one-third of the worldwide population now understands and speaks English to some degree, and English is the international language of business, travel, and diplomacy. While our products, in and of themselves, do not provide all the components necessary to teach English to non-native speakers, they have been demonstrated to be extremely effective in assisting in English language instruction, through building the necessary underlying cognitive, acoustic processing, fluency and other skills needed to learn and speak English. Strategic initiatives with VARs in China and Southeast Asia have included the creation of franchise-based, “business-in-a-box” learning center models where our products are augmented by direct instruction and other supplementary activities to achieve measurable results in English improvement for students age 5-14.

 

Transition

 

Historically, the majority of our sales have been large transactions from U.S. K-12 school districts.  In the recent and current economic conditions, it has been more challenging to close large transactions as district leaders feel pressure to fund only basic needs. In response, we have diversified our business model to target both building and district level decision-makers. We released our new platforms, SciLEARN Enterprise in late 2010 and MySciLEARN on demand in 2011,  allowing us to better address the U.S. K-12 school and district markets and the international, consumer and virtual school markets with improved access and ease-of-use. Our current technology activities are focused on maturing our platforms to make them more robust, scalable and easier to use and on consolidating some of our legacy products into our MySciLEARN platform.  As our model continues to become more diversified, we expect to become increasingly less dependent on large transactions and to significantly increase our subscription base with more predictable transactions and recurring revenue.

 

Products

 

Our products unify advances in the field of brain research with standards-based learning objectives to achieve enduring student gains. Our solutions augment any curricular approach and when blended with high-quality teacher- led instruction, build learning capacity by systematically and rigorously developing the academic and cognitive skills required for lifelong learning success. 

 

Fast ForWord

 

The components of our flagship Fast ForWord product were built on the foundation that the learning brain can improve through exercise - the concept of brain fitness.  These components apply learning principles that have been established through neuroscience

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and cognitive research as critical to learning new tasks:  frequency and intensity of exercises, adaptively to the students’ individual performance, timely motivation and simultaneous development of multiple skills. Fast ForWord is now web-based, improving its ease-of-use, access and overall effectiveness.

 

Fast ForWord Language and Literacy

 

Fast ForWord Language for elementary learners and Fast ForWord Literacy for adolescent learners build foundational reading and language skills to help districts move below grade level learners to be successful learners in the general classroom.  These components include Fast ForWord Language, Fast ForWord Language to Reading, Fast ForWord Literacy and Fast ForWord Literacy Advanced. 

 

The exercises in the Fast ForWord Language component specifically focus on oral language comprehension and listening, including phonological awareness, listening accuracy and comprehension, working memory, and familiarity with language structures.  The content and exercises of the Literacy component are similar to those of Language, but have been adapted to maximize impact for adolescents and English language learners.  The Fast ForWord Language to Reading product helps students make the link between spoken and written language, using exercises that focus on listening comprehension, sound letter recognition, phonological awareness, beginning word recognition and English language conventions. The Literacy Advanced software includes content and exercises similar to those in the Fast ForWord Language to Reading with a user interface that is designed to appeal to adolescents, emphasizing phonemic awareness, decoding, word recognition, sequential and inferential comprehension and the ability to sequence multi‑step instructions.

 

Fast ForWord Reading

 

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

 

Reading Assistant products

 

Reading Assistant provides a one-on-one reading tutor for every learner. This unique software combines advanced speech verification technology with scientifically-based interventions to provide help just when a learner needs it, strengthening their reading fluency, vocabulary and comprehension.  Reading fluency is the ability of a student to read quickly enough to garner meaning from a text, and is reported to have a high correlation with overall reading proficiency. However, to become a fluent reader, students must frequently read aloud and receive timely feedback and assistance with their reading. Providing effective fluency training for all students is a challenge in the classroom because teachers do not have enough resources and/or time to give the consistent and rigorous one-on-one attention a child needs to improve his or her reading fluency. Reading Assistant addresses this problem by acting as a personal tutor – saving time for teachers and engaging learners.

 

MySciLEARN, Progress Tracker and Reading Progress Indicator

Progress Tracker, our Internet‑based data analysis and reporting tool, analyzes student learning results to provide diagnostic and prescriptive intervention information and allows educators to track and report their students’ learning progress. Progress Tracker provides detailed reports at the student, classroom, school, and district level, and can be reported by subgroup, providing a tool for educators to analyze student progress towards required goals. The MySciLEARN reporting tab also provides a subset of this information, but in a more easy-to-understand user interface. We expect that during 2013 the MySciLEARN reports will replace Progress Tracker because of their improved ease-of-use.

 

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

 

BrainPro™  services

 

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

 

 

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Kinderspark

 

The Kinderspark series was launched in October 2011 with Eddy’s Number Party!.  We initially launched Eddy’s Number Party! as an iPad app.  We are currently conducting pre-release testing of Eddy’s Number Party!, along with a second game, Eddy’s Doggie Diner, on our web-based SaaS platform.  The Kinderspark series is designed to be a collection of engaging games for children aged 3-6 that help them build kindergarten readiness skills and excel in learning by combining proven research on how the brain learns, input from education experts, and fun.

 

License Terms

 

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

 

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

 

Services and Support

 

We believe that training and implementation support is important to achieving appropriate product use in schools, where a limited school day and competing priorities makes it challenging for educators to devote the time and resources needed for a solid implementation. As of December 31, 2012, our service and support organization included 17 employees supplemented by 32 independent contractors who provide on-site customer training, consulting and technical support services.

 

Services

 

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

 

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

 

Support

 

For customers who purchase our support services, we provide software technical update releases, and extensive telephone, email, and chat support. Through our new MySciLEARN platform and our customer support website, we provide extensive web-based implementation and technical resources.

 

Warranty

 

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

 

Sales and Marketing

 

We sell to our principal market, K-12 schools and districts throughout the United States, using a diversified sales channel, including both inside and field sales personnel. We also sell to K-12 schools in Canada using our inside sales team.

 

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

 

Although our focus on improved sales force productivity includes a balance of smaller sales with shorter cycles to get started in new accounts, the majority of our annual booked sales are from existing customers who have a year or more of positive experience with our programs, expanding to new sites and adding products and services to existing sites.

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

 

We also maintain a network of independent VARs outside North America. As of December 31, 2012, we had relationships with 22 VARs. To date, booked sales outside North America have not been significant. We are building this channel in response to the growing demand for English fluency around the world. We believe that our Fast ForWord and Reading Assistant products offer unique value in quickly “rewiring” the brain for English. We also believe that the international market has significant potential growth opportunities, and we are positioning ourselves to take advantage of these in the future.

 

Competition

 

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

 

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

 

Our patented products are highly differentiated by their proven results and focus on the development of learning capacity. With recent improvements in ease-of-use and access, we compete vigorously for available funding against other companies offering educational products and programs, as well as with providers of traditional methods of teaching. Many of the companies providing these competitive offerings are much larger than us, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to learning are fundamentally different from the approach we take, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

 

Product Development; New Products

 

The markets in which we compete are characterized by frequent product introductions and evolving educational standards and approaches. Our future success will depend in part on our ability to continue to enhance and update our existing products and to develop and successfully introduce new products. Most of our development leadership and personnel is located at our headquarters in Oakland, CA.

 

In 2010, we established a wholly-owned foreign subsidiary in Shanghai, China to provide research and development services to us, initially focused on Reading Assistant. As of December 31, 2012, 31 of our employees were engaged in research and development activities, which include product development, product management, and outcomes research. We also use extensive 3rd-party resources to supplement our employees in such areas as quality assurance, design and content development, which cost $0.6 million, $1.3 million and $0.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.   Our research and development expenses were approximately $7  million, $10.3 million and $7.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.

 

Development Strategy

 

Over the past several years, our development efforts have been primarily focused on transitioning our products to a web-based platform. The first milestone in this effort was achieved in 2010 with the release of SciLEARN Enterprise, a browser-based platform hosted by the school district or learning institution. In 2011 we released MySciLEARN, a browser-based platform hosted by us. These two platforms achieve our plan to roll out hosted offerings that expand our per student licensing option to the broader U.S. K-12 market and that we believe will more effectively address newer markets outside U.S. K-12.

 

During 2012, we launched the Reading Assistant product on the SciLEARN Enterprise and MySciLEARN platforms and continued to mature and expand MySciLEARN

 

During 2013, we plan to continue to focus on developing our MySciLEARN platform to be more robust, scalable and easier to use.  We also plan to consolidate some of our legacy products and components, including Progress Tracker, onto the MySciLEARN platform.

 

 

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Intellectual Property

 

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

 

At December 31, 2012, we held the rights to 67 issued and active patents and 10 pending applications. These include 44 issued U.S. patents and 5 pending U.S. applications that we own or co-own. We also held 5 issued patents from other countries and had 5 applications pending abroad. We were the exclusive licensee under 11 issued U.S. patents and 7 issued foreign patents.

 

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

 

The 18 patents that we license are owned by the Regents of the University of California (“the Regents”) and Rutgers, the State University of New Jersey (collectively the “University patents”), and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2012, approximately 47% of our product booked sales was derived from selling products that use the licensed inventions. This license is exclusive and extends for the life of the University patents, which expire in 2014, subject to the right of the Regents to terminate in case of default and our right to terminate at any time upon 60 days written notice. If we were to lose our rights under this license, it would materially harm our business. This license requires payment of royalties based upon cumulative net booked sales of our products, subject to certain minimum royalty amounts. For the remainder of the license term, the minimum annual royalty payment is $150,000. In fiscal 2012, 2011 and 2010, we had approximately $0.2 million, $0.4 million and $0.5 million, respectively, in royalty expense under the license.

 

We also have 15 U.S. trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark.

 

Posit Science Corporation

 

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

 

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

 

Seasonality

 

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

 

Backlog

 

Our deferred revenue was approximately $13.5 million as of December 31, 2012 and $17.3 million as of December 31, 2011. These deferred revenues are primarily composed of professional development and technical services that have not yet been performed and the portion of multi-year sales, subscription and term-based sales, support and Progress Tracker sales not yet recognized as revenue. Approximately $11 million of our deferred revenue as of December 31, 2012 is expected to be recognized within the next 12 months.

 

Employees

 

As of December 31, 2012 we had 140 full-time equivalent employees, compared to 240 at December 31, 2011. None of our employees are represented by a union or subject to collective bargaining agreements.

 

General

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

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Item 1A. Risk Factors

RISK FACTORS

 

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

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

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

The funding for a substantial portion of our K-12 sales typically comes from federal sources, in particular IDEA (special education) and Title I funding.  The amount of this funding varies from time to time, as do the rules governing the use of this funding.  The federal budget deficit and competing federal priorities could adversely impact the ongoing level of federal education funding.  The temporary additional American Recovery and Reinvestment Act (ARRA) education funding expired in 2011. There has been much recent discussion, and the administration has granted 34 states and the District of Columbia waivers from certain requirements, but there has been no legislative agreement about changes to the No Child Left Behind Act of 2001.  A cutback in federal education funding or a change in the funding rules to allow general rather than restricted uses of federal funding could have a materially adverse impact on our revenue. 

In August 2011, President Obama signed the Budget Control Act of 2011, which provided for both an increase in the federal government's borrowing authority and reductions in spending.  Under the Budget Control Act of 2011, Congress was required to  develop legislation to achieve further deficit reduction.  Legislation passed in early January 2013 averting the “fiscal cliff” merely postponed the deficit reduction requirements, and Congress subsequently failed to achieve the required level of deficit reduction.  As a result, automatic reductions in spending across-the-board (also known as “sequestration”) became effective on March 1, 2013.  As a result of this sequestration, it is expected that funding for federal education programs will be cut by approximately 5.1% across-the-board unless Congress passes retroactive legislation reversing the impact of sequestration. The National Education Association estimates that these cuts will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year. This or any other action or inaction by Congress that significantly reduces federal education funding, whether through across-the-board funding cuts or otherwise, would have a materially adverse effect on our financial condition, results of operations, and cash flows.

State education funding continues to be significantly impacted by state budget difficulties. According to the Center on Budget and Policy Priorities, in the 2012-2013 school year, elementary and high schools in approximately half of the states are receiving less state funding than in the prior school year, and in approximately 35 states, school funding now stands below 2008 levels.  These reductions have resulted in teacher layoffs, program restrictions and overall expense reductions. While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for the unemployed and homeowners and rising healthcare costs. Continued pressure on state budgets and state education funding could have a materially adverse impact on our revenue.

Our cash flow is highly variable and may not be sufficient to meet all of our objectives. We need additional financing in the future in order to continue our operations and as a result, there is uncertainty about our ability to continue as a going concern.

 

Our cash and cash equivalents were $2.3 million at December 31, 2012, compared to cash and cash equivalents of $5.9 million at December 31, 2011.  We have used cash from operations of $10.5 million, $7.2 million and $4.2 million in the years ended December 31, 2012, 2011 and 2010, respectively. Our existing cash and cash equivalents, expected cash flow from operations and the funding availability from our line of credit, may not provide sufficient liquidity to fund our operations and capital expenditures for the next 12 months. As such, there is uncertainty about our ability to continue as a going concern. In addition, our independent registered public accounting firm has concluded that there is substantial doubt about our ability to continue as a going concern, and accordingly, it has included an explanatory paragraph to that effect in its report on our December 31, 2012 consolidated financial statements.

 

In February 2012, we amended our credit line with Comerica, which has provided us with a line of credit since 2004. Our amended line of credit has a limit of $4.8 million, net of an outstanding letter of credit of $0.2 million and expires on December 31, 2013. 

 

Borrowings under the amended line of credit are subject to reporting covenants requiring the provision of financial statements to Comerica and ongoing compliance with certain financial covenants.  On August 14, 2012, we amended the financial covenants in

7


 

order align them with our then current operating plan.  The amended covenants require us to maintain a specified minimum adjusted quick ratio, to achieve certain levels of booked sales and to maintain a cash balance of at least $2.0 million. The required levels for the quick ratio and booked sales vary over the term of the agreement and if we do not comply with the covenants, we risk being unable to borrow under the line of credit. Even if we remain in compliance, a provision in the line of credit entitles Comerica to prevent us from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met.

 

Historically, our cash flows from operations have been worse in the first half of the year than in the second half. This pattern results largely from our seasonally low sales in the first and fourth calendar quarters, which reflects our industry pattern, and the time needed to collect on sales.  Because of the seasonality of our booked sales, we may have to borrow from our line of credit.  Our cash reserves and the cash available under the line of credit, if any, may be inadequate to meet our needs.

 

As of December 31, 2012, we had $0.8 million outstanding on the line of credit, and we were in compliance with all applicable covenants.  However, during the months ending January 31, 2013 and February 28, 2013, we were not in compliance. On March 1, 2013, we received a certificate from Comerica waiving the covenant violation for the period ending January 31, 2013.  We have requested a waiver for the period ending February 28, 2013, which if Comerica grants, would likely be included as part of a third amendment we are currently negotiating with Comerica to our line of credit.  There is no assurance that Comerica will grant us a waiver for the period ending February 28, 2013 or, if they do, that they will grant us any waivers in the future should we again fail to meet any covenant.

 

To obtain additional capital, we are actively working on a subordinated debt financing with a group of our current investors to provide needed working capital.  However, we cannot be certain that we will be able to secure the subordinated debt or any other debt or equity financing on acceptable terms, if at all.  In addition, we are actively working to amend our line of credit with Comerica to align certain of the financial covenants with our current forecast.  If we are unable to secure the subordinated debt or other additional financing, it is unlikely that Comerica will amend our agreement for our line of credit.  This would make it very unlikely that we would be able to comply with the current financial covenants in our agreement with Comerica.  Without access to our line of credit or other additional sources of financing, we would be required to further reduce expenses, or to sell assets. Reducing our expenses by an amount sufficient to meet our liquidity needs would adversely affect our operations. We cannot assure you that we will be able to secure additional debt or equity financing or sell assets on acceptable terms, if at all, and failure to do so could cause us to cease operations. In addition, raising additional equity financing could result in substantial dilution of our current equity holders and in the net tangible book value per share of such holdings.

 

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

 

More than 83% of our 2012 booked sales came from the K-12 market in the U.S. and Canada.  In that market we have historically depended on a relatively small number of large transactions for a significant part of our sales.  These types of sales require multiple levels of approval in a political environment, resulting in a time-consuming sales cycle that can be difficult to predict, particularly in a tight funding environment. Therefore, we may devote significant time and energy to a particular customer sale over the course of many months, and then not make the sale when expected or at all.  In 2012, we closed 25 transactions in excess of $100,000 compared to 63 in 2011.

 

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

 

We are completing the development of our new on-demand offerings to transition the business away from our historic sales model and to make us less dependent on large U.S. K-12 transactions.  In 2011, we began selling our flagship Fast ForWord on-demand, and in January 2012 and June 2012, we launched Fast ForWord and Reading Assistant, respectively, on our improved MySciLEARN on-demand platform.  We expect our on-demand offerings to allow us to better address the international, consumer and virtual school markets, as well as the U.S. K-12 market we now principally serve and to allow us to significantly increase the number of smaller, more predictable transactions and recurring revenue.  In order to successfully accomplish this transition, we need to rapidly increase our transaction volume, sell to and achieve acceptance with new types of customers, and complete our product development in a timely manner.  We may find our marketing and sales efforts in this market less effective or more expensive than we have planned.  If we fail to achieve the level of market acceptance that we expect, we may be unable to achieve our planned level of sales and revenue. 

 

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

 

Our revenue and results of operations are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. In 2012, we had a net loss of $9.7 million compared to a net loss of $6.5 million in 2011 and a net loss of $9.7 million in 2010 (which included a non-cash impairment charge of $3.9 million) .  In the past, our sales strategy has primarily emphasized district-level, multi-site transactions. While we continue to sell at the district level, our new SaaS technology and pricing enable us to expand our selling

8


 

efforts to building-level principals and lead teachers for smaller initial purchases.  We expect that this will make us less dependent on large unpredictable sales, but this is a new model for us, and the speed and extent of our transition is uncertain.

 

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

 

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

 

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

 

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

 

In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires at least 30 minutes per day out of a limited and already crowded school day.  We also have a recommended protocol for Reading Assistant, which ranges from 20 to 40 minutes a day, depending on grade level, for at least three days per week. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased revenue.

 

Our Reading Assistant product currently has a more limited content selection than many educators expect.  Adding content requires time and investment, and we may be unable to add content rapidly enough to attract new customers or retain existing customers.

 

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

 

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

 

If we determine that our goodwill is  impaired, we would be required to take a charge to earnings, which could have a material adverse effect on our results of operations. 

 

We recorded a significant amount of goodwill and other intangible assets, such as core technology, related to our acquisition of the Soliloquy product line in January 2008, which we periodically evaluate for impairment.  As of December 31, 2012, the acquired intangible assets have been fully amortized and we had a balance of $4.6 million of goodwill. 

 

Significant judgments are required to evaluate goodwill for impairment, including estimating future cash flows, projecting future sales, forecasting industry trends and market conditions, and making other assumptions. Changes in these estimates and assumptions could materially affect our impairment determinations, which could result in non-cash charges that would adversely affect our results of operations.

 

Concentration of our sales in the K-12 market exposes our business to risks specific to that market.

 

More than 83% of our 2012 booked sales came from the K-12 market in the United States and Canada.  Because of the concentration of our sales in this market, we are particularly exposed to its risks.  For example, the K-12 market is characterized by its dependence on federal funding and state and local tax revenues; a political environment, particularly when large transactions are involved; and a generally conservative approach to change.  All of these attributes, particularly in the current economic and political environment, can result in a time-consuming and unpredictable sales cycle for large transactions. 

 

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

 

We rely heavily on statistical studies of student results on assessments to demonstrate that our products lead to improved student achievement, which involves certain risks. For example, a school may fail to appropriately implement the products or adhere to the

9


 

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

 

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

 

We need to design, develop and introduce new and improved products and services on a cost effective basis and on a timeline that keeps pace with changing market trends and emerging technology developments.  We had significant product introductions in 2012, and we are planning additional product improvements in 2013.  We may encounter unexpected difficulties in developing new products and improvements that could delay our introduction of new products and services or cause their development to be more costly than planned.  Additionally, our product changes may not receive the market acceptance we anticipate.  If we fail to develop products and services costs effectively that respond to technology and market developments, we may lose market share and revenues, and our business could materially suffer.

 

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

 

Providing our products and services and conducting our general business operations both substantially rely on computer and network systems.  Over the past several years, our computer and network systems became outdated, and we have experienced disruptions in both our customer and internal network services due to hardware failures.  While we have taken steps to modernize much of our computer and network systems infrastructure, there are elements that remain outdated. Even with respect to those elements that are reasonably up to date, keeping them up to date requires an ongoing investment of both time and money, and we may have inadequate resources to accomplish this.  In addition, our disaster recovery capability, while improved, does not permit us to recover immediately from certain sorts of disasters. We believe that our business is becoming increasingly dependent on our hardware and software infrastructure, and as a result, the reliability of our systems has become increasingly important.  If our customer systems are disrupted, we may be required to issue credits, customers may elect not to renew their contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability. If our internal systems are disrupted, we may lose productivity and incur delays in product development, sales operations or other functions.

 

If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims. 

 

Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. We expect that, as we have experienced in the past, despite our testing, errors will be found in new products and product enhancements in the future. We launched important product revisions in 2012 and expect additional important launches in 2013.

 

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

 

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

 

Our product development office in China exposes us to risks specific to China, including those associated with currency exchange rates, Chinese government regulations and business practices, and intellectual property.

 

We established a wholly-owned subsidiary in Shanghai, China in 2010, which provides us with product development services.   Previously, substantially all of our operations were located in the United States, and our sales outside the United States and Canada were made in U.S. Dollars to local distributors. Our Chinese operation conducts its operations in Chinese RMB, and therefore exposes us to the risk of unexpected and possibly sudden increases in expenses caused by shifts in currency exchange rates. In addition, Chinese government regulations and business practices are quite different from those in the U.S., and operating under those regulations and challenges may pose unexpected costs, delays or difficulties. Further, intellectual property protection is not as strong in China as in the U.S., and operating a product development group in China may increase our risk of infringement or misappropriation of our intellectual property by others.

10


 

 

 

 

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

 

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

 

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

 

The market in which we operate is very competitive. We compete vigorously for the funding available to schools, not only against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than we are, are more established in the school market than we are, offer a broader range of products to schools, have already offered more web-based products, and have greater financial, technical, marketing and distribution resources than we do. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

 

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

 

We depend on the performance of our senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. During 2012, we reduced our number of full-time equivalent employees from 240 on December 31, 2011 to 140 on December 31, 2012. Reducing our workforce so dramatically has significantly increased the workload and strain on our remaining employees, which may make it more difficult for us to retain our employees or attract new ones. Additionally, these reductions in our workforce may also make it more difficult or impossible for us to effectively manage and operate our business, especially if we experience significant turnover among our current employee base. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

 

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

 

Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. These licensed patents expire in 2014.  In 2012, we generated approximately 47% of our booked sales from products that use this licensed technology. The University patents are the earliest and in some ways the broadest of our patents.  We have additional patents that we own with later expiration dates that we believe afford substantial continuing patent coverage for the same products.  However, once the University patents expire, it may be more difficult to prevent others from marketing similar products. 

 

We also have incorporated technology and content licensed from other third parties as part of our products and services. If we were to lose our rights under any of our in-licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.  

 

If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.

 

Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will be found invalid or will not offer sufficient protection against competitors, that our trademarks will be challenged or infringed, or that our pending patent applications will not result in the issuance of patents. If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our sales. The Company historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright.

11


 

 

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

 

Our shares of common stock have been delisted from NASDAQ and we are not listed on any other national securities exchange.  It will likely be more difficult for stockholders and investors to sell our common stock or to obtain accurate quotations of the share price of our common stock.

   

Effective October 18, 2012, our common stock was delisted from NASDAQ and our shares of common stock are currently quoted on the OTCMarkets, continuing under the trading symbol “SCIL.”  Stocks traded on the over-the-counter markets are typically less liquid than stocks that trade on a national securities exchange.  Trading on the over-the-counter market may also negatively impact the trading price of our common stock.  In addition, the liquidity of our common stock may be impaired, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and coverage by security analysts and the news media, if any, of our company.  Stockholders may find it difficult to resell their shares of our common stock due to the delisting.  The delisting of our common stock from NASDAQ may also result in other negative implications, including the potential loss of confidence by customers, strategic partners and employees, the loss of institutional investor interest in our common stock and our inability to take advantage of certain exemptions available to listed securities under the Exchange Act and the 1940 Act.

   

Additionally, as a result of the delisting of our shares of common stock from NASDAQ, we are no longer subject to the rules of  NASDAQ, including rules related to corporate governance matters such as the circumstances (including but not limited to certain issuances of our securities) in which stockholder approval is required, requirements regarding the independence of our directors and the existence of committees of our board of directors comprised of independent directors. 

   

We may not be able to be re-listed on NASDAQ, which could adversely affect trading and liquidity of our common stock.

 

Should we once again satisfy the applicable listing criteria, we would be able to apply for the re-listing of our shares of common stock on NASDAQ.  However, there is no assurance that NASDAQ or any other national stock exchange will approve our common stock for listing, as there is no assurance that we will satisfy the criteria for listing or be approved for listing on NASDAQ or any other national stock exchange.  Failure to list our shares on a national stock exchange could result in a less liquid market for existing and potential stockholders in which to trade our common stock, which could depress the trading price of our common stock and adversely impact our ability to raise capital in the future.

   

Our securities are subject to “penny stock” rules which may further reduce the liquidity and market price for our Common Stock.

   

Certain securities that are not listed on a national securities exchange, have a trading price below $5.00 and satisfy certain other requirements, such as our common stock, are subject to the SEC’s “penny stock” rules.  Under the SEC’s penny stock rules, among other things, broker-dealers may not sell a penny stock to, or effect the purchase of a penny stock by an investor (other than an accredited investor or an “established customer” as defined in Rule 15g-9), unless, prior to executing the transaction, the broker-deal has determined that transactions in penny stocks are suitable for the purchaser (and delivers a written statement of such determination to the purchaser), obtained the purchaser’s written agreement to engage in the transaction, provided the purchaser with a written disclosure document regarding certain risks associated with investing in penny stocks and obtained written acknowledgement from the purchaser that the purchaser has receive the required disclosure documents.  Broker-dealers may find it difficult to execute transactions in our common stock as a result of the penny stock rules summarized above.  These requirements may further reduce the liquidity and trading price of our common stock.

 

The ownership of our common stock is concentrated.

 

At December 31, 2012, Trigran Investments owned approximately 27% of our outstanding stock, Nantahala Capital Management owned approximately 11% of our outstanding stock, Osmium Partners and its affiliates owned approximately 10% of our outstanding stock, Noel G. Moore owned approximately 8% of our outstanding stock, and our executive officers and directors held approximately 11% of the outstanding stock. As a result, these stockholders are able to collectively control all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of the Company.

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ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES   

 

We currently have the following leased properties:

 

1.

A lease for approximately 30,500 square feet of office space in Oakland, California for our headquarters. The lease was modified in October 2012 to reduce our leased office space in Oakland, California to 14,200 square feet effective January 2014.  The modified lease expires in December 2015.

 

2.

A lease for approximately 10,800 square feet of office space in Tucson, Arizona for our support center that expires in August 2017.

 

3.

A lease for an office in Shanghai, China for 2,500 square feet that expires in June 2014 to be used for research and development.

 

We believe our facilities are sufficient for our operations currently and should be adequate to meet our needs for at least the next year.

 

ITEM 3. LEGAL PROCEEDINGS       

None.

 

ITEM 4. MINE SAFETY DISCLOSURES  

 

Not applicable.

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EXECUTIVE OFFICERS

 

The following table sets forth information concerning our executive officers: 

 

 

 

 

 

Name

 

Age

 

Title

Robert C. Bowen

 

71

 

President, CEO, Executive Chairman of the Board

Christopher John Brookhart

 

43

 

Senior Vice President, General Counsel and Corporate Secretary

Jane A. Freeman

 

59

 

Chief Financial Officer, Treasurer

 

 

 

 

 

 

Robert C. Bowen resumed his role as our CEO and Chairman in July 2012 after previously serving as our CEO from June 2002 through 2008, Executive Chairman in 2009 and Chairman in 2010.  Prior to joining us, he served as a senior executive and officer of National Computer Systems, a provider of educational assessment and administrative software and services from 1989 to 2001.  His last assignment there, from 1995 to 2001, was as President of NCS Education, a leading provider of enterprise software for K-12 school districts.  NCS was acquired by Pearson, PLC, in 2000.  After retiring from NCS in 2001, Mr. Bowen consulted for various businesses in education until joining us.  Previously, Mr. Bowen held senior executive positions with other leading education and publishing companies, including seventeen years with McGraw-Hill.  Early in his career, Mr. Bowen was a high school math teacher, a coach, and a school district administrator. 

 

Mr. Bowen received his bachelor’s and master’s degrees from the University of Tennessee, Chattanooga.

Chris J.  Brookhart joined us in June 2012, as Senior Vice President, General Counsel and Corporate Secretary.  Prior to joining us, he was an Associate General Counsel at Ancestry.com, a subscription-based SaaS and content internet company from 2008 to 2012. Previously, he served as Sr. Corporate Counsel at Novell, Inc. from 2006 to 2008, an enterprise software company, as a Senior Transaction Attorney at Honeywell Aerospace from 2003 to 2006 and as a corporate associate at the law firm of Dow, Lohnes & Albertson, PLLC from 1999 to 2003.

Mr. Brookhart holds a bachelor’s degree in political science and a law degree from Brigham Young University.

Jane A. Freeman rejoined us as Chief Financial Officer in July 2012. With over twenty years of strategic management and financial experience, she previously served as Scientific Learning’s EVP and CFO from 1999 to 2008. Most recently she has been a consultant to and interim CFO for several education technology startups. Prior to joining us in 1999, Ms. Freeman was employed in the investment industry at Rockefeller & Co. and Scudder, Stevens & Clark. She serves as Lead Independent Director of the Harding Loevner Funds and was the Audit Committee Chair for the Russell Exchange Traded Funds Trust in 2011 and 2012.

Ms. Freeman is a Chartered Financial Analyst (inactive) and holds an MBA and BA from Cornell University. She also earned a degree in Applied Economics from the University of Louvain in Belgium.

 

 

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PART II

 

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

 

(a)

Market Information. Our common stock is currently traded over the counter and reported on OTC Markets.  Between March 29, 2010  and October 17, 2012, our stock was traded on the Nasdaq Global Market.  Prior to March 29, 2010, our common stock traded on the Nasdaq Capital Market.  Our stock has been traded under the symbol “SCIL” since our stock began trading in 1999.

 

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

 

 

  

High

  

Low

Fiscal year ending December 31, 2012

 

 

 

 

 

 

First quarter

  

$

2.75 

  

$

1.65 

Second quarter

  

$

1.79 

  

$

1.17 

Third quarter

  

$

1.64 

  

$

0.94 

Fourth quarter

  

$

1.03 

  

$

0.50 

 

 

 

Fiscal year ending December 31, 2011

  

 

 

  

 

 

First quarter

  

$

3.54 

  

$

2.85 

Second quarter

  

$

3.27 

  

$

2.87 

Third quarter

  

$

3.25 

  

$

2.50 

Fourth quarter

  

$

3.46 

  

$

2.51 

 

Stockholders

As of March 25, 2013, the approximate number of stockholders of record of our common stock was 92.

Dividend Policy

We have never declared or paid cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. Our current Loan and Security Agreement with Comerica Bank provides that we may not pay any dividends other than stock dividends during the term of the Agreement.

15


 

Securities Authorized for Issuance under Equity Compensation Plans

For information regarding securities authorized for issuance under equity compensation plans, see Item 9.

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

Not applicable

 

(b) Not applicable

 

(c) Not applicable

16


 

ITEM 6.  SELECTED FINANCIAL DATA

 

In thousands, except per share amounts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended

 

 

2012

 

2011

 

2010

 

2009

 

2008

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

Subscription

$

4,524 

$

2,407 

$

1,476 

$

629 

$

169 

License

 

8,770 

 

20,002 

 

21,030 

 

35,234 

 

28,132 

Service and support

 

14,849 

 

18,670 

 

20,878 

 

19,425 

 

19,453 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

28,143 

 

41,079 

 

43,384 

 

55,288 

 

47,754 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

Cost of subscription

 

1,110 

 

613 

 

148 

 

100 

 

 -

Cost of license

 

974 

 

1,412 

 

2,091 

 

2,678 

 

2,178 

Cost of service and support

 

5,704 

 

8,663 

 

9,201 

 

8,796 

 

9,721 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenues

 

7,788 

 

10,688 

 

11,440 

 

11,574 

 

11,899 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

20,355 

 

30,391 

 

31,944 

 

43,714 

 

35,855 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

15,368 

 

17,979 

 

21,498 

 

24,042 

 

23,587 

Research and development

 

6,998 

 

10,324 

 

7,933 

 

6,418 

 

7,016 

General and administrative

 

7,549 

 

8,413 

 

8,129 

 

8,135 

 

7,883 

Restructuring

 

1,462 

 

 -

 

 -

 

 -

 

 -

Impairment charge

 

 -

 

 -

 

3,890 

 

 -

 

 -

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

31,377 

 

36,716 

 

41,450 

 

38,595 

 

38,486 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(11,022)

 

(6,325)

 

(9,506)

 

5,119 

 

(2,631)

 

 

 

 

 

 

 

 

 

 

 

Interest and other income (expense), net

 

1,560 

 

13 

 

(41)

 

110 

 

564 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

(9,462)

 

(6,312)

 

(9,547)

 

5,229 

 

(2,067)

Provision for income taxes

 

188 

 

164 

 

143 

 

429 

 

1,248 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

$

(9,650)

$

(6,476)

$

(9,690)

$

4,800 

$

(3,315)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

$

(0.43)

$

(0.34)

$

(0.52)

$

0.27 

$

(0.19)

Diluted net income (loss) per share

$

(0.43)

$

(0.34)

$

(0.52)

$

0.26 

$

(0.19)

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

$

2,272 

$

5,871 

$

5,415 

$

20,679 

$

7,550 

Short-term investments

 

 -

 

 -

 

9,631 

 

 -

 

 -

Working capital

 

(8,258)

 

(5,030)

 

1,176 

 

5,178 

 

(3,551)

Total assets

 

13,058 

 

21,863 

 

31,803 

 

43,128 

 

30,260 

Stockholders' equity (net capital deficiency) (1)

 

(5,228)

 

(681)

 

4,334 

 

11,929 

 

5,045 

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

17


 

 

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

 

Overview

We develop, distribute and license technology that accelerates learning by applying proven research on how the brain learns.  We are differentiated by our continuous focus on the “science of learning” – combining advances in the field of brain research with standards-based learning objectives to achieve dramatic student gains. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the U.S., to whom we sell through a direct sales force.  To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. As of December 31, 2012, 3,488 schools were licensed to use our products, a small fraction of the approximately 132,000 K-12 schools in the U.S.  As of December 31, 2012, we had 140 full-time equivalent employees, compared to 240 at December 31, 2011.

 

Business Highlights

 

We market our products primarily as learning acceleration solutions, to be used in a blended model with existing teaching and curriculum materials, at both the elementary and secondary school levels. According to the U.S. Department of Education (USDE), in 2012, 67% of fourth graders in the United States were not “proficient” in reading and 33% performed below the “basic” level. Between 2009 and 2011, there was no change in average 4th grade reading scores.

 

States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products.  Additionally, federal education funds are a critical resource in helping school districts address the needs of the most challenged learners.  We believe that a significant proportion of our sales are funded by federal sources, particularly Title I and IDEA (special education) grants.  With respect to these sources, the National Education Association estimates that the federal sequestration that went into effect on March 1, 2013 will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year, but it is not yet clear what level of impact this will have on our sales.  

 

We experienced a decline in revenue and booked sales in 2012 compared to 2011, which we believe resulted from state budget pressures, uncertainty about future education policies, and an increasing trend toward using federal funds wherever possible to save teacher jobs and core programs rather than on supplemental programs focused on struggling learners. According to the Center on Budget and Policy Priorities, in the 2012-2013 school year, elementary and high schools in at approximately half of the states are receiving less state funding than in the prior school year, and in approximately 35 states school funding now stands below 2008 levels.

 

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

 

Company Highlights

 

Our total revenue decreased by 31% during 2012 compared to 2011. Our total booked sales decreased 32% during 2012 compared to 2011.   Booked sales are not a generally accepted accounting principles (“GAAP”) financial measure. For more explanation on booked sales, see discussion below.) The change in booked sales is due primarily to a decline in K-12 booked sales of 35% compared to 2011. We believe that the decline in booked sales reflects continued budget pressures on schools and a change in our business model to increase the focus on selling lower priced subscription and per student licenses compared to perpetual licenses, as well as a decrease in the number of salespeople in the later part of the year.

 

This change in business model combined with a weak environment has also resulted in a lower average transaction value.  In 2012, we closed 25 transactions in excess of $100,000 compared to 63 transactions over $100,000 in 2011.

 

Over time, we believe our On Demand MySciLEARN platform will enable us to significantly increase the number of smaller, more predictable transactions and recurring revenue.  In 2012, subscription booked sales increased 53% and represented 27% of booked sales compared to 12% of total booked sales in the same period of 2011. 

 

K-12 booked sales decreased by 35% to $20.2 million in 2012 compared to 2011.  Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 13% to $4.1 million in 2012 compared to 2011 due to changes in pricing and the timing of certain international transactions.

 

18


 

Cost of revenues decreased 27% in 2012 compared to 2011, primarily due to lower staffing associated with lower revenue, lower royalties and the reduction in materials shipped as we moved more customers to our On Demand platforms which do not require materials to be shipped.

 

Operating expenses decreased by 15% in 2012, compared to 2011, which is due primarily to a decrease in sales and marketing expenditures due to lower sales commissions and reduced headcount as a result of two reductions in force during the third quarter of 2012.  In addition, the decrease is also due to lower expenditures in research and development due to the completion and release of our On Demand MySciLEARN platform in the prior year.

 

In the third quarter of 2012, we took action to reduce our ongoing expense structure which included the elimination of 65 positions and resulted in $1.5 million in severance charges.  Excluding these charges, operating expenses would have decreased 19% in 2012 compared to 2011.    These actions reduced our annualized expenses by approximately $6.0 million per year.  As a result of these actions, we became cash flow positive in the fourth quarter of the year.

 

 

During the year, we had five key personnel changes. In April 2012, Linda L. Carloni, our Senior Vice President and General Counsel, announced that she would be retiring. On June 29, 2012, we hired Chris J. Brookhart as General Counsel and Mrs. Carloni’s retirement date was July 26, 2012.  On July 6, 2012, we received notification from Robert E. Feller, our Senior Vice President and Chief Financial Officer, that he was electing to resign. On July 11, 2012, our Board of Directors appointed Jane A. Freeman to be our CFO and Treasurer effective immediately. On July 8, 2012 our Board of Directors appointed Robert C. Bowen as our Chief Executive Officer effective immediately, in place of D. Andrew Myers.  It was mutually agreed that Mr. Myers would step down from the CEO position and resign as a director of the Company.  Mr. Bowen previously served as our CEO from 2002 to 2008 and Ms. Freeman previously served as our CFO and Treasurer from 2000 to 2008.  On August 15, 2012, we announced that we were eliminating the position of Chief Technology Officer and had entered into a separation and release agreement with Ronald K. Park, our CTO, with respect to the elimination of his role.  On November 6, 2012 we received notice from Jessica Lindl, the Company’s Senior Vice President, Marketing & Inside Sales, that she was electing to resign.

 

Results of Operations  

 

Revenues

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

2012

 

2011

 

2010

 

% Change

 

% Change

Subscription

$

4,524 

 

$

2,407 

 

$

1,476 

 

88% 

 

63% 

License

 

8,770 

 

 

20,002 

 

 

21,030 

 

(56)%

 

(5)%

Service and support

 

14,849 

 

 

18,670 

 

 

20,878 

 

(20)%

 

(11)%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

$

28,143 

 

$

41,079 

 

$

43,384 

 

(31)%

 

(5)%

 

As a result of the shift in our business model, beginning in 2012, we have presented revenues and cost of revenues for subscriptions, licenses, and services and support. We have reclassified all prior year amounts to reflect the current year presentation and the reclassification of prior year amounts did not have an impact on our total net revenues or results of operations. 

 

Subscription revenue primarily includes revenue from annual or monthly customer subscriptions to our web-based applications, including Fast ForWord,  Reading Assistant and BrainPro. We expect that subscription revenue will grow as we add new subscription customers, our existing subscription customers renew their licenses and some of our perpetual license customers choose to buy additional licenses as subscriptions. 

 

License revenue includes primarily revenue from sales of perpetual licenses to our software applications, including Fast ForWord and  Reading Assistant.  We do not expect perpetual license revenue to return to its levels recorded in prior years as a result of our goal to convert to a SaaS-based subscription business model. 

 

Service and support revenue is primarily derived from annual agreements for us to host software applications purchased by our customers as perpetual licenses and provide reporting services, support, and maintenance, as well as ad hoc trainings, professional development, consulting, and other technical service agreements. We expect service and support revenue to continue to decline as we do not expect the additions to support revenue from customers purchasing additional perpetual licenses to offset a decline in support

19


 

from existing licenses.  In addition, we continue to expect customers to migrate toward our  lower-priced web-based trainings from on-site service delivery. 

 

 

2012 versus 2011: Total revenue decreased by $12.9 million or 31% in 2012 compared to 2011.  Booked sales decreased by $11.6 million or 32%.  Subscription revenue increased by $2.1 million or 88% as we increased the number of subscription customers on our MySciLEARN platform.  Our K-12 transaction count increased 9% in 2012 when compared to 2011.  License revenue declined $11.2 million or 56% due to the decline in booked sales and a smaller portion of customers purchasing perpetual licenses. Service and Support revenue declined $3.8 million or 20% primarily due to a lower level of on-site services delivered compared to 2011.

 

For 2012, our renewal rate decreased to 80% compared to 87% in 2011, primarily due to weak economic conditions which also impacted new business.  Renewal rate is determined by dividing the number of school sites that renewed annual support and maintenance contract by the total number of sites whose contracts were expiring in the period.  In 2013, we expect to begin reporting renewal rates on a dollar basis as it is a better representation of revenue potential.  In addition,  the increasing sales of per student licenses which can be moved from location to location make a site- based metric less useful. 

 

2011 versus 2010: Total revenue declined $2.3 million or 5% in 2011 compared to 2010.  Booked sales for the same period declined $5.9 million or14% for the same period.  Subscription revenue increased by $0.9 million or 63% compared to 2010 as we increased the number of customers on our MySciLEARN platform.  License revenue declined $1.0 million or 5% as booked sales of perpetual licenses declined in 2011 compared to 2010.   Service and support revenue declined by $2.2 million in 2011 compared to 2010 as we delivered fewer on-site training days.  For 2011, our renewal rate decreased to 87% from 88% in 2010.

 

We continue to focus on increasing the percentage of recurring, predictable revenue. In late 2010, we released the first version of our new SciLEARN platform, SciLEARN Enterprise, an on-premise solution that permits large customers to host our solutions on-premise and deploy from their own central server out to multiple school sites. In the second quarter of 2011, we released the second version of our SciLEARN platform, MySciLEARN On-Demand, which gives our customers the option to access our solutions online, via the SciLEARN platform hosted by us. At the end of 2012, the total number of active school sites increased 13% to 3,488 with 76% of those sites using the MySciLEARN On-Demand version of Fast ForWord and/ or Reading Assistant. Over time, we expect that the MySciLEARN platform will increase the portion of our revenue that is recurring. We also expect that MySciLEARN, together with new per student pricing options we introduced in the second quarter of 2011 and changes in our business model, will increase our volume of smaller transactions, shorten sales cycles, and increase our ability to drive predictable, recurring revenue.

 

Booked Sales

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

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

 

2012

 

 

2011

 

 

2010

 

% Change

 

% Change

Total deferred revenue beginning of period

$

17,322 

 

$

21,871 

 

$

22,230 

 

(21)%

 

(2)%

Booked sales

 

24,305 

 

 

35,950 

 

 

41,838 

 

(32)%

 

(14)%

Less: revenue recognized

 

(28,143)

 

 

(41,079)

 

 

(43,384)

 

(31)%

 

(5)%

Adjustments

 

 

 

580 

 

 

1,187 

 

n/a

 

(51)%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deferred revenue end of period

$

13,485 

 

$

17,322 

 

$

21,871 

 

(22)%

 

(21)%

 

2012 versus 2011: Booked sales declined 32% in 2012 compared to 2011.  Booked sales is primarily composed of sales to the K-12 sector which decreased by 35% to $20.2 million in 2012 compared to $31.3 million in 2011. During 2012, state budget pressures caused many school districts to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs.  Federal stimulus funds which had benefited 2011 spending declined.  Booked sales to non-school customers

20


 

decreased by 13% to $4.1 million in 2012 compared to 2011, primarily due to a change in contract terms with some of our international VARs.

 

2011 versus 2010:  Booked sales declined 14% in 2011 compared to 2010.  Booked sales to the K-12 sector decreased by 18% to $31.3 million in 2011 compared to $37.9 million in 2010. As described above, during 2011 state budget pressures again caused many school districts to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs. Booked sales to non-school customers increased by 20% to $4.7 million in 2011 as compared to 2010.  The increase in 2011 reflects higher sales to international VARs, OEM’s, consumers and virtual schools, partially offset by lower sales to private practice clinicians, who were more directly impacted by recent economic conditions.

 

Booked sales to the K-12 sector for 2012, 2011 and 2010 were 83%, 87% and 91%, respectively, of total  booked sales.  “Other adjustments” in 2011 consists primarily of the recognition of deferred revenue and the related receivable for 2010 booked sales with Free-On-Board (“FOB”) destination delivery terms that were not delivered until 2010.

 

Historically, large booked sales, which we define as transactions totaling more than $100,000, have been an important indicator of mainstream education industry acceptance and an important factor in sales force productivity. In 2012, we closed 25 transactions in excess of $100,000 compared to 63 in 2011 and 84 in 2010. In 2012 and 2011, school districts struggled with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. For the years ended December 31, 2012, 2011 and 2010, 26%, 41% and 47%, respectively, of our total booked sales arose from transactions over $100,000. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate.  GAAP requires us to allocate discounts disproportionately to product licenses compared to service and support fees for non-subscription orders and accordingly, our product license revenues are disproportionately smaller than the related product booked sales. We cannot predict the size and number of large transactions in the future. MySciLEARN, together with new per student pricing options we introduced in the second quarter of 2011 and changes in our business model, are designed to decrease our dependence on large transactions by increasing our volume of smaller transactions and shortening sales cycles.

 

We continue to focus on increasing the percentage of subscription sales. In 2012, subscription booked sales increased 53% to $6.4 million. The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

 

 

2012

 

 

2011

 

 

2010

 

% Change

 

% Change

Subscription booked sales

 

$

6,449 

 

$

4,213 

 

$

3,608 

 

53% 

 

17% 

Non-subscription booked sales

 

 

17,856 

 

 

31,737 

 

 

38,230 

 

(44)%

 

(17)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total booked sales

 

$

24,305 

 

$

35,950 

 

$

41,838 

 

(32)%

 

(14)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Subscription booked sales as a % of total booked sales

 

 

27% 

 

 

12% 

 

 

9% 

 

 

 

 

Non-subscription booked sales as a % of total booked sales

 

 

73% 

 

 

88% 

 

 

91% 

 

 

 

 

 

 

 

Non-subscription booked sales represents the sale of licenses, services and support for perpetual licenses and On Premise products.

 

Although the current economic and financial conditions, the expiration of federal stimulus funding, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 and non-school markets. However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.  Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding.  As a result of the federal sequestration that went into effect on March 1, 2013, it is expected that funding for federal education programs will be cut by approximately 5.1% across-the-board  unless Congress passes retroactive legislation reversing the impact of sequestration. The National Education Association estimates that these cuts will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year.  While federal funding for education remains significant, the current level of federal spending and the federal deficit are likely to put continued pressure on all areas in the federal budget, which could result in further cuts.  States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets although the outlook is improving.  These conditions may continue to impact state education spending.

21


 

 

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

 

Gross Profit and Cost of Revenues

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

 

 

2012

 

 

2011

 

 

2010

 

% Change

 

% Change

Gross profit on subscriptions

 

$

3,414 

 

$

1,794 

 

$

1,328 

 

90% 

 

35% 

Gross profit on licenses

 

 

7,796 

 

 

18,590 

 

 

18,939 

 

(58)%

 

(2)%

Gross profit on service and support

 

 

9,145 

 

 

10,007 

 

 

11,677 

 

(9)%

 

(14)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit

 

$

20,355 

 

$

30,391 

 

$

31,944 

 

(33)%

 

(5)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit margin on subscriptions

 

 

75% 

 

 

75% 

 

 

90% 

 

0% 

 

(15)%

Gross profit margin on licenses

 

 

89% 

 

 

93% 

 

 

90% 

 

(4)%

 

3% 

Gross profit margin on service and support

 

 

62% 

 

 

54% 

 

 

56% 

 

8% 

 

(2)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit margin

 

 

72% 

 

 

74% 

 

 

74% 

 

(2)%

 

0% 

 

2012 versus 2011: The overall gross profit margin decreased by 2% in 2012 compared to 2011 due primarily to a change in mix of revenues from higher margin license revenue to lower margin subscriptions and service and support.

Gross profit on subscriptions increased by 90% in 2012 compared to 2011, commensurate with the 88% increase in subscription revenue.  The gross profit margin was unchanged.    

 

Gross profit on licenses decreased by 58% in 2012 compared to 2011, commensurate with 56% decrease in license revenue.  The gross profit margin decreased 4% primarily due to fixed costs, comprised primarily of amortization of purchased software, spread over a lower base of license revenue.

 

Gross profit on service and support decreased by 9% in 2012 compared to 2011 primarily due to 20% decline in service and support revenue during the year, mitigated by cost reductions as a result of a 52% reduction of headcount as a part of our restructuring activities taken during the third quarter of 2012. The gross profit margin increased 8% primarily due to the restructuring activities in 2012.

 

2011 versus 2010: The overall gross profit margin in 2011 was comparable to 2010 due to declines in the proportion of higher margin license revenue offset by decreasing license and service and support costs.  Subscription margins decreased by 15% in 2011 over 2010, mainly due to implementation of the SaaS Operations department  which was staffed up for revenue growth. License margins increased by 3% in 2011 over 2010 primarily due to lower royalty costs in 2011. Service and support margins decreased by 2% in 2011 compared to 2010, reflecting lower on-site services delivered in 2011.  

 

Operating Expenses

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

 

 

2012

 

 

2011

 

 

2010

 

% Change

 

% Change

Sales and marketing

 

$

15,368 

 

$

17,979 

 

$

21,498 

 

(15)%

 

(16)%

Research and development

 

 

6,998 

 

 

10,324 

 

 

7,933 

 

(32)%

 

30% 

General and administrative

 

 

7,549 

 

 

8,413 

 

 

8,129 

 

(10)%

 

3% 

Restructuring

 

 

1,462 

 

 

 -

 

 

 -

 

100% 

 

n/a

Impairment

 

 

 -

 

 

 -

 

 

3,890 

 

n/a

 

(100)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

31,377 

 

$

36,716 

 

$

41,450 

 

(15)%

 

(11)%

22


 

 

Sales and Marketing: Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. The $2.6 million decrease in sales and marketing expenses in 2012 as compared to 2011 was mainly due a reduction in headcount, lower marketing activities expense and lower commission and bonus expenses as we did not meet our sales quotas in 2012.  The $3.5 million decrease in sales and marketing expenses in 2011 as compared to 2010 was mainly due to lower marketing activities expense and lower commission and bonus expenses as we did not meet our sales quotas in 2011. At December 31, 2012, we had 32 quota-bearing sales personnel compared to 50 and 51 at December 31, 2011 and 2010, respectively.

 

Research and Development: Research and development expenses principally consist of compensation paid to employees and consultants engaged in research, product development, product management and product testing activities, together with software and equipment costs.  Research and development expenses decreased by $3.3 million in 2012 compared to 2011.  The decrease in research and development costs in 2012 compared to 2011 was primarily due to a reduction in headcount and lower spending on development, as the second version of our On Demand offering was released early in 2012.  Research and development expenses increased by $2.4 million in 2011 compared to 2010.  In 2011, we continued to make critical investments in product development which resulted in increased headcount and consulting expenses related to the development of the new platform. 

 

General and Administrative: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. The $0.9 million decrease in general and administrative expenses in 2012 compared to 2011 was primarily due to a  reduction of headcount, lower spending in consulting and lower stock compensation expense.  General and administrative expenses increased $0.3 million in 2011 as compared to 2010 primarily due to an increase in the use of consultants as well as an increase in depreciation expense due to the implementation of a new accounting system.

 

Restructuring: During the third quarter of 2012, as part of our strategy to better align our costs and organization structure with the current economic environment and improve our profitability, we implemented reductions in our workforce totaling approximately 30% as compared to staff levels at the end of the second quarter.  The majority of the impact was on cost of service and support, sales and marketing and research and development expenses.  The restructuring charge of $1.5 million included severance and related costs associated with 65 employees notified of termination during the third quarter of 2012.  As of December 31, 2012, we have $0.3 million restructuring liability remaining, which we expect to be pay by the first quarter of 2015.  

 

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

We used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group associated with Reading Assistant exceeded the carrying values of those assets. As a result of this assessment, the carrying value of the asset group exceeded the undiscounted cash flows. We then applied a fair-value-based test.  The fair value of the asset group was estimated using the expected present value of future cash flows which rely on estimates, judgments and assumptions.  These estimates, judgments and assumptions include the discount rate, expected remaining useful life of the asset group and cash flows generated during the remaining useful life. This analysis resulted in a non-cash impairment charge of $3.9 million in 2010, which included $0.5 million related to capitalized software development costs.  As of December 31, 2012, the remaining value of the intangible assets acquired from Soliloquy have been fully amortized.

 

 

 

 

 

 

 

 

 

 

 

 

23


 

 

 

Other Income and Expenses 

 

The following table sets forth information relating to our interest and other income (expenses) (in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2012-2011

 

2011-2010

 

 

 

2012

 

 

2011

 

 

2010

 

% Change

 

% Change

Change in fair value of warrants

 

$

1,834 

 

$

 -

 

$

 -

 

100% 

 

n/a

Write off of long-term investment

 

 

(200)

 

 

 -

 

 

 -

 

(100)%

 

n/a

Interest and other income (expense)

 

 

(74)

 

 

13 

 

 

(41)

 

(669)%

 

132% 

Total interest and other income (expense)

 

$

1,560 

 

$

13 

 

$

(41)

 

11900% 

 

132% 

 

The change in fair value of warrants relates to the change in fair value of our common stock warrants which were issued on March 28, 2012. The fair value was estimated using the Black-Scholes Merton option pricing model, which requires the input of highly subjective assumptions as determined by the Company’s management. To the extent these assumptions change in future periods, the fair value of the common stock warrants may increase or decrease and the change in fair value will be recorded in our results of operations.  The decrease in the fair value of warrants during 2012 is primarily due to the decrease in the Company’s stock price since the issuance of the warrants.  

 

In the second quarter of 2012, we assessed the financial condition of a company in which we have a long-term investment and wrote off that investment because of a lower assessment of its prospects. 

 

Disposal of fixed assets relates to a write off for certain capitalized software amounts for which we determined we would have no future use. 

 

Interest and other income (expense) include foreign exchange gains and losses as well as interest paid on amounts borrowed under our revolving line of credit with Comerica Bank. 

 

 

Income Tax Provision  

 

2012: During 2012, we recorded an income tax provision of approximately $0.2 million, and our valuation allowance increased by approximately $3 million.  We did not owe any federal income taxes due to our current and past taxable losses. The tax provision in 2012 and 2011 resulted from minimum state and statutory foreign taxes. 

 

Our effective tax rate increased to (2.0%) for fiscal year 2012 compared to (2.7%) for the same period a year ago.

 

As of December 31, 2012, we had U.S. federal and state net operating loss carryforwards of approximately $81.5 million and $50.6 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2019 through 2031 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2012 through 2031. 

 

As of December 31, 2012, we had U.S. federal and state tax credit carryforwards of approximately $2.4 million and $3.5 million, respectively.  The federal credit will expire at various dates beginning in 2018 through 2031, if not utilized. California state research and development credits can be carried forward indefinitely.

 

2011: During 2011, we recorded an income tax provision of approximately $0.2 million, and our valuation allowance increased by approximately $2.6 million.  We did not owe any federal income taxes due to our current and past taxable losses. The tax provision in 2012 and 2011 resulted from minimum state and statutory foreign taxes. 

 

Our effective tax rate decreased to (2.7)% for fiscal 2011 compared to (1.5%) for fiscal 2010. The decrease was primarily due to U.S. losses not benefitted in 2011.

 

2010: During 2010, we recorded an income tax provision of approximately $0.1 million, and our valuation allowance increased by approximately $3.1 million.  We did not owe any federal income taxes due to our current and past taxable losses. The tax provision in 2011 and 2010 resulted from minimum state and statutory foreign taxes.

 

24


 

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

 

Liquidity and Capital Resources  

 

Our cash and cash equivalents were $2.3 million at December 31, 2012, compared to cash and cash equivalents of $5.9 million at December 31, 2011.  We have used cash from operations of $10.5 million, $7.2 million and $4.2 million in the years ended December 31, 2012, 2011 and 2010, respectively.  In addition, as of February 28, 2013 we are out of compliance with the covenants of our line of credit from Comerica Bank (“Comerica”).  

 

We expect to continue to fund our operations primarily from our current cash balances, cash borrowings available under our credit line from Comerica, and the completion of additional financing activities.  Under the terms of our credit line with Comerica, we are required to maintain certain financial covenants on a monthly basis.  This will require us to achieve certain level of booked sales, cash collections and expenses. In addition management plans to raise additional capital through the issuance of subordinated debt securities and renegotiating the terms of the Comerica line of credit. There can, however, be no assurance that we can achieve these objectives on terms that are acceptable to us.  If we are unable to achieve these objectives and obtain additional financing, we may be unable to continue the development of our products and may have to cease operations.   

 

To obtain additional financing, we are actively working to issue subordinated debt securities of approximately $4.5 million to a group of our current investors.   In conjunction with this potential financing we are working to amend the financial covenants currently required under our existing line of credit agreement with Comerica. If we are unable to accomplish this debt financing and or amend our existing line of credit agreement we may continue to be out of compliance with our financial covenants with Comerica, which would result in our inability to access our line of credit.

 

Historically, we have used more cash in our operations during the first half of the year and have improved cash from operations in the second half.  This pattern results largely from our seasonally low sales in the first and fourth calendar quarters, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.   We expect that this pattern will continue, and that we will use cash in operations during the first half of 2013.  We expect that our cash balances, available capacity under our line of credit, and the potential subordinated debt that we anticipate raising will be sufficient to fund our operating requirements.  Further, in the third quarter of 2012, we implemented restructuring plans designed to reduce operating expenses and believe that improved cash flows from operating activities, together with existing cash balances, cash borrowings available under our credit line, and the completion of additional financing activities will enable us to have sufficient cash to continue for the next twelve months.

 

Accomplishing this, however, will require us to achieve certain levels of booked sales and cash collections consistent with 2012 and maintain lower expenses. We cannot, however, be certain that we will achieve our forecasted booked sales or cash collections.  If we are unable to achieve the needed levels of booked sales and cash collections, we expect to further reduce our expenses to ensure that we have sufficient liquidity to continue our operations through at least December 31, 2013.  Reducing expenses beyond the actions we took in the third quarter of 2012 could have a negative impact on our future growth potential.  In addition, we may be required to sell assets, issue additional equity securities or incur additional debt, and we may need to obtain waivers or amendments from Comerica in the event we do not comply with our covenants. We may not be able to accomplish any of these alternatives. In addition, our line of credit agreement with Comerica enables Comerica to prevent us from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met.  As such, it is not certain that we will be able to utilize cash available under the line of credit. 

 

Historically, we have maintained a revolving line of credit with Comerica, which was amended February 9, 2012.  The amendment lowered the maximum amount that can be borrowed to $5.0 million, extended the term of the line of credit to December 31, 2013, and updated the financial covenants.  The maximum amount we can borrow is $4.8 million, net of an outstanding letter of credit of $0.2 million.  Borrowings under the line of credit bear interest at Prime plus 1.25%, are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, compliance with certain financial covenants.

 

On August 14, 2012, we and Comerica entered into the Second Amendment to its Amended and Restated Loan and Security Agreement entered into in February 2012 (the “Second Restated Agreement”). Under the terms of the Second Restated Agreement, the financial covenants have been amended as follows: (1) amended the adjusted quick ratio requirement to varying levels, which range from 0.6:1.0 to 1.0:1.0, over the term of the agreement; (2) added a booked sales to plan ratio covenant whereby we are required to maintain certain levels of booked sales on a three-month rolling basis; (3) added a minimum cash balance covenant whereby we are required to maintain a minimum cash balance of $2.0 million; and (4) removed the net worth covenant.  Compliance with these covenants is required to be maintained on a monthly basis. 

 

During the third quarter of 2012, as part of our strategy to better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented two reductions in our workforce, which had the effect of reducing

25


 

headcount by approximately 30% as compared to staff levels at the end of the second quarter of 2012.  We recorded a restructuring charge of $1.5 million, which included severance and related costs associated with 65 employees notified of termination during the third quarter of 2012.  We expect that these reductions will result in future expense savings of approximately $6 million per year, with the predominant impact affecting  cost of service, sales and marketing expense and research and development expense. 

 

As of December 31, 2012, we had $0.8 million outstanding on the line of credit and we were in compliance with all applicable covenants of the credit line.  However, during the months ending January 31, 2013 and February 28, 2013, we were not in compliance with our covenants. On March 1, 2013, we received a certificate from Comerica waiving the covenant violation for the period ending January 31, 2013. 

 

At April 1, 2013, we are actively working with Comerica to (1) obtain a certificate from Comerica waiving the covenant violation for the period of February 28, 2013, (2) execute a debt subordination agreement (3) extend the term of our line of credit and (4) modify financial covenants to be more in line with our current forecast.  

 

Should we fail to amend the line of credit or continue to fail to meet any required covenants, we risk being unable to borrow under the line of credit, and there is no assurance that Comerica will grant us waivers in the future. Even if we return to compliance, a provision in the line of credit entitles Comerica to prevent us from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met.  As of March 31, 2013, the balance of outstanding borrowings on the line of credit was $2.9 million.

 

We have used cash from operations of $10.5 million in 2012, an increase from $7.2 million in 2011. Our cash used in operations has increased in fiscal 2012 as a result of our lower booked sales as compared to the prior year, as we have continued to experience a decline in booked sales due to the funding constraints in the K-12 market and our business transition from selling perpetual software licenses to a SaaS model.  

 

Net cash used in investing activities for 2012 was $0.6 million compared to net cash provided by investing activities of $7.4 million for 2011. In 2012, we had $0.6 million of purchases of property and equipment.   Net cash provided by investing activities in 2011 was $7.4 million, of which $9.5 million was from the sales and maturities of investments (net of purchases of $5.3 million) and $2.1 million was used for capital spending primarily related to investments in the new SaaS platform and new systems for back-office operations. 

 

Net cash provided by financing activities for 2012 was $7.5 million due to $6.5 million from the issuance of common stock as part of our private offering, $0.8 million in net borrowings on our line of credit and $0.2 million from proceeds from the exercise of stock options. Net cash provided by financing activities generated $0.2 million for 2011 resulting from proceeds from the exercise of stock options offset by $0.1 million of net settlement of restricted stock unit awards. 

 

 

Off-Balance Sheet Arrangements

 

We have no off-balance sheet arrangements.

 

Contractual Obligations and Commitments  

 

We have a non-cancelable lease agreement for our corporate office facilities in Oakland, California. The lease was extended in October 2012 through December 2015,with the minimum lease payment of approximately $38,000 per month for 2013, net of $50,000 per month applied from the security deposit.  The minimum lease payments are $33,000 per month for 2014 and 2015.  We also have a lease agreement for our Tucson, Arizona office, which was extended in June 2012 through August 2017,  with an average minimum lease payment of approximately $18,000 per month and a lease for our Shanghai, China research and development office for 2,500 square feet with a minimum lease payment of approximately $5,000 per month through June 2014. In addition, we lease certain equipment under capital lease arrangements that extend through 2014 for the amounts of $101,000 in 2013 and $25,000 in 2014.

 

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

26


 

 

The following table summarizes our obligations at December 31, 2012 and the effects such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2013

 

2014

 

2015

 

2016 and thereafter

 

Total

Contractual Obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Lease obligations

 

$

831 

 

$

670 

 

$

624 

 

$

384 

 

$

2,509 

Minimum royalty obligations

 

 

150 

 

 

150 

 

 

 -

 

 

 -

 

 

300 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

981 

 

$

820 

 

$

624 

 

$

384 

 

$

2,809 

 

 

Lease obligations include both capital and operating leases.

 

 

Application of Critical Accounting Policies

 

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

 

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

 

Revenue Recognition  

 

We derive revenue from the sale of licenses to our software and from professional service and support fees. Software license revenue is recognized in accordance with accounting standards for software companies. Additionally, we derive revenue from subscription fees for access to and use of our on-demand application services.  Under our subscription arrangements for our on-demand application services, the customer does not have the contractual right to take possession of the software at any time during the subscription period. Thus, revenue for our subscription services is recognized in accordance with accounting standards for service contracts.

 

There are four basic criteria which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the collection of the fee is reasonably assured. The application of the relevant accounting standards requires us to exercise significant judgment related to specific transactions and transaction types. In cases where extended payment terms are granted to school customers, we determine if the fixed or determinable fee criterion is met by reference to the customer’s specific funding sources, especially where the payment terms extend into the customer’s next fiscal year. If we determine that the fixed or determinable fee criterion is not met at the inception of the arrangement, we defer revenue recognition until the payments become due.

 

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

 

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

 

Multiple-element software arrangements

 

Booked sales of software to our school customers typically include multiple elements (e.g., Fast ForWord perpetual software licenses, support, training, implementation management, and other professional services). We recognize software revenue using the residual method, whereby the difference between the total arrangement fee and the total “vendor specific objective evidence” (“VSOE”) of fair value of the undelivered elements is recognized as revenue relating to the delivered elements. VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and,

27


 

for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE of fair value exists for each undelivered element based on whether the pricing for these elements is sufficiently consistent.

 

Multiple-element on-demand application service arrangements

 

Booked sales of subscriptions to our on-demand application services can also include multiple elements similar to software arrangements.  We follow accounting guidance for revenue recognition of multiple-element arrangements to determine whether such arrangements contain more than one unit of accounting. Multiple-element arrangements require the delivery or performance of multiple products, services and/or rights to use assets. To qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis and revenue is allocated to each deliverable in the arrangement based on the relative fair value of the respective deliverable. Our on-demand subscription services, support, training and implementation management services have standalone value as these services are sold separately by us, and we have established VSOE of fair value for determining the fair value of each element except for our on-demand subscription services.

   

For our on-demand subscription services, we have determined the fair value to be allocated to these services based on our best estimate of selling price (BESP). In determining BESP, we have considered various factors including our historical pricing practices and internal costs, as well as historical student usage data related to previous sales of our products.

 

Subscription revenue

 

Subscription revenue primarily includes revenue from annual or monthly customer subscriptions to our web-based applications, including Fast ForWord,  Reading Assistant, and BrainPro.  Subscription revenue is recognized as follows:

 

·

On-demand application services – revenue for subscription services is recognized ratably over the term of the subscription period.

·

Per student per month – student  usage of any of our  products during a calendar  month.  Revenue is recognized monthly over the period of use

·

Individual participant licenses – software licensed for a single participant.  Revenue is recognized over the average period of use.

 

License revenue

 

License revenue primarily includes revenue from the sales of perpetual licenses to our software applications including Fast ForWord and Reading Assistant.  License revenue is recognized as follows:

 

·

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

·

Software term licenses – software licensed for a specific time period, generally a term of one to three years. Revenue is recognized ratably over the license term.

 

Professional service and support revenue

 

Professional service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, implementation, technical and other professional services are typically sold on a per day basis. Professional services revenue is recognized as performed. Online service and customer support are recognized ratably over the service period. If VSOE of fair value does not exist for all the elements in a software arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

We conduct business primarily with public school districts and speech and language professionals in the United States. We record accounts receivable at the invoiced amount and we do not require collateral. We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. The allowance is determined based on any specific reserves deemed necessary and our historical experience of bad debt write-offs.  Actual bad debt write-offs could vary from history.

 

28


 

 

Goodwill   

 

 

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

 

Goodwill is required to be tested annually for impairment or between annual impairment tests if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. We perform our annual impairment test in the fourth quarter.  In September 2011, the Financial Accounting Standards Board (“FASB”) amended Accounting Standards Codification (“ASC”) 350, Intangibles—Goodwill and Other. This amendment in this update permitted an entity to first assess only qualitative factors to determine whether it is more like than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform a two-step goodwill impairment test as described in Topic 350.  The Company elected to continue performing the quantitative assessment, in addition to the qualitative assessment. . The two steps are as follows:

 

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

 

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

When the carrying value of the reporting unit (in our case, the Company) is negative as of the impairment evaluation date, the accounting standards for goodwill also require us to further evaluate whether it is more likely than not that a goodwill impairment exists in determining whether the second step of the impairment test shall be performed. 

 

During the second and third quarters of 2012, the Company concluded that there were sufficient adverse qualitative indicators to require an interim goodwill impairment analysis.  Among the indicators were (1) economic and budgetary challenges in the Company’s key K-12 market, (2) the Company’s continued transition from an on-premise, perpetual license model to a subscription driven, web-based SaaS business model, and (3) a significant decrease in the Company’s market capitalization as a result of a decrease in the trading price of its common stock during the second and third quarters of 2012.  As a result of this quantitative analysis, the Company completed an estimate of the implied fair value of its goodwill and comparison to the carrying amount in accordance with ASC 350-20-35 (step 2). The Company engaged a valuation specialist to assist in the analysis, primarily focused on the determination of the fair value of the Company’s unrecorded intangible assets and the fair value of the Company’s deferred revenue.  The result of the step 2 analysis indicated that the implied fair value of goodwill exceeded its carrying value by approximately $18 million as of June 30, 2012 and by approximately $12 million as of September 30, 2012.  Therefore the Company concluded that a goodwill impairment did not exist as of June 30, 2012 and September 30, 2012.    

 

As part of the Company’s annual impairment test during the fourth quarter of 2012, the Company considered whether the adverse qualitative indicators, noted above, continued to exist as of December 31, 2012.  The Company concluded that although the adverse qualitative indicators continued to exist as of December 31, 2012, there was not a material change to these indicators.  The Company further noted that there were no significant changes to its projections of future cash flows used to determine the implied fair value of goodwill and that the Company met its fourth quarter projections. Given the significant headroom noted in the second and third quarter step 2 analyses, the lack of changes in the projected cash flows and discount rates that would be used as inputs in any current period analysis, and the fact that the Company met its fourth quarter projections, the Company concluded that it was not more likely than not that a goodwill impairment exists as of December 31, 2012 and therefore no step 2 analysis was performed

 

We will continue to assess goodwill for impairment on an interim basis when indicators, events or circumstances change. Conditions that indicate that goodwill may be impaired include market capitalization declining below net book value or a sustained decline in stock price. A significant impairment could have a material adverse effect on our consolidated balance sheets and results of operations.

 

29


 

Income Taxes  

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

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

 

Stock-Based Compensation

 

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

 

The estimated expected stock price volatility increased from 62% in 2010 and 2011 to 64% in 2012. Our expected stock price volatility over the expected life of the options is based upon our historical experience over the historical period equal to the expected life of the options.

 

Our estimate of the forfeiture rate has also changed from 7.7% in 2010 to 8.5% in 2011 to 8.5% in 2012, based on our experience of actual forfeiture rates and our expectations of future pre-vesting termination behavior. Stock-based compensation expense will be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.

 

The requirement to expense stock-based awards will continue to materially reduce our reported results of operations. As of December 31, 2012, we had an aggregate of $0.9 million of stock compensation remaining to be amortized to expense over the remaining requisite service period of the underlying awards. We currently expect this stock compensation balance to be amortized as follows: $0.5 million during 2013; $0.2 million during 2014; $0.1 million during 2015; and $0.1 million during 2016. These amounts reflect only outstanding stock awards as of December 31, 2012. We expect to continue to issue share-based awards to our employees in future periods.

 

Capitalization of internal use software and website development costs

 

We also capitalize costs related to internal use software and website application, infrastructure development and content development.  In each case, the software or website is for internal needs, and we do not plan to market the software externally. For the year ended December 31, 2012, we capitalized approximately $0.4 million of software and website development costs. For the years ended December 31, 2011 and 2010, we capitalized approximately $1.2 million and $1.2 million of software and website development costs, respectively.

 

The Company evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets.  If indicators of impairment are present, estimates of future cash flows are used to test the recoverability of the asset. If the carrying amount of the asset exceeds its fair value, an impairment charge is recognized. In 2010, we determined that capitalized software development costs relating to the Reading Assistant asset group was impaired.  See Long-lived assets below for further discussion.

 

Long-lived assets

 

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

 

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

30


 

We used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group exceeded the carrying values of those assets. As a result of this assessment, the carrying value of the asset group exceeded the undiscounted future cash flows. We then performed an analysis to determine the fair value of the asset group, which was determined using the expected present value of future cash flows which are based on estimates, assumptions and management’s judgments.  These include the forecast of future cash flows related to the asset group, the discount rate used in discounting those cash flows, and the expected remaining useful life of the asset group. This analysis resulted in a non-cash impairment charge of $3.9 million in 2010, which included $0.5 million related to capitalized software development costs. The impairment charge was allocated on a pro-rata basis using the relative carrying amounts of the asset group.  As of December 31, 2012, the remaining value of the intangible assets acquired from Soliloquy have been fully amortized.

 

Warrant Liability 

 

 In connection with our private common stock offering that closed on March 28, 2012, we issued 2,505,852 common stock warrants.  The warrants have an exercise price of $1.82 per share and expire five years from the date of issuance. In addition, the warrants contain a cash settlement provision that may be triggered upon request by the warrant holders if we are acquired or a merger event occurs.  Under the FASB ASC Topic 815, Derivatives and Hedging, an equity contract that can be settled in cash at the request of the holder must be classified as an asset or a liability. The accounting guidance also requires that the warrants be re-measured at fair value at each reporting date, with the change in fair value recorded in our consolidated statement of operations. At December 31, 2012 the estimated fair value of the warrants was $0.5 million and is recorded as a liability on our consolidated balance sheets. For the year ended December 31, 2012, there was a decrease of $1.8 million, to the warrant liability which was recorded in interest and other income on our consolidated statement of operations. The fair value was estimated using the Black-Scholes Merton option pricing model, which requires the input of highly subjective assumptions as determined by management. To the extent these assumptions change in future periods, the fair value of the common stock warrants may increase or decrease and the change in fair value will be recorded in our results of operations. 

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ITEM 8.            FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of Scientific Learning Corporation

 

We have audited the accompanying consolidated balance sheets of Scientific Learning Corporation as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity (net capital deficiency), and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scientific Learning Corporation at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company’s recurring losses from operations, deficiency in working capital and its need to raise additional capital raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

 

 

                                    /s/ Ernst & Young LLP

 

San Jose, California

April 1, 2013

 

 

 

 

 

 

32


 

 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

 

 

 

 

 

 

 

 

December 31, 2012

 

 

December 31, 2011

 

Assets

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

Cash and cash equivalents

$

2,272 

 

$

5,871 

 

Accounts receivable, net of allowance for doubtful accounts of $52 and $159, respectively

 

2,446 

 

 

4,433 

 

Prepaid expense and other current assets

 

1,484 

 

 

1,709 

 

Total current assets

 

6,202 

 

 

12,013 

 

 

 

 

 

 

 

 

Property and equipment, net

 

2,028 

 

 

3,326 

 

Goodwill

 

4,568 

 

 

4,568 

 

Intangible assets

 

 -

 

 

518 

 

Other assets

 

260 

 

 

1,438 

 

Total assets

$

13,058 

 

$

21,863 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity (net capital deficiency)

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

Accounts payable

$

715 

 

$

881 

 

Accrued liabilities

 

1,981 

 

 

3,556 

 

Loan payable

 

800 

 

 

 -

 

Deferred revenue, short-term

 

10,964 

 

 

12,606 

 

Total current liabilities

 

14,460 

 

 

17,043 

 

Deferred revenue, long-term

 

2,521 

 

 

4,716 

 

Warrant liability

 

534 

 

 

 -

 

Other liabilities

 

771 

 

 

785 

 

Total liabilities

 

18,286 

 

 

22,544 

 

 

 

 

 

 

 

 

Commitments and contingencies (see Note 16 to the consolidated financial statements)

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders' equity (net capital deficiency):

 

 

 

 

 

 

Common stock $0.001 par value: 40,000,000 authorized, 23,442,837 and 19,005,153 shares issued and outstanding at December 31, 2012 and 2011, respectively, and additional paid-in capital

 

95,839 

 

 

90,735 

 

Accumulated deficit

 

(101,069)

 

 

(91,419)

 

Accumulated other comprehensive income

 

 

 

 

Total stockholders' equity (net capital deficiency)

 

(5,228)

 

 

(681)

 

 

 

 

 

 

 

 

Total liabilities and stockholder's equity (net capital deficiency)

$

13,058 

 

$

21,863 

 

 

 

See accompanying notes to audited consolidated financial statements.

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SCIENTIFIC LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

 

 

2012

 

 

2011

 

 

2010

 

Revenues:

 

 

 

 

 

 

 

 

 

Subscription

$

4,524 

 

$

2,407 

 

$

1,476 

 

License

 

8,770 

 

 

20,002 

 

 

21,030 

 

Service and support

 

14,849 

 

 

18,670 

 

 

20,878 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

28,143 

 

 

41,079 

 

 

43,384 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

Cost of subscription

 

1,110 

 

 

613 

 

 

148 

 

Cost of license

 

974 

 

 

1,412 

 

 

2,091 

 

Cost of service and support

 

5,704 

 

 

8,663 

 

 

9,201 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenues

 

7,788 

 

 

10,688 

 

 

11,440 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

20,355 

 

 

30,391 

 

 

31,944 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

15,368 

 

 

17,979 

 

 

21,498 

 

Research and development

 

6,998 

 

 

10,324 

 

 

7,933 

 

General and administrative

 

7,549 

 

 

8,413 

 

 

8,129 

 

Restructuring

 

1,462 

 

 

 -

 

 

 -

 

Impairment charge

 

 -

 

 

 -

 

 

3,890 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

31,377 

 

 

36,716 

 

 

41,450 

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

(11,022)

 

 

(6,325)

 

 

(9,506)

 

 

 

 

 

 

 

 

 

 

 

Interest and other income (expense), net

 

1,560 

 

 

13 

 

 

(41)

 

 

 

 

 

 

 

 

 

 

 

Loss before for income tax

 

(9,462)

 

 

(6,312)

 

 

(9,547)

 

Provision for income taxes

 

188 

 

 

164 

 

 

143 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

$

(9,650)

 

$

(6,476)

 

$

(9,690)

 

 

 

 

 

 

 

 

 

 

 

Net loss per share:

 

 

 

 

 

 

 

 

 

Basic net loss per share

$

(0.43)

 

$

(0.34)

 

$

(0.52)

 

Diluted net loss per share

$

(0.43)

 

$

(0.34)

 

$

(0.52)

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in computation of per share data: