10-K 1 scil-20131231x10k.htm 10-K 0052c7c5e6f9437


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, 2013 

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. x

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 30,  2013 as reported on the OTC Bulletin Board was approximately $5,049,605. 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 20, 2014 the Registrant had outstanding 23,854,958 shares of Common Stock.



 

 

 


 

 

 

 

TABLE OF CONTENTS

 

 

 

PART I

 

PAGE NO.

 

 

 

Item 1.

Business

Item 1A.

Risk Factors

Item 1B.

Unresolved Staff Comments

12 

Item 2.

Properties

12 

Item 3.

Legal Proceedings

12 

Item 4.

Mine Safety Disclosures

12 

 

 

 

PART II

 

 

 

 

 

Item 5.

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

13 

Item 6.

Selected Financial Data

14 

Item 7.

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

15 

Item 8.

Financial Statements and Supplementary Data

28 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

54 

Item 9A.

Controls and Procedures

54 

Item 9B.

Other Information

55 

 

 

 

PART III

 

 

 

 

 

Item 10.

Directors and Executive Officers and Corporate Governance

56 

Item 11.

Executive Compensation

58 

Item 12.

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

68 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

70 

Item 14.

Principal Accountant Fees and Services

73 

 

 

 

PART IV

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

74 

 

 

 

SIGNATURES 

 

75 

 

 

 

 

 

 


 

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 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, 2013, proof that our products produce substantial academic gains was demonstrated in 282 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 implementing 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 2013 were estimated to total over 130,000 schools serving approximately 50 million students in almost 14,000 school districts. In the last three fiscal years, the U.S. K-12 sector has represented approximately 84% of our sales.

 

We sell our products primarily at the district level.  We also sell 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 2013, 65% of fourth graders in the United States failed to achieve a “proficient” level in reading and 32% performed below the “basic” level.  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

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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 (Individuals with Disabilities Education Act) grants and Title I funding.

This funding is subject to legislative adjustment, such as the sequestration cuts that went into effect in 2013.  The National Education Association estimates that the federal sequestration that went into effect on March 1, 2013 reduced Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year.  Sequestration had a negative impact on our sales in 2013, though most of this funding has been recently restored.  The amount of federal 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 discussion about changes to the federal No Child Left Behind Act, and the administration has granted 42 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, at least 34 states are providing less funding per student for the 2013-14 school year than they did before the recession started in 2008, resulting in teacher layoffs, program restrictions and overall expense reductions, although funding is expected to increase in approximately 60% of states in the 2013-2014 school year.

 

Other Markets

 

In addition to selling to K-12 schools, we also sell to and through private practice professionals and learning centers. These speech, 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 2013, 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 branded as BrainPro. Our BrainPro 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 2013, products were marketed to customers in approximately 45 countries. As of December 31, 2013, we were represented by 26 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.

 

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 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.  These products build learning capacity through developing cognitive skills using exercises focused on the oral language skills underlying reading.  

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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.

 

ResultsNow!

ResultsNow! is our online hosting and support solution for our Fast ForWord and Reading Assistant products.   ResultsNow! includes web-based initial training, access to Student Progress Reports and Reading Progress Indicator, SciLEARNU eLearning Courses, technical and instructional support and SaaS hosting on our MySciLEARN platform.  

 

Student Progress Reports are our online data reporting tools, which allows customers to monitor individual, classroom, school or district performance.  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.  The BrainPro Autism services include a more intense and customized version of tutoring services.

 

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.

 

 

 

 

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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.

 

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 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 and Canada, using a diversified direct sales channel, including both inside and field sales personnel. 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.

 

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, 2013, we had relationships with 26 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

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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, California.

 

During the fourth quarter of 2013, as part of our strategy to improve the efficiency of our development operations and to better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented a plan to discontinue our development operations in China.  Our plan is to consolidate development in the United States.

 

Our research and development expenses were approximately $3.8 million, $7 million and $10.3 million for the years ended December 31, 2013, 2012 and 2011, respectively.

 

Development Strategy

 

Over the past several years, our development efforts have been primarily focused on transitioning our products to a web-based platform and enhancing that platform and increasing its ease of use. 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.

 

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

 

In 2013, we focused on developing our MySciLEARN platform to be more robust, scalable and easier to use.  In addition, we expanded the reporting and analytical features of MySciLEARN and continued to enhance Reading Assistant performance.

 

During 2014, our primary product development goal is to enable the use of our Fast ForWord Language, Literacy and Reading products on the iPad ® mobile digital device.  

 

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, 2013, we held the rights to 66 issued and active patents and 10 pending applications. These include 43 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 2013, approximately 50% 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, and if the Regents were to assert these patents against us,  our business could be materially harmed.  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 2013, 2012 and 2011, we had approximately $0.2 million, $0.2 million and $0.4 million, respectively, in royalty expense under the license.

 

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We also have 19 U.S. trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark.

 

On March 21, 2014, the company sold seven US patents to a third party.  See Note 19 to the consolidated financial statements for further discussion..

 

Posit Science Corporation

 

In September 2003, we transferred certain aspects 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 were 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 also agreed to cross‑license any patents issued to PSC. We retain all rights to our technology outside of the specified healthcare field.

 

In December 2013, we amended our license agreement with PSC to make most of the exclusive licenses non-exclusive. In exchange for the change in the licenses, we agreed to significantly reduce PSC’s ongoing royalty obligation.

 

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 $10.6 million as of December 31, 2013 and $13.5 million as of December 31, 2012. 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 $9.7 million of our deferred revenue as of December 31, 2013 is expected to be recognized within the next 12 months.

 

Employees

 

As of December 31, 2013 we had 121 full-time equivalent employees, compared to 140 at December 31, 2012. 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.  There has been much recent discussion, and the administration has granted 42 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, funding for federal education programs was cut by approximately 5.1% across-the-board during the 2013-2014 school year.  Our fiscal year 2013 was significantly negatively impacted by the sequestration cuts.  The fiscal year 2014 appropriations restored most, but not all, of the funds from the sequestration cuts made to Title I grants and special education state grants for the next two years.  However, Congress will need to reach a broader agreement before the 2016-2017 school year to permanently restore these funds.

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 2013-2014 school year, elementary and high schools in at least 15 states are receiving less state funding than in the prior school year, and at least 34 states are providing less funding per student for the 2013-2014 school year than they did before the recession started.  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 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 $2.6 million at December 31, 2013, compared to cash and cash equivalents of $2.3 million at December 31, 2012.  On April 5, 2013, we entered into a subordinated note and warrant purchase agreement with certain existing stockholders for an aggregate principal amount of $4.6 million to provide us additional working capital.  We have used cash from operations of $3.2 million, $10.5 million and $7.2 million in the years ended December 31, 2013, 2012 and 2011, respectively. Our existing cash and cash equivalents and expected cash flow from operations and the sale of patents 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.  Our independent registered public accounting firm concluded that there is substantial doubt about our ability to continue as a going concern.  Accordingly, it included an explanatory paragraph to that effect in its report on our December 31, 2013 consolidated financial statements.

 

 

 

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As of December 31, 2013, the Company had no borrowings outstanding under our credit line with Comerica. On August 9, 2013, we amended our credit line. Under the amendment, we granted Comerica a security interest in our money market account to secure the letter of credit. Additionally, as we were not in compliance with one of our covenants in August 2013, Comerica waived the non-compliance and agreed not to test the minimum booking covenant for future measuring periods provided that no further credit extensions will be made until we agree upon a new financial covenant structure with Comerica.  As of December 31, 2013, we were in compliance with the covenants that are being measured by Comerica.  We are actively negotiating with banks to either amend our existing line of credit with Comerica or establish a new line of credit with a new bank.  A new line of credit would require us to amend our agreements with our subordinated debt holders to put a new line of credit in place.  We can provide no assurance that we will be able to reach an agreement with any bank or our subordinated debt holders.  If we are unable to do so, we will not have access to credit for future borrowings. 

 

Additionally, if we are unable to borrow from a line of credit in the future, we may have insufficient cash to satisfy our liquidity needs, which could force us to obtain additional debt or equity financing from other sources, to further reduce expenses, or to sell assets. Reducing our expenses could 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.

 

The notes issued pursuant to the April 5, 2013 subordinated note and warrant purchase agreement bear simple interest at a rate of 12% per annum.  From the issuance date through the first anniversary thereof, we will pay accrued and unpaid interest quarterly in arrears by increasing the principal amount of each note and thereafter will pay accrued and unpaid interest in cash in arrears on July 31, 2014, November 30, 2014 and the final payment date.  The notes mature on April 5, 2015.  The note and warrant purchase agreement contains customary affirmative and negative covenants, including notification and information covenants and covenants restricting our ability to merge or liquidate, incur debt, dispose of assets, incur liens, declare dividends or enter into transactions with affiliates.  The note and warrant purchase agreement also requires us to repay the notes upon the occurrence of a change of control (as defined in the note and warrant purchase agreement) at 101% of the principal amount thereof plus accrued and unpaid interest.

 

Our ability to meet our liquidity needs depends on our ability to achieve certain levels of booked sales and cash collections, or to reduce expenses. 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.  Our cash reserves, if any, may not be adequate to meet our needs especially during or immediately after this seasonally low period.

 

We are in the process of deregistering our shares of common stock, and we will not be filing future reports with the Securities and Exchange Commission.  It may be difficult to obtain information about our business.

 

Our Board of Directors recently evaluated our status as a reporting company under the Securities Exchange Act of 1934 Act, as amended (the “Exchange Act”)  and decided that it was in our best interests and that of our stockholders to de-register our common stock under the Exchange Act to reduce cash expenses.

 

On December 31, 2013, we filed a Form 15 with the Securities and Exchange Commission (the “SEC”)  to de-register our shares and immediately suspend our 1934 Act reporting obligations.  We are required to file this annual report on Form 10-K for our fiscal year 2013, but we do not intend to file any other current or periodic reports hereafter. During the 90-day period after December 31, 2013, any obligations to file proxy statements as well as reporting obligations under Section 13(d), 13(g) and Section 16 of the 1934 Act continue. At the completion of this 90-day period, on March 31, 2014, our shares will be de-registered unless the SEC affirmatively determines otherwise.  Although we currently expect that we will continue to make quarterly unaudited and annual audited financial statements publicly available through www.OTCmarkets.com or another website, it may be difficult for investors to obtain adequate information about our business and results of operations and de-registering may negatively impact the trading price of our common stock.

 

Our shares of common stock are not listed on any 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.

 

Currently, our common stock is traded on the OTC Bulletin Board under the trading symbol “SCIL.” However, the OTC Bulletin Board may de-list our shares once we cease to file reports with the SEC, and we can provide no assurance that our shares would continue to trade on the OTC Bulletin Board or elsewhere.  Stocks traded on the over-the-counter markets are typically less liquid than stocks that trade on a national securities exchange and accurate price quotations are more difficult to obtain.  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.  Because we are not traded on any national securities exchange certain institutional investors  may not be permitted to invest in our common stock, which could result in a sustained depressed stock price due to lack of investor demand. 

 

8


 

Additionally, because our common stock is not traded on a national exchange, we are not subject to listing exchange rules, 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. Because we are no longer subject to these requirements, we may make corporate governance changes as a way to reduce costs.  This, as well as other corporate governance practices, may make it more difficult for our board to effectively govern our business and may result in a loss of investor confidence, which could have a material negative impact on our stock price. 

 

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 80% of our 2013 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 2013, we closed 17 transactions in excess of $100,000.  These transactions represented 22% of our total booked sales in 2013.

 

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 2013, we had a net loss of $6.2 million compared to a net loss of $9.7 million in 2012 and a net loss of $6.5 million in 2011. 

 

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 desire.  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.

 

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

 

More than 80% of our 2013 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

9


 

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 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 improvements in 2013, and we are planning additional product introductions and improvements in 2014.  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 cost 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 2013 and expect additional important launches in 2014.

 

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.

 

 

 

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. As of December 31, 2013, we had 121 full-time employees.  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 2013, we generated approximately 50% 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 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, 2013, Trigran Investments owned approximately 20% of our outstanding stock, Nantahala Capital Management owned approximately 12% 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 12% 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.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES   

 

We currently have the following leased properties:

 

1.

A lease for approximately 14,200 square feet of office space in Oakland, California for our headquarters. 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.

 

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.

 

 

12


 

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, 2013

 

 

 

 

 

 

First quarter

 

$

0.90 

 

$

0.61 

Second quarter

 

$

1.00 

 

$

0.50 

Third quarter

 

$

0.67 

 

$

0.32 

Fourth quarter

 

$

0.79 

 

$

0.13 

 

 

 

 

 

 

 

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 

 

 

Stockholders

As of March 24, 2014, the approximate number of stockholders of record of our common stock was 89.

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.  The subordinated note and warrant purchase agreement entered into on April 5, 2013 contains customary affirmative and negative covenants, including notification and information covenants and covenants restricting the our ability to declare dividends.

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

13


 

ITEM 6. SELECTED FINANCIAL DATA

 

In thousands, except per share amounts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended

 

 

2013

 

2012

 

2011

 

2010

 

2009

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

Subscription

$

6,709 

$

4,524 

$

2,407 

$

1,476 

$

629 

License

 

3,011 

 

8,770 

 

20,002 

 

21,030 

 

35,234 

Service and support

 

11,342 

 

14,849 

 

18,670 

 

20,878 

 

19,425 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

21,062 

 

28,143 

 

41,079 

 

43,384 

 

55,288 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

Cost of subscription

 

1,247 

 

1,110 

 

613 

 

148 

 

100 

Cost of license

 

258 

 

974 

 

1,412 

 

2,091 

 

2,678 

Cost of service and support

 

3,404 

 

5,704 

 

8,663 

 

9,201 

 

8,796 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenues

 

4,909 

 

7,788 

 

10,688 

 

11,440 

 

11,574 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

16,153 

 

20,355 

 

30,391 

 

31,944 

 

43,714 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

9,105 

 

15,368 

 

17,979 

 

21,498 

 

24,042 

Research and development

 

3,778 

 

6,998 

 

10,324 

 

7,933 

 

6,418 

General and administrative

 

5,277 

 

7,549 

 

8,413 

 

8,129 

 

8,135 

Impairment of goodwill

 

4,568 

 

 -

 

 -

 

 -

 

 -

Restructuring

 

219 

 

1,462 

 

 -

 

 -

 

 -

Impairment charge

 

 -

 

 -

 

 -

 

3,890 

 

 -

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

22,947 

 

31,377 

 

36,716 

 

41,450 

 

38,595 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(6,794)

 

(11,022)

 

(6,325)

 

(9,506)

 

5,119 

 

 

 

 

 

 

 

 

 

 

 

Interest and other income (expense), net

 

(41)

 

1,560 

 

13 

 

(41)

 

110 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision (benefit) for income taxes

 

(6,835)

 

(9,462)

 

(6,312)

 

(9,547)

 

5,229 

Provision (benefit) for income taxes

 

(631)

 

188 

 

164 

 

143 

 

429 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

$

(6,204)

$

(9,650)

$

(6,476)

$

(9,690)

$

4,800 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

$

(0.26)

$

(0.43)

$

(0.34)

$

(0.52)

$

0.27 

Diluted net income (loss) per share

$

(0.26)

$

(0.43)

$

(0.34)

$

(0.52)

$

0.26 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

$

2,638 

$

2,272 

$

5,871 

$

5,415 

$

20,679 

Short-term investments

 

 -

 

 -

 

 -

 

9,631 

 

 -

Working capital

 

(6,230)

 

(8,258)

 

(5,030)

 

1,176 

 

5,178 

Total assets

 

7,115 

 

13,058 

 

21,863 

 

31,803 

 

43,128 

Stockholders' equity (deficit) (1)

 

(10,635)

 

(5,228)

 

(681)

 

4,334 

 

11,929 

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

14


 

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, 2013, 3,109 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, 2013, we had 121 full-time equivalent employees, compared to 140 at December 31, 2012.

 

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 2013, 65% of fourth graders in the United failed to achieve a “proficient” level in reading and 32% 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 critical resources 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.  Both of these programs were severely impacted by the federal sequestration that went into effect on March 1, 2013.  According to the National Education Association, sequestration was expected to reduce Title I funding by $740 million and IDEA special education funding by $645 million in the 2013-14 school year.  Approximately, 80% of the cuts to these programs were restored in the spending bill passed in January, 2014.  

 

We experienced a decline in revenue and booked sales in 2013 compared to 2012, which we believe resulted from continued budget pressures, on schools as well as a lower number of sales employees compared to the same period of 2012According to the Center on Budget and Policy Priorities, in the 2013-2014 school year, elementary and high schools in approximately 60% of the states are expected to receive more funding per student compared to the  prior school year.  However, education funding remains under pressure; in approximately 34 states school funding remains below 2008 levels. 

 

We believe our solutions will remain well-positioned for federal Title I, IDEA and competitive funding opportunities such as Race to the Top and School Improvement Grants, due to the continued emphasis on achievement mandates and education reform.

 

Company Highlights

 

Our total revenue decreased by 25% during 2013 compared to 2012.  Our total booked sales decreased 25% during 2013 compared to 2012.   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 28% compared to 2012. We believe that the decline in booked sales reflects continued budget pressures on schools, the effect of sequestration on K-12 spending trends 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 predominantly new field sales team.

 

The weak environment and concerns about federal funding  has also resulted in a lower average transaction value.  In 2013, we closed 17 transactions in excess of $100,000 compared to 25 transactions over $100,000 in 2012.

 

We offer our customers both subscription and perpetual license options in a number of pricing configurations.  Our goal is to increase our recurring revenue over time through a larger number of smaller and more predictable subscription transactions.  In 2013, subscription booked sales represented 36% of booked sales compared to 27% of total booked sales in the same period of 2012. 

 

K-12 booked sales decreased by 28% to $14.6 million in 2013 compared to 2012.  Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 13% to $3.5 million in 2013 compared to 2012 . We believe that the decline in booked sales primarily reflects continued budget pressures on schools including the effects of sequestration.

 

15


 

Cost of revenues decreased 37% in 2013 compared to 2012, primarily due to reduced headcount as a result of our fiscal year 2012 restructuring and lower levels of on-site training.  In addition, we have completed the amortization of purchased software and have lower royalty payments.

 

Operating expenses decreased by 27% in 2013, compared to 2012, which is due primarily to a reduction in headcount compared to 2012, lower sales commissions, consulting, audit and tax related expenses and restructuring costs, partly offset by a $4.6 million impairment of goodwill.  Excluding the goodwill impairment charge and restructuring costs in both years, operating expenses decreased by $11.7 million.

 

As a result of these expense reductions, we have reduced our operating loss during 2013 to $6.8 million from $11 million for 2012.  Excluding restructuring costs and goodwill impairment, our operating loss in 2013 would have been $2.0 million compared to $9.6 million in 2012.

 

During the fourth quarter of 2013, as part of our strategy to improve the efficiency of our development operations, and to better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented a plan to discontinue our development operations in China.  The effected plan included a reduction in our workforce and closure of our China office and legal entity.  We notified the employees affected by the workforce reduction on November 5, 2013.  We  expect to complete the exit plan by June 30, 2014.  During the fourth quarter of 2013, we incurred a $0.2 million restructuring charge in connection with this exit activity.  The charge included severance costs, contract termination costs and legal fees.  Substantially all of the costs were cash expenditures and were paid through December 31, 2013.

 

We dissolved our Puerto Rico subsidiary as of December 31, 2013.  This subsidiary did not have any employees during 2013 and had minimal operating expenses.   This dissolution did not have a material effect on our results of operations.

 

On March 21, 2014, we entered into a patent purchase agreement pursuant to which we sold seven U.S. patents.  See Note 19 to the consolidated financial statements for further discussion.

 

Results of Operations  

 

Revenues

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2013-2012

 

2012-2011

 

2013

 

2012

 

2011

 

% Change

 

% Change

Subscription

$

6,709 

 

$

4,524 

 

$

2,407 

 

48%

 

88%

License

 

3,011 

 

 

8,770 

 

 

20,002 

 

(66)%

 

(56)%

Service and support

 

11,342 

 

 

14,849 

 

 

18,670 

 

(24)%

 

(20)%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

$

21,062 

 

$

28,143 

 

$

41,079 

 

(25)%

 

(31)%

 

 

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

16


 

2013 versus 2012: Total revenue decreased by $7.1 million or 25% in 2013 compared to 2012.  Booked sales decreased by $6.1 million or 25%.  Subscription revenue increased by $2.2 million or 48% as we increased the number of subscription customers on our MySciLEARN platform.  License revenue declined $5.8 million or 66% due to the decline in booked sales and a smaller portion of customers purchasing perpetual licenses. Service and support revenue declined $3.5 million or 24% primarily due to a lower level of on-site services delivered compared to 2012, as on-site services are disproportionally related to large transactions.

 

For 2013, our K-12 renewal rate decreased to 83% compared to 93% in 2012, primarily due to weak economic conditions and a difficult back to school period in fall 2012.  Renewal rate is determined by dividing renewals sales, plus additions of services or licenses made at the same time to renewing customers, divided by support and subscription licenses available for renewal.  In 2013, we began reporting renewal rates on a dollar basis as it is a better representation of revenue potential.  Prior to 2013, we reported on a per site basis.  We believe the increasing sales of per student licenses which can be split between or combined in locations made a site- based metric less useful. 

 

2012 versus 2011: Total revenue declined $12.9 million or 31% in 2012 compared to 2011.  Booked sales for the same period declined $11.6 million or 32% for the same period.  Subscription revenue increased by $2.1 million or 88% compared to 2011 as we increased the number of subscription customers on our MySciLEARN platform.  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% from 87% in 2011, on a site basis. 

 

We continue to focus on increasing the percentage of recurring, predictable revenue.  In the second quarter of 2011, we launched SciLEARN On Demand, a fully cloud-based platform.  Hosted off-site by Scientific Learning, SciLEARN On Demand allows anytime, anywhere access to our Fast ForWord products. In the second quarter of 2012, we released Reading Assistant on the MySciLEARN platform.  As of December 31, 2013, the total number of active schools was 3,109 with 89% of those sites using the MySciLEARN version of Fast ForWord and/or Reading Assistant. Over time, we expect that the increased availability of the MySciLEARN platform will help increase the portion of our revenue that is recurring.

 

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,

 

2013-2012

 

2012-2011

 

 

2013

 

 

2012

 

 

2011

 

% Change

 

% Change

Total deferred revenue beginning of period

$

13,485 

 

$

17,322 

 

$

21,871 

 

(22)%

 

(21)%

Booked sales

 

18,162 

 

 

24,305 

 

 

35,950 

 

(25)%

 

(32)%

Less: revenue recognized

 

(21,062)

 

 

(28,143)

 

 

(41,079)

 

(25)%

 

(31)%

Adjustments

 

 -

 

 

 

 

580 

 

(100)%

 

(100)%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deferred revenue end of period

$

10,585 

 

$

13,485 

 

$

17,322 

 

(22)%

 

(22)%

 

2013 versus 2012: Booked sales declined 25% in 2013 compared to 2012.  Booked sales is primarily composed of sales to the K-12 sector which decreased by 28% to $14.6 million in 2013 compared to $20.2 million in 2012.  During 2013, reductions in federal spending due to sequestration more than offset slight improvements in state education budgets.  School districts elected to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs.  Booked sales to non-school customers decreased by 13% to $3.5 million in 2013 compared to 2012, primarily due to the termination of a large OEM contract and a change in contract terms with a significant licensee. Consumer and international sales increased in 2013 compared to 2012.

 

17


 

2012 versus 2011:  Booked sales declined 32% in 2012 compared to 2011.  Booked sales to the K-12 sector decreased by 35%  to $20.2 million in 2012 compared to $31.3 million in 2011. As described above, during 2012, 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 decreased by 13% to $4.1 million in 2012 as compared to 2011, primarily due to a change in contract terms with some of our international VARs.

 

Booked sales to the K-12 sector for 2013, 2012 and 2011 were 80%, 83% and 87%, 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 2011.

 

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 2013 and 2012, school districts struggled with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. In 2013, we closed 17 transactions in excess of $100,000 compared to 25 in 2012 and 63 in 2011. 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.

 

We continue to focus on increasing the percentage of subscription sales. In 2013, subscription booked sales increased 2% to $6.6 million. The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2013-2012

 

2012-2011

 

 

 

2013

 

 

2012

 

 

2011

 

% Change

 

% Change

Subscription booked sales

 

$

6,576 

 

$

6,449 

 

$

4,213 

 

2% 

 

53% 

Non-subscription booked sales

 

 

11,586 

 

 

17,856 

 

 

31,737 

 

(35)%

 

(44)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total booked sales

 

$

18,162 

 

$

24,305 

 

$

35,950 

 

(25)%

 

(32)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Subscription booked sales as a % of total booked sales

 

 

36% 

 

 

27% 

 

 

12% 

 

 

 

 

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

 

 

64% 

 

 

73% 

 

 

88% 

 

 

 

 

 

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 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. Although both federal and state budgets and education spending are expected to improve in 2014, there is no guarantee that these improvements will be reflected in our booked sales.

 

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.

 

 

 

 

 

 

 

 

 

 

18


 

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,

 

2013-2012

 

2012-2011

 

 

 

2013

 

 

2012

 

 

2011

 

% Change

 

% Change

Gross profit on subscriptions

 

$

5,462 

 

$

3,414 

 

$

1,794 

 

60% 

 

90% 

Gross profit on licenses

 

 

2,753 

 

 

7,796 

 

 

18,590 

 

(65)%

 

(58)%

Gross profit on service and support

 

 

7,938 

 

 

9,145 

 

 

10,007 

 

(13)%

 

(9)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit

 

$

16,153 

 

$

20,355 

 

$

30,391 

 

(21)%

 

(33)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit margin on subscriptions

 

 

81% 

 

 

75% 

 

 

75% 

 

 

 

 

Gross profit margin on licenses

 

 

91% 

 

 

89% 

 

 

93% 

 

 

 

 

Gross profit margin on service and support

 

 

70% 

 

 

62% 

 

 

54% 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit margin

 

 

77% 

 

 

72% 

 

 

74% 

 

 

 

 

 

2013 versus 2012: The overall gross profit margin increased by five percentage points in 2013 compared to 2012 due primarily to improved gross margins in each revenue category.

Gross profit on subscriptions increased by 60% in 2013 compared to 2012, commensurate with the 48% increase in subscription revenue.  The gross profit margin increased by six percentage points primarily due to the increase in subscription sales without a significant increase in variable spending.    

  

Gross profit on licenses decreased by 65% in 2013 compared to 2012, commensurate with the 66% decrease in license revenue.  The gross profit margin increased two percentage points primarily due to lower fixed costs, primarily of amortization of purchased software which declined.

 

Gross profit on service and support decreased by 13% in 2013 compared to 2012 primarily due to a 24% decline in service and support revenue during the year, mitigated by cost reductions as a result of a reduction of headcount as a part of our restructuring activities taken during the third quarter of 2012. The gross profit margin increased eight percentage points primarily due to the restructuring activities in 2012 and a lower proportion of onsite services which have a lower gross margin.

 

2012 versus 2011: The overall gross profit margin decreased by two percentage points 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 revenue.

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 four percentage points 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 eight percentage points primarily due to the restructuring activities in 2012.

 

 

 

 

 

19


 

Operating Expenses

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2013-2012

 

2012-2011

 

 

 

2013

 

 

2012

 

 

2011

 

% Change

 

% Change

Sales and marketing

 

$

9,105 

 

$

15,368 

 

$

17,979 

 

(41)%

 

(15)%

Research and development

 

 

3,778 

 

 

6,998 

 

 

10,324 

 

(46)%

 

(32)%

General and administrative

 

 

5,277 

 

 

7,549 

 

 

8,413 

 

(30)%

 

(10)%

Impairment of goodwill

 

 

4,568 

 

 

 -

 

 

 -

 

100% 

 

n/a

Restructuring

 

 

219 

 

 

1,462 

 

 

 -

 

(85)%

 

100% 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

22,947 

 

$

31,377 

 

$

36,716 

 

(27)%

 

(15)%

 

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 $6.3 million decrease in sales and marketing expenses in 2013 as compared to 2012 was mainly due to a reduction in headcount, a move to lower cost virtual marketing activities and lower commission and bonus expenses.  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.  At December 31, 2013, we had 32 quota-bearing sales personnel compared to 32 and 50 at December 31, 2012 and 2011, 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 $3.2 million in 2013 compared to 2012.  The decrease in research and development costs in 2013 compared to 2012 was primarily due to a reduction in headcount and lower spending on product development, as we have now released on demand versions of all our products.  Research and development expenses decreased by $3.3 million in 2012 compared to 2011, 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. 

 

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 $2.3 million decrease in general and administrative expenses in 2013 compared to 2012 was primarily due to a  reduction of headcount, lower spending in consulting, reduced audit and tax expenses, lower software maintenance costs, and lower depreciation.  General and administrative expenses decreased $0.9 million in 2012 as compared to 2011, primarily due to a  reduction of headcount, lower spending in consulting and lower stock compensation expense.

 

Impairment of goodwill:  As part of our annual impairment test during the fourth quarter of 2013, we concluded that there were sufficient adverse indicators that triggered a goodwill impairment analysis.  Among the indicators were (1) economic and budgetary challenges in our key K-12 market, (2) our continued transition from an on-premise, perpetual license model to a subscription driven, web-based SaaS business model and its short term impact on profitability, and (3) a significant decrease in our market capitalization as a result of a decrease in the trading price of our common stock during the fourth quarter of 2013.  As a result of this analysis, we estimated the implied fair value of goodwill and compared the estimate to the carrying amount.  The results of the analysis indicated that the carrying value exceeded the implied fair value of goodwill by approximately $5 million.  Based on this, we concluded that a goodwill impairment existed as of December 31, 2013.  During the fourth quarter of 2013, we wrote off the full goodwill balance in the amount of $4.6 million.     

 

Restructuring: During the fourth quarter of 2013, as part of our strategy to improve the efficiency of our development operations, better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented a plan to discontinue our development operations in China.  The effected plan included a reduction in our workforce and closure of our China office and legal entity.  We notified the employees affected by the workforce reduction on November 5, 2013.  We  expect to complete the exit plan by June 30, 2014.  During the fourth quarter of 2013, we incurred a $0.2 million restructuring charge in connection with this exit activity.  The charge included severance costs, contract termination costs and legal fees.  Substantially all of these costs were cash expenditures and were paid through December 31, 2013.

 

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

20


 

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, 2013, we have $0.1 million restructuring liability remaining.  

 

Other Income and Expenses 

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

2013-2012

 

2012-2011

 

 

 

2013

 

 

2012

 

 

2011

 

% Change

 

% Change

Change in fair value of warrants

 

$

737 

 

$

1,834 

 

$

 -

 

(60)%

 

100% 

Write off of long-term investment

 

 

 -

 

 

(200)

 

 

 -

 

100% 

 

(100)%

Accrued interest payment-in-kind

 

 

(426)

 

 

 -

 

 

 -

 

(100)%

 

n/a

Amortization of debt discount and debt issuance costs

 

 

(325)

 

 

 -

 

 

 -

 

(100)%

 

n/a

Interest and other income (expense), net

 

 

(27)

 

 

(74)

 

 

13 

 

(64)%

 

(669)%

Total interest and other income (expense), net

 

$

(41)

 

$

1,560 

 

$

13 

 

(103)%

 

11900% 

 

 

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 and April 5, 2013. 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 2013 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. 

 

Accrued payment-in-kind interest is the amount of principal and interest payable related to the subordinated debt financing completed on April 5, 2013.  From the issuance date through the first anniversary thereof, we accrue interest and increase the principal.  See Note 7 to the consolidated financial statements for further discussion.

 

Debt discount and debt issuance costs related to the subordinated debt issued on April 5, 2013, are being amortized to interest expense over the life of the debt.  In addition, we are amortizing the deferred debt issuance costs over the life of the debt.  See Note 7 to the consolidated financial statements for further discussion.

 

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  

 

2013: During 2013, we recorded an income tax benefit of approximately $0.6 million, and our valuation allowance increased by approximately $2.8 million.  The large benefit is attributable to the decrease of the deferred tax liability related to the impairment of goodwill during the fourth quarter of 2013.  We did not owe any federal income taxes due to our current and past taxable losses. The tax provision in 2013 resulted from minimum state and statutory foreign taxes. 

 

Our effective tax rate increased to 9.2% for fiscal year 2013 compared to (2.0%) for the same period a year ago.  The rate for 2013 was positive due to a large tax benefit recorded in the fourth quarter of 2013, related to the decrease of our deferred tax liability as it related to the impairment of goodwill.

 

As of December 31, 2013, we had U.S. federal and state net operating loss carryforwards of approximately $88.9 million and $37.1 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2014 through 2033 if not utilized.  State net operating loss carryforwards will expire at various dates beginning in 2014 through 2033. 

 

 

21


 

As of December 31, 2013, we had U.S. federal and state tax credit carryforwards of approximately $2.5 million and $3.5 million, respectively.  The federal credit will expire at various dates beginning in 2018 through 2033, if not utilized. California state research and development credits can be carried forward indefinitely.

 

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 resulted from minimum state and statutory foreign taxes. 

 

Our effective tax rate increased to (2.0)% for fiscal 2012 compared to (2.7%) for fiscal 2011.

 

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 2011 resulted from minimum state and statutory foreign taxes.

 

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 $2.6 million at December 31, 2013, compared to cash and cash equivalents of $2.3 million at December 31, 2012.  We have used cash from operations of $3.2 million, $10.5 million and $7.2 million in the years ended December 31, 2013, 2012 and 2011, respectively.   

 

During the next twelve months, we expect to continue to fund our operations primarily from our current cash balances, cash from our sale of patents completed on March 21, 2014 and the completion of additional financing activities.  On March 21, 2014, we completed the sale of patents to a third party.  See Note 19 to the consolidated financial statements for further discussion.  To obtain additional financing we are currently negotiating with banks to either amend our existing line of credit agreement with Comerica or to establish a new line of credit with a new bank to help fund our seasonal cash funding needs.  However, there can be no assurance that we can establish a line of credit on terms that are acceptable to us.  If we are unable to obtain additional financing, we may be unable to continue the development of our products and may have to cease operations. 

 

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 2014.  We expect that our cash balances, cash from our patent sale and the potential new line of credit that we anticipate completing will be sufficient to fund our operating requirements through the next twelve months. 

 

However, funding our operations in this manner will require us to achieve certain levels of booked sales and cash collections and maintain lower expenses. We cannot, 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, 2014.  Reducing expenses substantially below current levels 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. We may not be able to accomplish any of these alternatives. 

 

On April 5, 2013, we issued $4.6 million of subordinated debt securities and warrants to purchase an aggregate of 1,846,940 shares of our common stock, immediately exercisable at an exercise price initially equal to $1.03 per share, to a group of our current investors.  These notes issued pursuant to the subordinated note and warrant purchase agreement bear simple interest at a rate of 12% per annum.  From the issuance date through the first anniversary thereof, we will pay accrued and unpaid interest quarterly in arrears by increasing the principal amount of each note and thereafter will pay accrued and unpaid interest in cash in arrears on July 31, 2014, November 30, 2014 and the final payment date.  The notes mature on April 5, 2015.  The note and warrant purchase agreement contains customary affirmative and negative covenants, including notification and information covenants and covenants restricting our ability to merge or liquidate, incur debt, dispose of assets, incur liens, declare dividends or enter into transactions with affiliates.  The notes and warrant purchase agreements also require us to repay the notes upon the occurrence of a change of control (as defined in the note and warrant purchase agreement) at 101% of the principal amount thereof plus accrued and unpaid interest.

 

As of December 31, 2013, we had no borrowings outstanding on our line of credit with Comerica.  During the months ending January 31, 2013, February 28, 2013, May 31, 2013 and June 30, 2013 we were not in compliance with our line of credit covenants.  Comerica granted us waivers of the covenant violations for these periods. 

 

22


 

On August 9, 2013, we amended our line of credit with Comerica. In the amendment, Comerica agreed to waive past covenant violations and agreed not to measure compliance with the minimum bookings covenant until such time as we seek to borrow against the line of credit. As of December 31, 2013, we were in compliance with the covenants that are being measured by Comerica.  The amendment also requires that the financial covenants be renegotiated prior to us borrowing against the line of credit. 

 

At March 28, 2014, we are actively negotiating with banks to amend our existing line of credit or establish a new line of credit.  A new line of credit would require us to amend agreements with our subordinated debt holders. Should we fail to do this we may not have  a line of credit to draw upon.

 

We have used cash from operations of $3.2 million in 2013, a decrease from $10.5 million in 2012. Our cash used in operations has decreased in fiscal 2013 primarily due to the reduction of operating expenses as a result of our restructuring activities in 2012.  This was offset by our lower booked sales as compared to 2012, 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 2013 was $0.2 million compared to net used in investing activities of $0.6 million for 2012.  Net cash used in investing activities in 2013 and 2012 solely consisted of the purchases of property and equipment of $0.2 million and $0.6 million, respectively.

  

Net cash provided by financing activities for 2013 was $3.7 million due to $4.6 million from the issuance of subordinated debt in April 2013, offset by the pay down of our line of credit by $0.8 million.  Net cash provided by financing activities generated $7.5 million for 2012 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. 

 

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.  In addition, we lease certain equipment under capital lease arrangements that extend through 2014 for the amount of $25,000.

 

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.

 

The following table summarizes our obligations at December 31, 2013 and the effects such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2014

 

2015

 

2016

 

2017 and thereafter

 

Total

Contractual Obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Lease obligations

 

$

643 

 

$

624 

 

$

229 

 

$

155 

 

$

1,651 

Minimum royalty obligations

 

 

150 

 

 

 -

 

 

 -

 

 

 -

 

 

150 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

793 

 

$

624 

 

$

229 

 

$

155 

 

$

1,801 

 

 

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.

 

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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 are 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, 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.

 

Multiple-element arrangements—arrangements with software and nonsoftware elements

 

Booked sales may include a combination of software related and nonsoftware related products and services offerings including on-demand subscription services, perpetual software licenses, support, training, implementation management, and other professional services. In such arrangements, we first allocate the total arrangement consideration based on the relative selling prices of the software group of elements as a whole and to the nonsoftware elements. We then further allocate consideration within the software group to the respective elements within that group following the guidance in ASC 985-605 and our policies as described above. After the

24


 

arrangement consideration has been allocated to the elements, we account for each respective element in the arrangement as described above.

 

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 ratably over the term of the subscription period.

 

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.

 

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.

 

We evaluate the carrying value of goodwill for impairment annually and whenever events or changes in circumstances indicate that the carrying value of goodwill may exceed its fair value.  For the purposes of conducting our assessment, we have determined that there is a single reporting unit.  In assessing potential impairment, we estimate the fair value of the reporting unit and compare the  amount to the carrying value of the reporting unit.  If we determine that the carrying value of the reporting unit exceeds its fair value, an impairment charge is measured.

 

During the first three quarters of 2013, we concluded that there were sufficient adverse indicators to require an interim goodwill impairment analysis.  Among the indicators were (1) economic and budgetary challenges in our key K-12 market, (2) our continued transition from an on-premise, perpetual license model to a subscription driven, web-based SaaS business model and its short term impact on profitability, and (3) a significant decrease in our market capitalization as a result of a decrease in the trading price of our

25


 

common stock during the first three quarters of 2013.  As a result of this analysis, we estimated the implied fair value of its goodwill and compared the estimate to the carrying amount.  The result of the analysis for the first three quarters of 2013 indicated that a goodwill impairment did not exist as of  March 31, 2013, June 30, 2013 and September 30, 2013. 

 

As part of our annual impairment test during the fourth quarter of 2013, we considered whether the adverse indicators, noted above, continued to exist as of December 31, 2013.  We concluded that the adverse indicators continued to exist as of December 31, 2013, in addition to our stock price declining.  We further noted that there were no significant changes to its projections of future cash flows used to determine the implied fair value of goodwill.  As a result of the analysis, we estimated the implied fair value of our goodwill and compared the estimate to the carrying amount.  The results indicated that the carrying value exceeded the implied fair value of goodwill by approximately $5.0 million.  Based on this, we concluded that a goodwill impairment existed.  During the fourth quarter, we wrote off the full balance of goodwill in the amount of $4.6 million.

 

Income Taxes  

We account for income taxes using the asset and 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-Merton 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 2011 and 64% in 2012 to 84% in 2013. 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 8.5% in 2011 and 2012 to 11.6% in 2013, 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, 2013, we had an aggregate of $0.7 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: $0.3 million during 2014; $0.2 million during 2015; $0.1 million during 2016; and $0.05 million during 2017. These amounts reflect only outstanding stock awards as of December 31, 2013. 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, 2013, we capitalized approximately $0.2 million of software and website development costs. For the years ended December 31, 2012 and 2011, we capitalized approximately $0.4 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.

 

 

 

26


 

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.

 

Warrant Liability 

 

In connection with the Company’s private common stock offering that closed on March 28, 2012, we issued warrants (“PIPE warrants”) to purchase an aggregate of 2,505,852 shares of common stock.  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, as defined by the warrant agreement, occurs. 

 

In addition, in connection with our subordinated debt financing completed on April 5, 2013, we issued warrants (“Sub-debt warrants”) to purchase an aggregate of 1,846,940 shares of common stock.  The warrants have an exercise price of $1.03 per share and expire three years from the date of issuance. The warrants contain a cash settlement provision that may be triggered upon request by the warrant holders if we are acquired or in the event of a merger, as defined by the warrant agreement, 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, 2013 the estimated fair value of the PIPE warrants was $268,000 and is recorded as a liability on our consolidated balance sheets. For the year ended December 31, 2013, there was a decrease of $266,000 to the warrant liability which was recorded in interest and other income on our consolidated statement of operations.

 

On April 5, 2013, the initial estimated fair value of the Sub-debt warrants was approximately $698,000.  At December 31, 2013, the estimated fair value of the Sub-debt warrants was approximately $227,000 and is recorded as a liability on the Company’s consolidated balance sheet.  For the year ended December 31, 2013, there was a decrease of $471,000, 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.  As of December 31, 2013, all common stock warrants were outstanding.

 

Payment in-kind interest 

 

We accrue payment-in-kind interest.  It is the amount of principal and interest payable related to the subordinated debt financing completed on April 5, 2013.  From the issuance date through the first anniversary thereof, we accrue interest and increase the principal.  See Note 7 for further discussion.

 

Debt discount and debt issuance costs 

 

We have debt discount and debt issuance costs related to the subordinated debt issued on April 5, 2013.  These costs are being amortized to interest expense over the life of the debt.  In addition, we are amortizing the deferred debt issuance costs over the life of the debt.  See Note 7 to the consolidated financial statements for further discussion.

 

27


 

 

ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Report of Armanino LLP, Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of Scientific Learning Corporation

 

We have audited the accompanying consolidated balance sheet of Scientific Learning Corporation as of December 31, 2013, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity (deficit), and cash flows for the year  ended December 31, 2013. Our audit 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 audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures  that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness its 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 audit provides 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, 2013, and the consolidated results of its operations and its cash flows for the year ended December 31, 2013, 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/ Armanino LLP

 

San Ramon, California

March 28, 2014

 

 

 

 

 

 

28


 

Report of Ernst & Young LLP, Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of Scientific Learning Corporation

 

We have audited the accompanying consolidated balance sheet of Scientific Learning Corporation as of December 31, 2012, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity (deficit), and cash flows for each of the two 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 the consolidated results of its operations and its cash flows for each of the two 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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

29


 

 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

 

 

 

 

 

 

 

 

 

December 31, 2013

 

 

December 31, 2012

 

Assets

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

Cash and cash equivalents

$

2,638 

 

$

2,272 

 

Accounts receivable, net of allowance for doubtful accounts of $23 and $52, respectively

 

2,259 

 

 

2,446 

 

Prepaid expense and other current assets

 

630 

 

 

1,484 

 

Total current assets

 

5,527 

 

 

6,202 

 

 

 

 

 

 

 

 

Property and equipment, net

 

936 

 

 

2,028 

 

Goodwill

 

 -

 

 

4,568 

 

Other assets

 

652 

 

 

260 

 

Total assets

$

7,115 

 

$

13,058 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ deficit

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

Accounts payable

$

294 

 

$

715 

 

Accrued liabilities

 

1,760 

 

 

1,981 

 

Loan payable

 

 -

 

 

800 

 

Deferred revenue, short-term

 

9,703 

 

 

10,964 

 

Total current liabilities

 

11,757 

 

 

14,460 

 

Deferred revenue, long-term

 

882 

 

 

2,521 

 

Long-term debt

 

4,608 

 

 

 -

 

Warrant liability

 

495 

 

 

534 

 

Other liabilities

 

 

 

771 

 

Total liabilities

 

17,750 

 

 

18,286 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders' deficit:

 

 

 

 

 

 

Common stock $0.001 par value: 40,000,000 authorized, 23,873,705 and 23,442,837 shares issued and outstanding at December 31, 2013 and 2012, respectively, and additional paid-in capital

 

96,642 

 

 

95,839 

 

Accumulated deficit

 

(107,273)

 

 

(101,069)

 

Accumulated other comprehensive income (loss)

 

(4)

 

 

 

Total stockholders' deficit

 

(10,635)

 

 

(5,228)

 

 

 

 

 

 

 

 

Total liabilities and stockholders' deficit

$

7,115 

 

$

13,058 

 

 

 

See accompanying notes to audited consolidated financial statements.

30


 

 

 

 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

 

 

2013

 

 

2012

 

 

2011

 

Revenues:

 

 

 

 

 

 

 

 

 

Subscription

$

6,709 

 

$

4,524 

 

$

2,407 

 

License

 

3,011 

 

 

8,770 

 

 

20,002 

 

Service and support

 

11,342 

 

 

14,849 

 

 

18,670 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

21,062 

 

 

28,143 

 

 

41,079 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

Cost of subscription

 

1,247 

 

 

1,110 

 

 

613 

 

Cost of license

 

258 

 

 

974 

 

 

1,412 

 

Cost of service and support

 

3,404 

 

 

5,704 

 

 

8,663 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenues

 

4,909 

 

 

7,788 

 

 

10,688 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

16,153 

 

 

20,355 

 

 

30,391 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

9,105 

 

 

15,368 

 

 

17,979 

 

Research and development

 

3,778 

 

 

6,998 

 

 

10,324 

 

General and administrative

 

5,277 

 

 

7,549 

 

 

8,413 

 

Impairment of goodwill

 

4,568 

 

 

 -

 

 

 -

 

Restructuring

 

219 

 

 

1,462 

 

 

 -

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

22,947 

 

 

31,377 

 

 

36,716