S-1 1 w35617sv1.htm FORM S-1 K12 INC. sv1
 

 
As filed with the Securities and Exchange Commission on July 26, 2007
Registration No. 333-          
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
 
 
 
 
K12 INC.
(Exact name of registrant as specified in its charter)
         
Delaware
  8211   95-4774688
(State or Other Jurisdiction of
Incorporation or Organization)
  (Primary Standard Industrial
Classification Number)
  (IRS Employer
Identification No.)
 
 
 
 
K12 Inc.
2300 Corporate Park Drive
Herndon, VA 20171
(703) 483-7000
(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)
 
 
 
 
Ronald J. Packard
Chief Executive Officer
K12 Inc.
2300 Corporate Park Drive
Herndon, VA 20171
(703) 483-7000
(Name, address, including zip code, and telephone number, including area code, of agent for service)
 
 
 
 
Copies to:
         
         
William P. O’Neill, Esq.    Howard D. Polsky, Esq.   Richard D. Truesdell, Jr., Esq.
Latham & Watkins LLP   Senior Vice President, General Counsel and Secretary   Davis Polk & Wardwell
555 Eleventh Street, N.W   K12 Inc.   450 Lexington Avenue
Washington, D.C. 20004   2300 Corporate Park Drive   New York, NY 10017
(202) 637-2200   Herndon, VA 20171   (212) 450-4674
    (703) 483-7000    
 
 
 
 
Approximate date of commencement of proposed sale to the public:  As soon as practicable after the effective date of this registration statement.
 
If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  o
 
If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
 
 
 
CALCULATION OF REGISTRATION FEE
 
             
Title of Each Class of
    Proposed Maximum
    Amount of
Securities to be Registered     Aggregate Offering Price(a)(b)     Registration Fee
Common stock, $0.0001 par value     $172,500,000     $5,296
             
 
(a) Estimated solely for the purpose of calculating the registration fee in accordance with Rule 457(o) promulgated under the Securities Act of 1933.
(b) Including shares of common stock which may be purchased by the underwriters to cover overallotments, if any.
 
The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.
 


 

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and we are not soliciting offers to buy these securities in any state or jurisdiction where the offer or sale is not permitted.
 
 
PROSPECTUS (Subject to Completion)
Issued July 26, 2007
 
           Shares
 
(k12 LOG)
K12 INC.
 
Common Stock
 
 
 
 
K12 Inc. is offering           shares of its common stock and the selling stockholders are offering           shares of common stock. We will not receive any proceeds from the sale of shares by the selling stockholders. This is our initial public offering and no public market exists for our shares. We anticipate that the initial public offering price will be between $      and $      per share.
 
 
Investing in our common stock involves risks.  See “Risk Factors” beginning on page 10 to read about factors you should consider before buying shares of our common stock.
 
 
 
 
We intend to apply to list our common stock on the New York Stock Exchange under the symbol “LRN.”
 
 
 
 
                                 
          Underwriting
          Proceeds to
 
          Discounts and
    Proceeds to
    Selling
 
    Price to Public     Commissions     K12 Inc.     Stockholders  
 
Per Share
  $             $             $             $          
Total
  $       $       $       $  
 
The underwriters may also purchase up to an additional        shares of common stock from the selling stockholders at the public offering price, less the underwriting discount within 30 days from the date of this prospectus to cover over allotments, if any.
 
 
 
 
Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.
 
The underwriters expect to deliver the shares of common stock to purchasers on or about          , 2007.
 
Morgan Stanley Credit Suisse
 
          , 2007


 

 
[INSIDE FRONT COVER]
 


 

TABLE OF CONTENTS
 
         
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  F-1
 
 
You should rely only on the information contained in this prospectus. We and the underwriters have not authorized anyone to provide you with different or additional information. This prospectus is not an offer to sell or a solicitation of an offer to buy our common stock in any jurisdiction where it is unlawful to do so. The information contained in this prospectus is accurate only as of its date, regardless of the date of delivery of this prospectus or of any sale of our common stock.
 
Until and including          , 2007, 25 days after the commencement of this offering, all dealers that affect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.


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PROSPECTUS SUMMARY
 
This summary highlights selected information contained elsewhere in this prospectus and does not contain all of the information you should consider in making your investment decision. You should read the following summary together with the more detailed information regarding us and our common stock being sold in the offering, including the risks of investing in our common stock discussed under “Risk Factors” beginning on page 10 and our consolidated financial statements and the related notes appearing elsewhere in this prospectus, before making an investment decision. For convenience in this prospectus, “the Company,” “K12,” “K12,” “we,” “us,” and “our” refer to K12 Inc. and its subsidiaries, taken as a whole. References to fiscal years refer to the fiscal year ended June 30 of the year indicated.
 
K12 Inc.
 
Our Company
 
We are a technology-based education company. We offer proprietary curriculum, software and educational services created for online delivery to students in kindergarten through 12th grade, or K-12. Our mission is to maximize a child’s potential by providing access to an engaging and effective education, regardless of geographic location or socio-economic background. Since our inception, we have invested more than $95 million to develop curriculum and an online learning platform that promotes mastery of core concepts and skills for students of all abilities. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for a virtual school and other educational applications. From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from approximately 11,000 students to 27,000 students, representing a compound annual growth rate of approximately 35%. From fiscal year 2004 to fiscal year 2006, we increased revenues from $71.4 million to $116.9 million, representing a compound annual growth rate of approximately 28%.
 
We believe we are unique in the education industry because of our direct involvement in every component of the educational development and delivery process. Most educational content, software and service providers typically concentrate on only a portion of that process, such as publishing textbooks, managing schools or providing testing and assessment services. This traditional segmented approach has resulted in an uncoordinated and unsatisfactory education for many students. Unburdened by legacy, we have taken a holistic approach to the design of our learning system. We have developed an engaging curriculum which includes online lessons delivered over our proprietary school platform. We combine this with a rigorous system to test and assess students and processes to manage school performance and compliance. In addition, our professional development programs enable teachers to better utilize technology for instruction. Our end-to-end learning system is designed to optimize the performance of the schools we serve and enhance student academic achievement.
 
As evidence of the benefit of our holistic approach, the virtual public schools we serve generally test near or above state averages on standardized achievement tests. These results have been achieved despite the enrollment of a significant number of new students each school year who have had limited exposure to our learning system prior to taking these required state tests. Students using our learning system for at least three years usually perform better on standardized tests relative to state averages than students using it for one year or less. The efficacy of our learning system has also helped us achieve high levels of customer satisfaction. According to a 2006 internal survey of parents of students enrolled in virtual public schools we serve, approximately 97% of respondents stated that they were either satisfied or very satisfied with our curriculum and 95% of respondents stated that they would recommend our curriculum to other families.
 
We deliver our learning system to students primarily through virtual public schools. As with any public school, these schools must meet state educational standards, administer proctored exams and are subject to fiscal oversight. The fundamental difference is that students attend virtual public schools primarily over the Internet instead of traveling to a physical classroom. In their online learning environment, students receive assignments, complete lessons, and obtain instruction from certified teachers with whom they interact online, telephonically, and face-to-face. Many states have embraced virtual public schools as a means to provide families with a publicly funded alternative to a traditional classroom-based education. For parents who believe their child is not thriving and for


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whom relocating or private school is not an option, virtual public schools can provide a compelling choice. This widespread availability makes them the “most public” of schools. From an education policy standpoint, virtual public schools often represent a savings to the taxpayers when compared with traditional public schools because they are generally funded at a lower per pupil level than the per pupil state average reported by the U.S. Department of Education. Finally, because parents are not required to pay tuition, virtual public schools make our learning system available to the broadest range of students.
 
We offer virtual schools our proprietary curriculum, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions, under long-term contracts. These contracts provide the basis for a recurring revenue stream as students progress through successive grades. Additionally, without the requirement of a physical classroom, virtual schools can be scaled quickly to accommodate a large dispersed student population, and allow more capital resources to be allocated towards teaching, curriculum and technology rather than towards a physical infrastructure.
 
Our proprietary curriculum is currently used by public school students in 16 states and the District of Columbia. Parents can also purchase our curriculum and online learning platform directly to facilitate or supplement their children’s education. Additionally, we have piloted our curriculum in brick and mortar classrooms with promising academic results. We also believe there is additional widespread applicability for our learning system internationally.
 
Families that choose our learning system for their children come from a broad range of social, economic and academic backgrounds. They share, however, the desire for an individualized learning program to maximize their children’s potential. Examples include, but are not limited to, families with: (i) students seeking to learn faster or slower than they could in a “one size fits all” traditional classroom; (ii) safety concerns about their local school; (iii) students with disabilities for which traditional classrooms are problematic; (iv) students with geographic or travel constraints; and (v) student athletes and performers who are not able to attend regularly scheduled classes. Our individualized learning approach allows students to optimize their individual academic performance and, therefore, their chances of achieving their goals.
 
Our Market
 
The U.S. market for K-12 education is large and growing. For example:
 
  •  According to the National Center for Education Statistics (NCES), a division of the U.S. Department of Education, there were more than 47 million students in K-12 public schools during the 2005-06 school year. In addition, according to National Home Education Research, approximately two million students are home schooled and, according to a March 2006 NCES report, approximately five million students are enrolled in private schools.
 
  •  According to the NCES, the public school system alone encompassed more than 97,000 schools and 17,000 school districts during the 2005-06 school year.
 
  •  According to the NCES, total spending in the public K-12 market was $536 billion for the 2004-05 school year.
 
Parents and lawmakers are demanding increased standards and accountability in an effort to improve academic performance in U.S. public schools. As a result, each state is now required to establish performance standards and to regularly assess student progress relative to these standards. We expect continued focus on academic standards, assessments and accountability in the near future.
 
Many parents and educators are also seeking alternatives to traditional classroom-based education that can help improve academic achievement. Demand for these alternatives is evident in the growing number of choices available to parents and students. For example, charter schools emerged in 1988 to provide an alternative to traditional public schools. Currently, 40 states and the District of Columbia have passed charter school legislation and there are approximately 4,000 charter schools in the U.S. with an estimated enrollment of over 1.1 million students according to the Center for Education Reform. Similarly, acceptance of online education as an effective, alternative form of education is growing. As of September 2006, 38 states had authorized some form of online


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education, and Michigan recently became the first state to pass legislation mandating that high school students take part in an “online learning experience” in order to graduate.
 
Virtual public schools represent another approach to online education that is gaining acceptance. According to the Center for Education Reform, as of January 2007 there were 173 virtual schools with total enrollment exceeding 92,000 students, operating in 18 states. Virtual schools can offer a comprehensive curriculum and flexible delivery model; therefore, we believe that a growing number of families will pursue virtual public schools as an attractive public school alternative. Given these statistics and the nascence of this market, we believe there is a significant opportunity for a high-quality, trusted, national education provider to serve virtual public schools.
 
Our Competitive Strengths
 
We believe the following to be our key competitive strengths:
 
Proprietary Curriculum Specifically Designed for a Technology-Enabled Environment.  We specifically designed our curriculum for online learning, in contrast to other online curriculum providers who often just digitize classroom textbooks for transmission over the Internet. Our lessons utilize a combination of innovative technologies, including flash animations, online interactivity and real-time individualized feedback, which we combine with textbooks and other offline course materials to create an engaging and highly effective curriculum. Our curriculum contains more than 11,000 discrete lessons, each of which addresses specific learning objectives and can be utilized in the manner most appropriate for each student. We continuously measure student performance and use this information to improve our curriculum and drive greater, more consistent academic achievement, a valuable competitive advantage we enjoy by virtue of our integration into all aspects of the educational development and delivery process. We believe our curriculum is the most advanced cognitive research-based curriculum in K-12 education.
 
Flexible, Integrated Online Learning Platform.  Our online learning platform provides a highly flexible and effective means for delivering educational content to students. Our platform offers assessment capabilities to identify the current and targeted academic level of achievement for each individual student, and then incorporates this information into a detailed lesson plan. As students progress through their studies, our learning platform measures mastery of each learning objective to ensure that students grasp each concept prior to proceeding to the next lesson. Additionally, our learning platform updates each student’s lesson plan for completed lessons and enables us to track the effectiveness of each lesson with each student on a real-time basis. Finally, the fact that our learning system is Internet-based allows us to update our proprietary content and incorporate user feedback on a real-time basis. For example, our content for the 2006-07 school year reflected the fact that Pluto is no longer considered a planet, which was announced in August 2006.
 
Expertise in Opening Channels for Virtual Schooling.  Our education policy experts and established relationships with key educational authorities have allowed us to participate effectively in advocating for virtual public schools. Specifically, we have demonstrated our expertise in helping individual educational policymakers understand the benefits of virtual schools and in managing the regulatory requirements once new virtual schools are opened. Since our inception, we have partnered with individual state governing bodies to establish highly effective, publicly funded education alternatives for parents and their children. Our experience in opening up these new channels gives us a valuable first-mover advantage over potential competitors.
 
Track Record of Student Achievement and Customer Satisfaction.  The virtual public schools we serve generally test near or above state averages on standardized achievement tests. These results have been achieved despite the enrollment of a significant number of new students each school year who have had limited exposure to our learning system prior to taking these required state tests. Students using our learning system for at least three years usually perform better on standardized tests relative to state averages than students using it for one year or less. A comprehensive analysis of individual student progression conducted during the 2006-07 school year in Ohio, the first state to conduct such an analysis, concluded that a virtual public school using our learning system outperformed 97% and 60% of participating public schools in reading and mathematics, respectively. Additionally, in California, the only state to adjust standardized test scores for student demographics, the virtual public schools we serve performed in the 70th to 90th percentile of all public schools in the state during the 2005-06 school year. Among statewide virtual public schools, those using the K12 learning system outperform other providers in terms of


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academic performance. The efficacy of our learning system has also helped us achieve high levels of customer satisfaction. According to a 2006 internal survey of parents of students enrolled in virtual public schools we serve, approximately 97% of respondents stated that they were either satisfied or very satisfied with our curriculum and 95% of respondents stated that they would recommend our curriculum to other families. This high degree of customer satisfaction has been a strong contributor to our growth, helps drive new student referrals and leads to re-enrollments.
 
Highly Scalable Model.  We have built our educational model, systems and management team to successfully and efficiently serve the academic needs of a large dispersed student population. We generate high levels of recurring revenue as a result of our long-term contracts with schools (typically five years in length), the extended duration over which an individual student can utilize our learning system (kindergarten through 12th grade) and our high level of customer satisfaction. Since our inception, we have invested over $95 million to develop our learning system, incurring significant losses. Our ability to leverage this historical investment in our learning system and our ability to deliver our offering over the Internet enables us to successfully serve a greater number of students at a reduced level of capital investment.
 
Our Growth Strategy
 
We intend to pursue the following strategies to drive our future growth:
 
Generate Enrollment Growth at Existing Virtual Public Schools.  From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from more than 11,000 students to more than 27,000 students. In the 2007-08 school year, we will serve virtual public schools in 16 states and the District of Columbia. We intend to continue to drive increased enrollments at the virtual public schools we serve through targeted marketing and recruiting efforts as well as through referrals. Our marketing and recruiting efforts utilize both traditional and online media as well as community events to communicate the effectiveness of our solution to parents who are evaluating educational alternatives for their children. Historically, we have also enrolled a significant number of new students each year through referrals from families who have had a positive experience with our learning system and recommended K12 to their friends and family members.
 
Enhance Curriculum to Include a Complete High School Offering.  We believe the high school market represents a significant growth opportunity for online education delivery given the increased independence of high school students and the wide variance in academic achievement levels and objectives of students who are entering high school. America’s Digital Schools 2006, a survey conducted by Discovery Education and Pearson Education, projects that the percentage of U.S. high school students enrolled in online courses will increase from 3.8% in 2006 to 15.6% in 2011. We believe that our market-leading position in the K-8 virtual public schools positions us well for growth in the high school market. In the 2005-06 and 2006-07 school years, we began enrolling 9th and 10th grade students, respectively, and with the planned launch of our 11th and 12th grades in the 2007-08 school year, we will be able to provide a complete high school offering. We are developing our high school curriculum to satisfy the broad range of high school student interests with a broad variety of required and elective courses, supplemented by selected courses from other content providers.
 
Expand Virtual Public School Presence into Additional States.  We work closely with state policymakers and school districts to assist them in considering virtual public schools as an effective educational choice for parents and students. A virtual public school program can help state administrations or school districts quickly establish and offer an alternative to traditional classroom-based education, expanding the range of choices available to parents and students. The flexibility and comprehensiveness of our learning system allows us to efficiently adapt our curriculum to meet the individual educational standards of any state with minimal capital investment. We intend to continue to seek opportunities to assist states in establishing virtual public schools and to contract with them to provide our curriculum, online learning platform and related services.
 
Strengthen Awareness and Recognition of the K12 Brand.  Within the virtual public school community, we enjoy strong brand recognition among parents and students as a leading provider of virtual education. Outside of this community, however, the K12 brand is not as well recognized. We have developed a comprehensive brand strategy and intend to invest in further developing awareness of both the K12 brand and the core philosophy behind our learning system. The recent launch of our “Unleash the xPotential” campaign is a strong first step towards this


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goal of creating broader brand awareness. We believe that a strong and recognized brand will result in an increased presence among virtual public schools, attract more student applications and facilitate our entry into adjacent markets.
 
Pursue International Opportunities to Offer Our Learning System.  We believe there is strong worldwide demand for high-quality, flexible education alternatives. In many countries, students seek a U.S. accredited education to gain access to higher education and improved employment opportunities. Given the highly flexible design and technology-based nature of our platform, it can be adapted to other languages and cultures efficiently and with modest capital investment. Additionally, our ability to operate virtually is not constrained by the need for a physical classroom or local teachers, which makes our learning system ideal for use internationally.
 
Develop Additional Channels Through Which to Deliver our Learning System.  We believe there are many additional channels through which the K12 learning system can be offered. These include direct classroom instruction, hybrid models, and as a supplemental educational offering. For example, in an urban public school in Philadelphia, we piloted our K-5 curriculum in traditional classrooms and were able to generate meaningful improvements in academic performance. Additionally, we have recently implemented a hybrid offering in Chicago that combines face-to-face time in the classroom with online instruction. Outside the public school channels, the flexibility of our learning system enables us to package lessons to be sold as individual products directly to parents and students. We intend to regularly evaluate additional delivery channels and to pursue opportunities where we believe there is likely to be significant demand for our offering.
 
Certain Risk Factors
 
Investing in our common stock involves substantial risk. You should carefully consider all the information in this prospectus prior to investing in our common stock and review the section entitled “Risk Factors” immediately following this prospectus summary. These risks and uncertainties include, but are not limited to, the following:
 
  •  Most of our revenues depend on adequate funding of the virtual public schools we serve. If our revenues from virtual public schools are reduced, restricted or delayed, our business, financial condition, results of operations and cash flows will be adversely affected.
 
  •  The poor performance or misconduct of other virtual public school operators could tarnish the reputation of all virtual public school operators, which could have a negative influence on our business.
 
  •  Opponents of virtual public schools have sought to challenge the establishment and expansion of such schools through the judicial process. If their interests prevail, it could damage our ability to sustain or grow our current business in certain jurisdictions.
 
  •  We have a limited operating history, and sustained losses of approximately $90 million before only recently achieving profitability. If we fail to remain profitable or achieve further marketplace acceptance for our products and services, our business, financial condition and results of operations will be adversely affected.
 
  •  Highly qualified teachers are critical to the success of our learning system. If we are not able to continue to recruit, train and retain quality certified teachers, our lessons might not be effectively delivered to students, compromising their academic performance and our reputation with the virtual public schools we serve. As a result, our brand, business and operating results may be adversely affected.
 
Our Corporate Information
 
We were incorporated in Delaware in December 1999. Our principal executive offices are located at 2300 Corporate Park Drive, Herndon, VA 20171. Our telephone number is (703) 483-7000. Our website address is www.K12.com. These are textual references only. We do not incorporate the information on, or accessible through, any of our websites into this prospectus, and you should not consider any information on, or that can be accessed through, our websites as part of this prospectus.


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The Offering
         
         
Common Stock offered by us
             shares
Common Stock offered by selling stockholders
      shares
         
Total
      shares
         
Common Stock outstanding after the offering
      shares
Overallotment option
      shares
 
Proposed New York Stock Exchange symbol “LRN”
 
Use of proceeds from this offering We estimate that our net proceeds from this offering will be approximately $      million, based on an assumed initial public offering price of $      per share (which is the midpoint of the range on the cover page of this prospectus). We intend to use the net proceeds from this offering for general corporate purposes, including working capital, capital expenditures and the development of new courses and product offerings as well as to repay approximately $6.5 million indebtedness under our revolving credit facility. We will receive no proceeds from the sale of common stock by the selling stockholders. See “Use of Proceeds.”
 
The number of shares of common stock outstanding after this offering is based on 111,589,989 shares outstanding as of March 31, 2007 and:
 
  •  gives effect to the automatic conversion of all of the outstanding shares of our preferred stock into 101,386,536 shares of our common stock immediately prior to the completion of this offering; and
 
  •  excludes 18,450,344 shares of common stock issuable upon the exercise of options outstanding as of March 31, 2007 at a weighted average exercise price of $1.41 per share, 2,328,358 shares of preferred stock (or upon the consummation of the offering an equivalent amount of common stock) that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are currently exercisable at a purchase price of $1.34 per share, and 108,649 shares of common stock that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are exercisable at a purchase price of $1.60 per share.
 
Except as otherwise indicated, all information contained in this prospectus assumes:
 
  •  a           for           stock split of our common stock to be effected prior to completion of this offering;
 
  •  an initial offering price of $      per share (which is the midpoint of the range on the cover page of this prospectus); and
 
  •  the underwriters’ option to purchase up to           additional shares of common stock is not exercised.


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SUMMARY CONSOLIDATED FINANCIAL DATA
 
We derived the summary consolidated financial data presented below as of June 30, 2005 and 2006 and for each of the three years ended June 30, 2004, 2005 and 2006, from our audited consolidated financial statements included elsewhere in this prospectus. We have derived our summary consolidated balance sheet data as of June 30, 2004 from our audited consolidated financial statements that are not included this prospectus. We have derived our consolidated statement of operations data for the nine months ended March 31, 2006 and 2007 and consolidated balance sheet data as of March 31, 2007 from our unaudited consolidated financial statements. Our historical results are not necessarily indicative of future operating results. You should read the information set forth below in conjunction with “Selected Consolidated Financial and Operating Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and their related notes included elsewhere in this prospectus.
 
                                         
          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2004     2005     2006     2006     2007  
    (dollars in thousands, except per share data)  
 
Consolidated Statement of Operations Data:
                                       
Revenues
  $ 71,434     $ 85,310     $ 116,902     $ 90,088     $ 104,930  
Cost and expenses:
                                       
Instructional costs and services
    39,943       49,130       64,828       48,473       55,103  
Selling, administrative, and other operating expenses
    25,656       30,031       41,660       28,403       35,059  
Product development expenses
    12,750       9,410       8,568       5,587       5,855  
                                         
Total costs and expenses
    78,349       88,571       115,056       82,463       96,017  
                                         
Income (loss) from operations
    (6,915 )     (3,261 )     1,846       7,625       8,913  
Interest expense, net
    (516 )     (279 )     (488 )     (394 )     (474 )
                                         
Net income (loss) before income taxes
    (7,431 )     (3,540 )     1,358       7,231       8,439  
Income tax expense
                            (227 )
                                         
Net income (loss)
    (7,431 )     (3,540 )     1,358       7,231       8,212  
Dividends on preferred stock
    (2,667 )     (5,261 )     (5,851 )     (4,333 )     (4,707 )
Preferred stock accretion
    (15,768 )     (15,947 )     (18,697 )     (13,880 )     (16,544 )
                                         
Net loss attributable to common stockholders
  $ (25,866 )   $ (24,748 )   $ (23,190 )   $ (10,982 )   $ (13,039 )
                                         
Net loss attributable to common stockholders per share:
                                       
Basic and diluted
  $ (2.58 )   $ (2.46 )   $ (2.30 )   $ (1.09 )   $ (1.28 )
Basic and diluted (pro forma)(1)
    n/a       n/a     $ 0.01       n/a     $ 0.07  
Weighted average shares used in computing per share amounts:
                                       
Basic and diluted
    10,017,162       10,062,587       10,083,721       10,081,180       10,195,440  
Basic (pro forma)(1)
    n/a       n/a       106,937,388       n/a       111,581,976  
Diluted (pro forma)(1)
    n/a       n/a       107,055,314       n/a       111,621,446  


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          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2004     2005     2006     2006     2007  
    (dollars in thousands)  
 
Other Data:
                                       
Net cash provided by (used in) operating activities
  $ (8,020 )   $ 9,697     $ 3,625     $ 1,137     $ 7,324  
Depreciation and amortization
  $ 4,922     $ 5,509     $ 4,986     $ 3,574     $ 4,618  
Capital expenditures(2)
  $ 4,643     $ 5,133     $ 10,842     $ 6,509     $ 10,350  
EBITDA(3)
  $ (1,993 )   $ 2,248     $ 6,832     $ 11,199     $ 13,531  
Average enrollments(4)
    11,158       15,097       20,220       20,183       27,297  
 
                                 
                      As of
 
    As of June 30,     March 31,
 
    2004     2005     2006     2007  
    (dollars in thousands)  
 
Consolidated Balance Sheet Data:
                               
Cash and cash equivalents
  $ 15,881     $ 19,953     $ 9,475     $ 5,147  
Total assets
    42,714       41,968       48,485       64,001  
Total short-term debt
                      1,500  
Total long-term obligations
    3,432       4,466       4,025       6,112  
Convertible redeemable preferred stock
    155,069       176,277       200,825       222,076  
Total stockholders’ deficit
    (125,621 )     (150,299 )     (173,451 )     (186,390 )
Working capital
    24,130       22,953       15,421       14,617  
 
 
(1) Pro forma net income per common share gives effect to the automatic conversion of all of our outstanding shares of preferred stock into common stock immediately prior to the completion to this offering. Assuming the completion of this offering on March 31, 2007 and June 30, 2006, all of our outstanding shares of preferred stock would convert into 101,386,536 and 96,853,667 shares of common stock respectively.
(2) Capital expenditures consist of the purchase of property and equipment and new capital lease obligations.
(3) EBITDA consists of net income (loss) minus interest income, plus interest expense, plus income tax expense and plus depreciation and amortization. Interest income consists primarily of interest earned on short-term investments or cash deposits. Interest expense primarily consists of interest expense for capital leases, long-term and short-term borrowings. We use EBITDA as a measure of operating performance. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles, or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, net income (loss) as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management’s discretionary use, as it does not consider certain cash requirements such as tax payments.
 
  We believe EBITDA is useful to an investor in evaluating our operating performance because it is widely used to measure a company’s operating performance without regard to items such as depreciation and amortization, which can vary depending upon accounting methods and the book value of assets, and to present a meaningful measure of corporate performance exclusive of our capital structure and the method by which assets were acquired.
 
Our management uses EBITDA:
 
  •  as a measurement of operating performance, because it assists us in comparing our performance on a consistent basis, as it removes depreciation, amortization, interest and taxes; and

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  •  in presentations to the members of our board of directors to enable our board to have the same measurement basis of operating performance as is used by management to compare our current operating results with corresponding prior periods and with the results of other companies in our industry.
 
The following table provides a reconciliation of net income (loss) to EBITDA:
 
                                         
          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2004     2005     2006     2006     2007  
    (dollars in thousands)  
 
Net income (loss)
  $ (7,431 )   $ (3,540 )   $ 1,358     $ 7,231     $ 8,212  
Interest expense, net
    516       279       488       394       474  
Income tax expense
                            227  
Depreciation and amortization
    4,922       5,509       4,986       3,574       4,618  
                                         
EBITDA
  $ (1,993 )   $ 2,248     $ 6,832     $ 11,199     $ 13,531  
                                         
 
(4) To ensure that all schools are reflected in our measure of enrollments, we consider our enrollments as of the end of September to be our opening enrollment level, and the number of students enrolled at the end of May to be our ending enrollment level. To provide comparability, we do not consider enrollment levels for June, July and August as all schools are not open during these months. For each period, average enrollments represent the average of the month end enrollment levels for each month that has transpired between September and the end of the period, up to and including the month of May.


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RISK FACTORS
 
Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus, including our consolidated financial statements and the related notes, before investing in our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, also may become important factors that affect us. If any of the following risks materialize, our business, financial condition or results of operations could be materially harmed. In that case, the trading price of our common stock could decline, and you may lose some or all of your investment.
 
Risks Related to Government Funding and Regulation of Public Education
 
Most of our revenues depend on adequate funding of the virtual public schools we serve. If these schools do not receive adequate funding, our revenues could be reduced, restricted or delayed and our business, financial condition, results of operations and cash flows would be adversely affected.
 
The public schools we contract with are financed with government funding from federal, state and local taxpayers. Our business is primarily dependent upon those funds. Budget appropriations for education at all levels of government are determined through the political process and, as a result, funding for virtual public schools may fluctuate. This political process creates a number of risks that could have an adverse affect on our business including the following:
 
  •  legislative proposals could result in budget cuts for the virtual public schools we serve, and therefore reduce or eliminate the products and services those schools purchase from us, causing our revenues to decline. From time to time, proposals are introduced in state legislatures that single out virtual public schools for disparate treatment. For example, in its FY 2007-09 education budget appropriation, the Indiana legislature decided not to fund any virtual public school if it provided for the online delivery of more than 50 percent of its instruction to students. Other examples include laws that decrease per pupil funding for virtual public schools or alter eligibility and attendance criteria or other funding conditions that could decrease our revenues and limit our ability to grow;
 
  •  as a public company, we will be required to file periodic financial and other disclosure reports with the Securities and Exchange Commission, or the SEC. This information may be referenced in the legislative process, including budgetary considerations, related to the funding of alternative public school options, including virtual public schools. The disclosure of this information by a for-profit education company, regardless of parent satisfaction and student academic achievement, may nonetheless be used by opponents of virtual public schools to propose funding reductions; and
 
  •  from time to time, government funding to schools is not provided when due, which sometimes causes the affected schools to delay or cease payments to us for our products and services. These payment delays have occurred in the past and can deprive us of significant working capital until the matter is resolved, which could hinder our ability to implement our growth strategies and conduct our business.
 
The poor performance or misconduct of other virtual public school operators could tarnish the reputation of all virtual public school operators, which could have a negative impact on our business.
 
As a relatively new form of public education, virtual school operators will be subject to scrutiny, perhaps even greater than that applied to traditional public schools or charter schools. Not all virtual public school operators will have successful academic programs or operate efficiently, and new entrants may not perform well either. Such underperforming operators could create the impression that virtual schooling is not an effective way to educate students, whether or not our learning system achieves solid performance. Moreover, some virtual school operators have been subject to governmental investigations alleging the misuse of public funds or financial irregularities. These allegations have attracted significant adverse media coverage and have prompted legislative hearings and regulatory responses. Although these investigations have focused on specific companies and individuals, they may negatively impact public perceptions of virtual public school providers generally, including us. If these few situations cause all virtual public school providers to be viewed by the public and/or policymakers unfavorably, we


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may find it difficult to enter into or renew contracts to operate virtual schools. In addition, this perception could serve as the impetus for more restrictive legislation, which could limit our future business opportunities.
 
Opponents of virtual public schools have sought to challenge the establishment and expansion of such schools through the judicial process. If these interests prevail, it could damage our ability to sustain or grow our current business or expand in certain jurisdictions.
 
We have been, and will likely continue to be, subject to lawsuits filed against virtual public schools by those who do not share our belief in the value of this form of public education. Legal claims have involved challenges to the constitutionality of authorizing statutes, methods of instructional delivery, funding provisions and the respective roles of parents and teachers. We currently face two such lawsuits pertaining to the Wisconsin Virtual Academy and the Chicago Virtual Charter School. See “Business — Legal Proceedings”. An adverse judgment in these cases could serve as a negative precedent in other jurisdictions where we do business, and new lawsuits could result in unexpected liabilities and limit our ability to grow.
 
The failure of the virtual public schools we serve to comply with applicable government regulations could result in a loss of funding and an obligation to repay funds previously received, which could adversely affect our business, financial condition and results of operations.
 
Once authorized by law, virtual public schools are generally subject to extensive regulation. These regulations cover specific program standards and financial requirements including, but not limited to: (i) student eligibility standards; (ii) numeric and geographic limitations on enrollments; (iii) prescribed teacher funding allocations from per pupil revenue; (iv) state-specific curriculum requirements; and (v) restrictions on open-enrollment policies by and among districts. State and federal funding authorities conduct regular program and financial audits of virtual public schools, including the virtual public schools we serve, to ensure compliance with applicable regulations. Two virtual public schools we serve are currently undergoing such audits. If a virtual public school we serve is found to be noncompliant, it can be barred from receiving additional funds and could be required to repay funds received during the period of non-compliance, which could impair that school’s ability to pay us for services in a timely manner, if at all. Additionally, the indemnity provisions in our standard service agreements with virtual public schools may require us to return any contested funds on behalf of the school. For a more detailed discussion of the regulations affecting our business, see “Regulation.”
 
Virtual public schools are relatively new, and enabling legislation therefore is often ambiguous and subject to discrepancies in interpretation by regulatory authorities, which may lead to disputes over our ability to invoice and receive payments for services rendered.
 
Statutory language providing for virtual public schools is sometimes interpreted by regulatory authorities in ways that may vary from year to year, making compliance subject to uncertainty. For example, in Colorado, the regulators’ approach to determining the eligibility of virtual school students for funding purposes, which is based on a student’s substantial completion of a semester in a public school, has undergone varying interpretations. These regulatory uncertainties may lead to disputes over our ability to invoice and receive payments for services rendered, which could adversely affect our business, financial condition and results of operations.
 
The operation of virtual public schools depends on the maintenance of the authorizing charter and compliance with applicable laws. If these charters are not renewed, our contracts with these schools would be terminated.
 
In some cases, virtual public schools operate under a charter that is granted by a state or local authority to the charter holder, such as a community group or an established not-for-profit corporation, which typically is required by state law to qualify for student funding. The service agreement for these schools is with the charter holder or the charter board. For example, non-profit charter schools qualifying for exemption from federal taxation under Internal Revenue Code Section 501(c)(3) as charitable organizations must also operate in accordance with Internal Revenue Service rules and policies to maintain that status and their funding eligibility. In addition, all state charter school statutes require periodic reauthorization. If a virtual public school fails to maintain its tax-exempt status and funding eligibility, or if its charter is revoked for non-performance or other reasons that may be due to actions of the independent charter board completely outside of our control, our contract with that school would be terminated.


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Actual or alleged misconduct by our senior management and directors would make it more difficult for us to enter into new contracts or renew existing contracts.
 
If any of our directors, officers or key employees are accused or found to be guilty of serious crimes, including the mismanagement of public funds, the schools we serve could be barred from entering into or renewing service agreements with us or otherwise discouraged from contracting with us and, as a result, our business and revenues would be adversely affected.
 
Risks Related to Our Business and Our Industry
 
We have a limited operating history, and sustained losses of approximately $90 million before only recently achieving profitability. If we fail to remain profitable or achieve further marketplace acceptance for our products and services, our business, financial condition and results of operations will be adversely affected.
 
The virtual public schools we serve began enrolling students in the 2002-03 school year. As a result, we have only a limited operating history upon which you can evaluate our business and prospects. Since our inception, we have recorded net losses totaling approximately $90 million until we recently achieved profitability. We recorded our first profit in the fiscal year ended June 30, 2006. There can be no assurance that we will remain profitable, or that our products and services will achieve further marketplace acceptance. Our marketing efforts may not generate a sufficient number of student enrollments to sustain our business plan; our capital and operating costs may exceed planned levels; and we may be unable to develop and enhance our service offerings to meet the demands of virtual public schools and students to the extent that such demands and preferences change. If we are not successful in managing our business and operations, our financial condition and results of operations will be adversely affected.
 
Highly qualified teachers are critical to the success of our learning system. If we are not able to continue to recruit, train and retain quality certified teachers, our curriculum might not be effectively delivered to students, compromising their academic performance and our reputation with the virtual public schools we serve. As a result, our brand, business and operating results may be adversely affected.
 
Effective teachers are critical to maintaining the quality of our learning system and assisting students with their daily lessons. Teachers in virtual public schools must be state certified and have strong interpersonal communications skills to be able to effectively instruct students in a virtual school setting. They must also possess the technical skills to use our technology-based learning system. There is a limited pool of teachers with these specialized attributes and the virtual public schools we serve must provide competitive compensation packages to attract and retain such qualified teachers.
 
The teachers in most virtual public schools we serve are not our employees and the ultimate authority relating to those teachers resides with the governing body overseeing the schools. However, under many of our service agreements with virtual public schools, we have responsibility to recruit, train and manage these teachers. We must also provide continuous training to virtual public school teachers so that they can stay abreast of changes in student demands, academic standards and other key trends necessary to teach online effectively. We may not be able to recruit, train and retain enough qualified teachers to keep pace with our growth while maintaining consistent teaching quality in the various virtual public schools we serve. Shortages of qualified teachers or decreases in the quality of our instruction, whether actual or perceived, would have an adverse effect on our business.
 
The schools we contract with and serve are governed by independent governing bodies who may shift their priorities or change objectives in ways adverse to us.
 
We contract with and provide a majority of our products and services to virtual public schools governed by independent boards or similar governing bodies. While we typically share a common objective at the outset of our business relationship, over time our interests could diverge. If these independent boards of the schools we serve subsequently shift their priorities or change objectives, and as a result reduce the scope or terminate their relationship with us, our ability to generate revenues would be adversely affected.


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Our contracts with the virtual public schools we serve are subject to periodic renewal, and each year several of these agreements are set to expire. If we are unable to renew several such contracts or if a single significant contract expires during a given year, our business, financial condition, results of operations and cash flow could be adversely affected.
 
For the 2007-08 school year, we have contracts to provide our full range of products and services to virtual public schools in 16 states and the District of Columbia. Several of these contracts are scheduled to expire in any given year. For example, five such contracts are scheduled to expire in 2008, and we usually begin to engage in renewal negotiations during the final year of these contracts. In order to renew these contracts, we have to enter into negotiations with the independent boards of these virtual public schools. If we are unable to renew several such contracts or one significant contract expiring during a given year, our business, financial condition, results of operations and cash flow could be adversely affected.
 
We generate significant revenues from four virtual public schools, and the termination, revocation, expiration or modification of our contracts with these virtual public schools could adversely affect our business, financial condition and results of operation.
 
During the nine months ended March 31, 2007, sales of our products and services to four virtual public schools accounted for approximately 17%, 12%, 11% and 10% of our revenues. If our contracts with any of these virtual public schools are terminated, the charters to operate any of these schools are not renewed or are revoked, enrollments decline substantially, funding is reduced, or more restrictive legislation is enacted, our business, financial condition and results of operations could be adversely affected.
 
We may not be able to effectively address the execution risks associated with our expansion into the virtual high school market. Our failure to do so could substantially harm our growth strategy.
 
The virtual high school market presents us with a number of challenges, including timely deployment of new courses in the 2007-08 school year, and the planned launch of 11th and 12th grade offerings. We are currently using third-party platforms and some third-party curriculum in our high school offering. If the quality of the third-party curriculum or platforms is unsatisfactory, student enrollments could decline. Furthermore, the subject matter expertise and skills necessary to teach in high school are fundamentally different than those necessary to teach kindergarten through 8th grade. If the high school instructional experience does not meet the expectations of students previously enrolled in our kindergarten through 8th grade programs, or new enrollees experience performance issues with our high school program delivery, the virtual public schools we serve may decline to offer our high school program and our business, financial condition and results of operations may be adversely affected.
 
Our growth strategy anticipates that we will create new products and distribution channels and expand existing distribution channels. If we are unable to effectively manage these initiatives, our business, financial condition, results of operations and cash flows would be adversely affected.
 
As we create new products and distribution channels and expand our existing distribution channels, we expect to face challenges distinct from those we currently encounter, including:
 
  •  our development of public hybrid schools, which will produce different operational challenges than those we currently encounter. In addition to the online component, hybrid schools require us to lease facilities for classrooms, staff classrooms with teachers, provide meals, adhere to local safety and fire codes, purchase additional insurance and fulfill many other responsibilities;
 
  •  our expansion into international markets may require us to conduct our business differently than we do in the United States. For example, we may attempt to open a tuition-based private school or establish a traditional brick and mortar school. Additionally, we may have difficulty training and retaining qualified teachers or generating sufficient demand for our products and services in international markets. International opportunities will also produce different operational challenges than those we currently encounter; and
 
  •  our use of our curriculum in classrooms will produce challenges with respect to adapting our curriculum for effective use in a traditional classroom setting.


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Our failure to manage these new distribution channels, or any new distribution channels we pursue, may have an adverse effect on our business, financial condition, results of operations and cash flows.
 
Increasing competition in the market segments that we serve could lead to pricing pressures, reduced operating margins, loss of market share and increased capital expenditures.
 
We face varying degrees of competition from several discrete education providers because our learning system integrates all the elements of the education development and delivery process, including curriculum development, textbook publishing, teacher training and support, lesson planning, testing and assessment, and school performance and compliance management. We compete most directly with companies that provide online curriculum and support services to K-12 virtual public schools. Additionally, we expect increased competition from for-profit post-secondary and supplementary education providers that have begun to offer virtual high school curriculum and services. In certain jurisdictions and states where we currently serve virtual public schools, we expect intense competition from existing providers and new entrants. Our competitors may adopt similar curriculum delivery, school support and marketing approaches, with different pricing and service packages that may have greater appeal in the market. If we are unable to successfully compete for new business, win and renew contracts or maintain current levels of academic achievement, our revenue growth and operating margins may decline. Price competition from our current and future competitors could also result in reduced revenues, reduced margins or the failure of our product and service offerings to achieve or maintain more widespread market acceptance.
 
We may also face direct competition from publishers of traditional educational materials that are substantially larger than we are and have significantly greater financial, technical and marketing resources. As a result, they may be able to devote more resources to develop products and services that are superior to our platform and technologies. We may not have the resources necessary to acquire or compete with technologies being developed by our competitors, which may render our online delivery format less competitive or obsolete.
 
Our future success will depend in large part on our ability to maintain a competitive position with our curriculum and our technology, as well as our ability to increase capital expenditures to sustain the competitive position of our product. We cannot assure you that we will have the financial resources, technical expertise, marketing, distribution or support capabilities to compete effectively.
 
If demand for increased options in public schooling does not continue or if additional jurisdictions do not authorize or adequately fund virtual public schools, our business, financial condition and results of operations could be adversely affected.
 
According to the Center for Education Reform, as of January 2007 there were 173 virtual schools with total enrollments exceeding 92,000 students, operating in 18 states. However, if the demand for virtual public schools does not increase, if additional jurisdictions do not authorize new virtual schools or if the funding of such schools is inadequate, our business, financial condition and results of operations could be adversely affected.
 
Our business is subject to seasonal fluctuations, which may cause our operating results to fluctuate from quarter-to-quarter and adversely impact the market price of our common stock.
 
Our revenues and operating results normally fluctuate as a result of seasonal variations in our business, principally due to the number of months in a fiscal quarter that our virtual public schools are fully operational and serving students. In the typical academic year, our first and fourth fiscal quarters may have fewer than three full months of operations, whereas our second and third fiscal quarters will have three complete months of operations. We ship offline learning kits to students in the beginning of the school year, our first fiscal quarter, generally resulting in higher offline learning kit revenues and margins in the first fiscal quarter relative to the other quarters. In aggregate, the seasonality of our revenues has generally produced higher revenues in the first fiscal quarter and lower revenues in the fourth fiscal quarter.
 
Our operating expenses are also seasonal. Instructional costs and services increase in the first fiscal quarter primarily due to the costs incurred to ship offline learning kits at the beginning of the school year. These instructional costs may increase significantly quarter-to-quarter as school operating expenses increase. The majority of our selling and marketing expenses are incurred in the first and fourth fiscal quarters, as our primary enrollment season is July through September.


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We expect quarterly fluctuations in our revenues and operating results to continue. These fluctuations could result in volatility and adversely affect our cash flow. As our business grows, these seasonal fluctuations may become more pronounced. As a result, we believe that quarterly comparisons of our financial results may not be reliable as an indication of future performance.
 
Our revenues for a fiscal year are based in part on our estimate of the total funds each school will receive in a particular school year and our estimate of the full year deficits to be incurred by each school. As a result, differences between our estimates and the actual funds received and deficits incurred could have an adverse impact on our results of operations and cash flows.
 
We recognize revenues from certain of our fees ratably over the course of our fiscal year. To determine the amount of revenues to recognize, we estimate the total funds each school will receive in a particular school year. Additionally, we take responsibility for any operating deficits at most of the virtual schools we serve. Because these operating deficits may impair our ability to collect the full amount invoiced in a period and collection cannot reasonably be assured, we reduce revenues by the estimated amount of these deficits. We review our estimates of total funds and operating deficits periodically, and we revise as necessary, amortizing any adjustments over the remaining portion of the fiscal year. Actual funding received and operating deficits incurred may vary from our estimates or revisions and could adversely impact our results of operation and cash flows.
 
The continued development of our brand identity is important to our business. If we are not able to maintain and enhance our brand, our business and operating results may suffer.
 
Expanding brand awareness is critical to attracting and retaining students, and for serving additional virtual public schools. In order to expand brand awareness, we intend to spend significant resources on a brand-enhancement strategy, which includes sales and marketing efforts directed to targeted locations as well as the national marketplace, the educational community at large, key political groups, image-makers and the media. We believe that the quality of our curriculum and management services has contributed significantly to the success of our brand. As we continue to increase enrollments and extend our geographic reach, maintaining quality and consistency across all of our services and products may become more difficult to achieve, and any significant and well-publicized failure to maintain this quality and consistency will have a detrimental effect on our brand. We cannot provide assurances that our new sales and marketing efforts will be successful in further promoting our brand in a competitive and cost effective manner. If we are unable to further enhance our brand recognition and increase awareness of our products and services, or if we incur excessive sales and marketing expenses, our business and results of operations could be adversely affected.
 
Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.
 
Our patent, trademarks, trade secrets, copyrights and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights could harm our business or our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results.
 
Although we seek to obtain patent protection for our innovations, it is possible that we may not be able to protect some of these innovations. In addition, given the costs of obtaining patent protection, we may choose not to protect certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable.
 
We also seek to maintain certain intellectual property as trade secrets. This secrecy could be compromised by outside parties, or by our employees intentionally or accidentally, which would cause us to lose the competitive advantage resulting from these trade secrets.


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We must monitor and protect our Internet domain names to preserve their value.
 
We own the domain names K12 (.com and .org) and K-12 (.com, .net, and .org) as well as the service mark K12. Third parties may acquire substantially similar domain names that decrease the value of our domain names and trademarks and other proprietary rights which may hurt our business. The regulation of domain names in the United States and foreign countries is subject to change. Governing bodies could appoint additional domain name registrars or modify the requirements for holding domain names. Governing bodies could also establish additional “top-level” domains, which are the portion of the Web address that appears to the right of the “dot,” such as “com,” “gov,” or “org.” As a result, we may not maintain exclusive rights to all potentially relevant domain names in the United States or in other countries in which we conduct business.
 
We may be sued for infringing the intellectual property rights of others and such actions would be costly to defend, could require us to pay damages and could limit our ability or increase our costs to use certain technologies in the future.
 
Companies in the Internet, technology, education, curriculum and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. As we grow, the likelihood that we may be subject to such claims also increases. Regardless of the merits, intellectual property claims are often time-consuming and expensive to litigate or settle. In addition, to the extent claims against us are successful, we may have to pay substantial monetary damages or discontinue any of our products, services or practices that are found to be in violation of another party’s rights. We also may have to seek a license and make royalty payments to continue offering our products and services or following such practices, which may significantly increase our operating expenses.
 
We may be subject to legal liability resulting from the actions of third parties, including independent contractors and teachers, which could cause us to incur substantial costs and damage our reputation.
 
We may be subject, directly or indirectly, to legal claims associated with the actions of our independent contractors and teachers. In the event of accidents or injuries or other harm to students, we could face claims alleging that we were negligent, provided inadequate supervision or were otherwise liable for their injuries. Additionally, we could face claims alleging that our independent curriculum contractors or teachers infringed the intellectual property rights of third parties. A liability claim against us or any of our independent contractors or teachers could adversely affect our reputation, enrollment and revenues. Even if unsuccessful, such a claim could create unfavorable publicity, cause us to incur substantial expenses and divert the time and attention of management.
 
Unauthorized disclosure or manipulation of student, teacher and other sensitive data, whether through breach of our network security or otherwise, could expose us to costly litigation or could jeopardize our contracts with virtual public schools.
 
Maintaining our network security is of critical importance because our Student Administration Management System (SAMS) stores proprietary and confidential student and teacher information, such as names, addresses, and other personal information. Individuals and groups may develop and deploy viruses, worms and other malicious software programs that attack or attempt to infiltrate SAMS. If our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise, third parties may be able to access student records and we could be subject to liability or our business could be interrupted. Penetration of our network security could have a negative impact on our reputation and could lead virtual public schools and parents to choose competitive offerings. As a result, we may be required to expend significant resources to provide additional protection from the threat of these security breaches or to alleviate problems caused by these breaches.


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We rely on the Internet to enroll students and to deliver our products and services to children, which exposes us to a growing number of legal risks and increasing regulation.
 
We collect information regarding students during the online enrollment process, and a significant amount of our curriculum content is delivered over the Internet. As a result, specific federal and state laws that could have an impact on our business include the following:
 
  •  the Children’s Online Privacy Protection Act, which restricts the distribution of certain materials deemed harmful to children and imposes additional restrictions on the ability of online companies to collect personal information from children under the age of 13; and
 
  •  the Family Educational Rights and Privacy Act, which imposes parental or student consent requirements for specified disclosures of student information, including online information.
 
In addition, the laws applicable to the Internet are still developing. These laws impact pricing, advertising, taxation, consumer protection, quality of products and services, and are in a state of change. New laws may also be enacted, which could increase the costs of regulatory compliance for us or force us to change our business practices. As a result, we may be exposed to substantial liability, including significant expenses necessary to comply with such laws and regulations.
 
System disruptions and vulnerability from security risks to our online computer networks could impact our ability to generate revenues and damage our reputation, limiting our ability to attract and retain students.
 
The performance and reliability of our technology infrastructure is critical to our reputation and ability to attract and retain virtual public schools, parents and students. Any sustained system error or failure, or a sudden and significant increase in bandwidth usage, could limit access to our learning system, and therefore, damage our ability to generate revenues. Our technology infrastructure could be vulnerable to interruption or malfunction due to events beyond our control, including natural disasters, terrorist activities and telecommunications failures.
 
Substantially all of the inventory for our offline learning kits is located in one warehouse facility. Any damage or disruption at this facility would have an adverse effect on our business, financial condition and results of operations.
 
Substantially all of the inventory for our offline learning kits is located in one warehouse facility operated by a third-party. A natural disaster, fire, power interruption, work stoppage or other unanticipated catastrophic event, especially during the period from May through September when we have received most of the curriculum materials for the school year and have not yet shipped such materials to students, could significantly disrupt our ability to deliver our products and operate our business. If any of our material inventory were to experience any significant damage, we would be unable to meet our contractual obligations and our business would suffer.
 
Any significant interruption in the operations of our data center could cause a loss of data and disrupt our ability to manage our network hardware and software and technological infrastructure.
 
We host our products and serve all of our students from a third-party data center facility. While we are developing a risk mitigation plan, such a plan may not be able to prevent a significant interruption in the operation of this facility or the loss of school and operational data due to a natural disaster, fire, power interruption, act of terrorism or other unanticipated catastrophic event. Any significant interruption in the operation of this facility, including an interruption caused by our failure to successfully expand or upgrade our systems or manage our transition to utilizing the expansions or upgrades, could reduce our ability to manage our network and technological infrastructure, which could result in lost sales, enrollment terminations and impact our brand reputation.
 
Additionally, we do not control the operation of this facility and must rely on a third-party to provide the physical security, facilities management and communications infrastructure services related to our data center. Although we believe we would be able to enter into a similar relationship with another third-party should this relationship fail or terminate for any reason, our reliance on a third-party vendor exposes us to risks outside of our control. If this third-party vendor encounters financial difficulty such as bankruptcy or other events beyond our control that causes it to fail to secure adequately and maintain its hosting facilities or provide the required data


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communications capacity, students of the virtual public schools we serve may experience interruptions in our service or the loss or theft of important customer data.
 
Any significant interruption in the operations of our call center could disrupt our ability to respond to service requests and process orders and to deliver our products in a timely manner.
 
Our call center is housed in a single facility. We do not currently have a fully functional back-up system in place for this facility. While we are developing a risk mitigation plan, such a plan may not be able to prevent a significant interruption in the operation of this facility due to natural disasters, accidents, failures of the inventory locator or automated packing and shipping systems we use or other events. Any significant interruption in the operation of this facility, including an interruption caused by our failure to successfully expand or upgrade our systems or to manage these expansions or upgrades, could reduce our ability to respond to service requests, receive and process orders and provide products and services, which could result in lost and cancelled sales, and damage to our brand reputation.
 
Capacity limits on some of our technology, transaction processing systems and network hardware and software may be difficult to project and we may not be able to expand and upgrade our systems in a timely manner to meet significant unexpected increased demand.
 
As the number of virtual public schools we serve increases and our student base grows, the traffic on our transaction processing systems and network hardware and software will rise. We may be unable to accurately project the rate of increase in the use of our transaction processing systems and network hardware and software. In addition, we may not be able to expand and upgrade our systems and network hardware and software capabilities to accommodate significant unexpected increased use. If we are unable to appropriately upgrade our systems and network hardware and software in a timely manner, our operations and processes may be temporarily disrupted.
 
We may be unable to manage and adapt to changes in technology.
 
We will need to respond to technological advances and emerging industry standards in a cost-effective and timely manner in order to remain competitive. The need to respond to technological changes may require us to make substantial, unanticipated expenditures. There can be no assurance that we will be able to respond successfully to technological change.
 
We may be unable to attract and retain skilled employees.
 
Our success depends in large part on continued employment of senior management and key personnel who can effectively operate our business. If any of these employees leave us and we fail to effectively manage a transition to new personnel, or if we fail to attract and retain qualified and experienced professionals on acceptable terms, our business, financial conditions and results of operations could be adversely affected.
 
Our success also depends on our having highly trained financial, technical, recruiting, sales and marketing personnel. We will need to continue to hire additional personnel as our business grows. A shortage in the number of people with these skills or our failure to attract them to our Company could impede our ability to increase revenues from our existing products and services and to launch new product offerings, and would have an adverse effect on our business and financial results.
 
We may not be able to effectively manage our growth, which could impair our ability to operate profitably.
 
We have experienced significant expansion since our inception, which has sometimes strained our managerial, operational, financial and other resources. A substantial increase in our enrollment or the addition of new schools in a short period of time could strain our current resources and increase capital expenditures, without an immediate increase in revenues. Our failure to successfully manage our growth in a cost efficient manner and add and retain personnel to adequately support our growth could disrupt our business and decrease profitability.
 
We may need additional capital in the future, but there is no assurance that funds will be available on acceptable terms.
 
We may need to raise additional funds in order to achieve growth or fund other business initiatives. This financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing


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stockholders. Additionally, any securities issued to raise funds may have rights, preferences or privileges senior to those of existing stockholders. If adequate funds are not available or are not available on acceptable terms, our ability to expand, develop or enhance services or products, or respond to competitive pressures will be limited.
 
Our curriculum and approach to instruction may not achieve widespread acceptance, which would limit our growth and profitability.
 
Our curriculum and approach to instruction are based on the structured delivery, clarification, verification and practice of lesson subject matter. The goal of this approach is to make students proficient at the fundamentals and to instill confidence in a subject prior to confronting new and complex concepts. This approach, however, is not accepted by all academics and educators, who may favor less formalistic methods. Accordingly, some academics and educators are opposed to the principles and methodologies associated with our approach to learning, and have the ability to negatively influence the market for our products and services.
 
If student performance falls or parent and student satisfaction declines, a significant number of students may not remain enrolled in a virtual public school that we serve, and our business, financial condition and results of operations will be adversely affected.
 
The success of our business depends on a family’s decision to have their child continue his or her education in a virtual public school that we serve. This decision is based on many factors, including student achievement and parent and student satisfaction. Students may perform significantly below state averages or the virtual school may fail to meet the standards of the No Child Left Behind Act. For instance, in the 2005-06 school year, an increase in certain enrollments in two of the virtual schools we served created the need to monitor two subgroups that did not meet Adequate Yearly Progress requirements of NCLB, causing those schools not to meet the Adequate Yearly Progress requirements for that year. We expect that, as our enrollments increase and the portion of students that have not used our learning system for multiple years increases, the average performance of all students using our learning system may decrease, even if the individual performance of other students improves over time. Additionally, parent and student satisfaction may decline as not all parents and students are able to devote the substantial time and energy necessary to complete our curriculum. A student’s satisfaction may also suffer if his or her relationship with the virtual school teacher does not meet expectations. If a student’s performance or satisfaction declines, students may decide not to remain enrolled in a virtual public school that we serve and our business, financial condition and results of operations will be adversely affected.
 
Although we do not currently transact business in a foreign country, we intend to expand into international markets, which will subject us to additional economic, operational and political risks that could increase our costs and make it difficult for us to continue to operate profitably.
 
One of our growth strategies is to pursue international opportunities that leverage our current product and service offerings. The addition of international operations may require significant expenditure of financial and management resources and result in increased administrative and compliance costs. As a result of such expansion, we will be increasingly subject to the risks inherent in conducting business internationally, including:
 
  •  foreign currency fluctuations, which could result in reduced revenues and increased operating expenses;
 
  •  potentially longer payment and sales cycles;
 
  •  difficulty in collecting accounts receivable;
 
  •  the effect of applicable foreign tax structures, including tax rates that may be higher than tax rates in the United States or taxes that may be duplicative of those imposed in the United States;
 
  •  tariffs and trade barriers;
 
  •  general economic and political conditions in each country;
 
  •  inadequate intellectual property protection in foreign countries;
 
  •  uncertainty regarding liability for information retrieved and replicated in foreign countries;


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  •  the difficulties and increased expenses in complying with a variety of U.S. and foreign laws, regulations and trade standards, including the Foreign Corrupt Practices Act; and
 
  •  unexpected changes in regulatory requirements.
 
Risks Related to this Offering
 
The price of our common stock may be subject to wide fluctuations and may trade below the initial public offering price.
 
Before this offering, there has not been a public market for our common stock. The initial public offering price of our common stock will be determined by negotiations between us and representatives of the underwriters based on numerous factors, including those that we discuss under “Underwriting.” This price may not be indicative of the market price of our common stock after this offering. We cannot assure you that an active public market for our common stock will develop or be sustained after this offering. The market price of our common stock also could be subject to significant fluctuations. As a result, you may not be able to sell your shares of our common stock quickly or at prices equal to or greater than the price you paid in this offering.
 
Among the factors that could affect our common stock price are the risks described in this section and other factors, including:
 
  •  quarterly variations in our operating results compared to market expectations;
 
  •  changes in expectations as to our future financial performance, including financial estimates or reports by securities analysts;
 
  •  changes in market valuations of similar companies;
 
  •  liquidity and activity in the market for our common stock;
 
  •  sales of our common stock by our stockholders;
 
  •  strategic moves by us or our competitors, such as acquisitions or restructurings;
 
  •  general market conditions; and
 
  •  domestic and international economic, legal and regulatory factors unrelated to our performance.
 
Stock markets in general have experienced extreme volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations could adversely affect the trading price of our common stock, regardless of our operating performance.
 
Sales of substantial amounts of our common stock in the public markets, or the perception that they might occur, could reduce the price of our common stock and may dilute your voting power and your ownership interest in us.
 
After the completion of this offering, we will have           shares of common stock outstanding (           shares of common stock outstanding if the underwriters exercise their overallotment option in full). This number is comprised of all the shares of our common stock that we and the selling stockholders are selling in this offering (including           shares that we expect to be issued upon exercise of stock options by certain of the selling stockholders and resold in this offering), which may be resold immediately in the public market. Subject to certain exceptions described under the caption “Underwriting,” we and all of our directors and executive officers and all of our stockholders and optionholders have agreed not to offer, sell or agree to sell, directly or indirectly, any shares of common stock without the permission of the underwriters for a period of 180 days from the date of this prospectus. When this period expires we and our locked-up stockholders will be able to sell our shares in the public market. Sales of a substantial number of such shares upon expiration, or early release, of the lock-up (or the perception that such sales may occur) could cause our share price to fall.
 
We cannot predict what effect, if any, future sales of our common stock, or the availability of common stock for future sale, will have on the market price of our common stock. Sales of substantial amounts of our common stock in the public market following our initial public offering, including a secondary offering by the Company, or the perception that such sales could occur, could adversely affect the market price of our common stock and may make it more difficult for you to sell your common stock at a time and price that you deem appropriate.


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We also may issue our shares of common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we may issue may in turn be significant. In addition, we may also grant registration rights covering those shares in connection with any such acquisitions and investments.
 
Upon completion of this offering,           of our shares of common stock will be restricted or control securities within the meaning of Rule 144 under the Securities Act of 1933, as amended, (           shares of common stock if the underwriters’ overallotment option is exercised in full). The rules affecting the sale of these securities are summarized under “Shares Eligible for Future Sale.”
 
Our principal stockholders hold (and following completion of this offering will continue to hold) shares of our common stock in which they have a large unrealized gain, and these stockholders may wish, to the extent they may permissibly do so, to realize some or all of that gain relatively quickly by selling some or all of their shares.
 
Investors purchasing common stock in this offering will experience immediate and substantial dilution.
 
The assumed initial public offering price of our common stock is substantially higher than the net tangible book value per outstanding share of our common stock immediately after this offering. As a result, you will pay a price per share that substantially exceeds the book value of our assets after subtracting our liabilities. Purchasers of our common stock in this offering will incur immediate and substantial dilution of $      per share in the net tangible book value of our common stock from the assumed initial public offering price of $      per share, which is the mid-point of the estimated range set forth on the cover of this prospectus. If the underwriters exercise their over-allotment option in full, there will be an additional dilution of $      per share in the net tangible book value of our common stock, assuming the same public offering price. See “Dilution.” In addition, if outstanding options to purchase shares of common stock are exercised, there could be substantial additional dilution.
 
Antitakeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.
 
Provisions in our amended and restated certificate of incorporation and amended and restated bylaws to be effective upon the consummation of this offering may delay or prevent an acquisition of us or a change in our management. These provisions will include a classified board of directors, prohibition on actions by written consent of our stockholders, and the ability of our board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirers to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.
 
As a result of becoming a public company, we will be obligated to develop and maintain proper and effective internal control over financial reporting and will be subject to other requirements that will be burdensome and costly. We may not timely complete our analysis of our internal control over financial reporting, or these internal controls may not be determined to be effective, which could adversely affect investor confidence in our company and, as a result, the value of our common stock.
 
We will be required, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404), to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting for the first fiscal year beginning after the effective date of this offering. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. In addition, our auditors will issue an attestation report on our internal control over financial reporting.
 
We are just beginning the costly and challenging process of compiling the system and processing documentation before we perform the evaluation needed to comply with Section 404. We may not be able to complete our


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evaluation, testing and any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control is effective. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to issue an unqualified opinion that we maintained, in all material respects, effective internal control over financial reporting, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our common stock. Failure to comply with the new rules might make it more difficult for us to obtain certain types of insurance, including director and officer liability insurance, and we might be forced to accept reduced policy limits and coverage and/or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on committees of our board of directors, or as executive officers.
 
In addition, as a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company, and our administrative staff will be required to perform additional tasks. For example, in anticipation of becoming a public company, we will need to create or revise the roles and duties of our board committees, adopt disclosure controls and procedures, retain a transfer agent, adopt an insider trading policy and bear all of the internal and external costs of preparing and distributing periodic public reports in compliance with our obligations under federal securities laws. In addition, changing laws, regulations and standards relating to corporate governance and public disclosure, and related regulations implemented by the SEC and the New York Stock Exchange, are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and our business may be harmed.
 
Our largest stockholders will continue to have significant control over us after this offering, and they may make decisions with which you disagree.
 
Following the offering, assuming no exercise of the underwriters’ overallotment option, our current stockholders will beneficially own approximately     % of the outstanding shares of common stock (or approximately     % of the shares of common stock on a fully diluted basis, after giving effect to the exercise of all outstanding options and other rights to acquire common stock). As a result, such current stockholders may have the ability to control the election of our directors and the outcome of corporate actions requiring stockholder approval. This concentration of ownership could have the effect of discouraging potential take-over attempts and may make attempts by stockholders to change our management more difficult.
 
We have not paid and do not expect to pay dividends, and any return on your investment will likely be limited to the appreciation of our common stock.
 
We have never paid dividends on our common stock and do not anticipate paying dividends on our common stock in the foreseeable future. If, however, we decide to pay dividends on our common stock in the future, the payment of dividends will depend on our earnings, financial condition and other business and economic factors affecting us at such time as our board of directors may consider relevant. In addition, our credit facility with PNC Bank, N.A. (PNC Bank) contains covenants prohibiting the payment of cash dividends without their consent. Accordingly, for the foreseeable future, any return on your investment will be related to the appreciation of our stock price.
 
We have broad discretion in the use of the net proceeds from this offering and may not use them effectively.
 
We cannot specify with certainty the particular uses of the net proceeds we will receive from this offering. Our management will have broad discretion in the application of the net proceeds, including for any of the purposes described in “Use of Proceeds.” The failure by our management to apply these funds effectively could harm our


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business. Pending their use, we may invest the net proceeds from this offering in a manner that does not produce income or that loses value.
 
If equity research analysts do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our common stock, the price of our common stock could decline.
 
The trading market for our common stock will rely in part on the research and reports that equity research analysts publish about us and our business. The price of our stock could decline if one or more securities analysts downgrade our stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.


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CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
 
The Securities and Exchange Commission, or SEC, encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. This prospectus contains such “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.
 
All statements other than statements of historical facts contained in this prospectus, including our disclosure and analysis concerning our operations, cash flows and financial position, business strategy and plans and objectives, including, in particular, the likelihood of our success developing and expanding our business, are forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. All forward-looking statements are management’s present expectations of future events and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. These risks include, but are not limited to, the risks and uncertainties set forth in “Risk Factors,” beginning on page 10 of this prospectus.
 
In light of these assumptions, risks and uncertainties, the results and events discussed in the forward-looking statements contained in this prospectus might not occur. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this prospectus. We are not under any obligation, and we expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. All subsequent forward-looking statements attributable to us or to any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.
 
This prospectus also contains estimates and other statistical data made by independent parties and by us relating to market size and growth and other industry data. These data involves a number of assumptions and limitations, and you are cautioned not to give undue weight to such estimates. We have not independently verified the statistical and other industry data generated by independent parties and contained in this prospectus and, accordingly, we cannot guarantee their accuracy or completeness. In addition, projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this prospectus. These and other factors could cause results to differ materially from those expressed in the estimates made by the independent parties and by us.


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USE OF PROCEEDS
 
Assuming an initial public offering price of $      per share, we estimate that we will receive net proceeds from this offering of approximately $      million, after deducting underwriting discounts and commissions and other estimated expenses of $      million payable by us. If the underwriters exercise their overallotment option in full, we estimate that our net proceeds from this offering will be approximately $      million. We will not receive any of the proceeds from the sale of shares by the selling stockholders. A $1.00 increase (decrease) in the assumed initial public offering price of $      per share would increase (decrease) the net proceeds to us from this offering by approximately $      million, assuming the number of shares offered, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.
 
We intend to use the net proceeds from this offering for general corporate purposes, including working capital, capital expenditures and the development of new courses and product offerings. In addition, we intend to repay approximately $6.5 million of borrowings under our revolving credit facility, which bears interest at rates of approximately 6.6%, with various maturity dates on or before October 1, 2007 that may be renewed at the then current interest rate. Management will have broad discretion in the allocation of the net proceeds of this offering. Depending upon future events, we may determine at a later time to use the net proceeds for different purposes. Pending their use, we plan to invest the net proceeds in short-term, investment grade, interest-bearing securities.
 
DIVIDEND POLICY
 
We have never paid or declared a dividend on our common stock, and we intend to retain all future earnings, if any, for use in the operation of our business and to fund future growth. We do not anticipate paying any dividends for the indefinite future, and our credit facility with PNC Bank, N.A. limits our ability to pay dividends or other distributions on our common stock. The decision whether to pay dividends will be made by our board of directors in light of conditions then existing, including factors such as our results of operations, financial condition and requirements, business conditions, and covenants under any applicable contractual arrangements.


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CAPITALIZATION
 
The following table sets forth our capitalization as of March 31, 2007:
 
  •  on an actual basis;
 
  •  on a pro forma basis, giving effect to the automatic conversion of all of the outstanding shares of our preferred stock into 101,386,536 shares of our common stock immediately prior to the completion of this offering; and
 
  •  on a pro forma basis as discussed in the prior bullet point, as adjusted to give effect to our receipt of the estimated net proceeds from the sale of           shares of common stock offered by us in this offering, assuming an initial public offering price of $        , the midpoint of the estimated price range shown on the cover page of this prospectus, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us and our use of proceeds from this offering to repay approximately $4.5 million of outstanding indebtedness under our revolving credit facility.
 
You should read this table in conjunction with the consolidated financial statements and the related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Use of Proceeds” included elsewhere in this prospectus.
 
                         
    As of March 31, 2007  
                Pro forma
 
    Actual     Pro forma     as adjusted(1)  
    (dollars in thousands)  
 
Cash and cash equivalents
  $ 5,147     $ 5,147     $  
                         
Total debt
    7,612       7,612          
                         
Redeemable Convertible Preferred Stock
                       
Redeemable Convertible Series C Preferred Stock, par value $0.0001 per share; 55,000,000 shares authorized, 49,861,562 issued and outstanding, actual; no shares issued and outstanding pro forma and pro forma as adjusted
    87,097                
Redeemable Convertible Series B Preferred Stock, par value $0.0001 per share; 76,000,000 shares authorized; 51,524,974 issued and outstanding, actual; no shares issued and outstanding pro forma and pro forma as adjusted
    134,979                
Stockholders’ deficit:
                       
Common stock, par value $0.0001 per share; 170,000,000 shares authorized, 10,203,453 issued and outstanding, actual; 111,589,989 issued and outstanding, pro forma;          shares authorized,          issued and outstanding pro forma as adjusted
    1       11          
Additional paid-in capital
          222,066          
Accumulated deficit
    (186,391 )     (186,391 )        
                         
Total stockholders’ (deficit) equity
    (185,390 )     35,686                  
                         
Total capitalization
  $ 43,298     $ 43,298     $  
                         
 
 
(1) A $1.00 increase (decrease) in the assumed initial public offering price of $      per share, which is the midpoint of the range on the cover page of this prospectus, would increase (decrease) each of cash and cash equivalents, additional paid-in capital, total stockholders’ equity and total capitalization by approximately $      million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.


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DILUTION
 
Dilution is the amount by which the offering price paid by the purchasers of the common stock to be sold in the offering exceeds the net tangible book value per share of common stock after the offering. Net tangible book value per share is determined at any date by subtracting our total liabilities from the total book value of our tangible assets and dividing the difference by the number of shares of common stock deemed to be outstanding at that date.
 
Our pro forma net tangible book value as of March 31, 2007 was $35.7 million, or $0.32 per share after giving effect to the automatic conversion of all of our preferred stock into shares of common stock in accordance with their terms immediately prior to the consummation of the offering. After giving effect to our receipt of the estimated net proceeds from the sale of shares of common stock offered by us in this offering, assuming an initial public offering price of $     , the midpoint of the estimated price range shown on the cover page of this prospectus, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of March 31, 2007 would have been approximately $      million, or $      per share. This represents an immediate increase in pro forma net tangible book value of $      per share to existing stockholders and an immediate dilution of $      per share to new investors purchasing shares of common stock in the offering. The following table illustrates this substantial and immediate per share dilution to new investors:
 
                 
          Per Share  
 
Assumed initial public offering price per share
          $             
Pro forma net tangible book value before the offering
  $ 0.32          
Increase per share attributable to our investors in the offering
               
                 
Pro forma net tangible book value after the offering
               
                 
Dilution per share to new investors
          $    
                 
 
A $1.00 increase (decrease) in the assumed initial public offering price of $      per share would increase (decrease), the as adjusted pro forma net tangible book value per share after this offering by $      and the dilution per share to new investors in this offering by $     , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.
 
The following table summarizes on a pro forma as adjusted basis as of March 31, 2007, giving effect to the automatic conversion of all of our shares of preferred stock into shares of common stock in connection with the offering and for a           for           stock split which will occur prior to the completion of this offering:
 
  •  the total number of shares of common stock purchased from us by our existing stockholders and by new investors purchasing shares in this offering;
 
  •  the total consideration paid to us by our existing stockholders and by new investors purchasing shares in this offering, assuming an initial public offering price of $      per share (before deducting the estimated underwriting discount and commissions and offering expenses payable by us in connection with this offering); and
 
  •  the average price per share paid by existing stockholders and by new investors purchasing shares in this offering:
 
                                         
    Shares Purchased     Total Consideration     Average Price
 
    Number     Percent     Amount     Percent     Per Share  
 
Existing stockholders
    111,589,989       %   $ 149,521,516       %   $ 1.34  
Investors in the offering
            %             %        
                                         
Total
            100 %   $         100 %   $  
                                         


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The tables and calculations above assume no exercise of:
 
  •  stock options outstanding as of March 31, 2007 to purchase 18,450,344 shares of common stock at a weighted average exercise price of $1.80 per share;
 
  •  2,328,358 shares of preferred stock (or upon the consummation of the offering an equivalent amount of common stock) that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are currently exercisable at a purchase price of $1.34 per share, and 108,649 shares of common stock that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are exercisable at a purchase price of $1.60 per share; or
 
  •  the underwriters’ overallotment option.
 
To the extent any of these options are exercised, there will be further dilution to new investors.


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SELECTED CONSOLIDATED FINANCIAL DATA
 
The following table sets forth our selected consolidated statement of operations, balance sheet and other data for the periods indicated. We have derived our selected consolidated statement of operations data for the years ended June 30, 2004, 2005 and 2006 and our balance sheet data as of June 30, 2005 and 2006, from our audited consolidated financial statements that are included elsewhere in this prospectus. We have derived our selected consolidated statement of operations data for the years ended June 30, 2002 and 2003, and our balance sheet data as of June 30, 2002, 2003 and 2004, from our audited consolidated financial statements that are not included in this prospectus. We have derived our selected consolidated statement of operations data for the nine months ended March 31, 2006 and 2007 and consolidated balance sheet data as of March 31, 2007 from our unaudited consolidated financial statements. Our historical results are not necessarily indicative of future operating results. You should read the information set forth below in conjunction with “Selected Consolidated Financial and Operating Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and their related notes included elsewhere in this prospectus.
 
                                                         
          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2002     2003     2004     2005     2006     2006     2007  
    (dollars in thousands, except per share data)  
 
Consolidated Statement of Operations Data:
                                                       
Revenues
  $ 6,693     $ 30,930     $ 71,434     $ 85,310     $ 116,902     $ 90,088     $ 104,930  
Cost and expenses
                                                       
Instructional costs and services
    5,818       25,580       39,943       49,130       64,828       48,473       55,103  
Selling, administrative, and other operating expenses
    11,661       20,903       25,656       30,031       41,660       28,403       35,059  
Product development expenses
    19,621       12,416       12,750       9,410       8,568       5,587       5,855  
                                                         
Total costs and expenses
    37,100       58,899       78,349       88,571       115,056       82,463       96,017  
                                                         
Income (loss) from operations
    (30,407 )     (27,969 )     (6,915 )     (3,261 )     1,846       7,625       8,913  
Interest expense, net
    (11 )     (388 )     (516 )     (279 )     (488 )     (394 )     (474 )
                                                         
Net income (loss) before taxes
    (30,418 )     (28,357 )     (7,431 )     (3,540 )     1,358       7,231       8,439  
Income tax expense
                                        (227 )
                                                         
Net income (loss)
    (30,418 )     (28,357 )     (7,431 )     (3,540 )     1,358       7,231       8,212  
Dividends on preferred stock
                (2,667 )     (5,261 )     (5,851 )     (4,333 )     (4,707 )
Preferred stock accretion
    (6,628 )     (11,912 )     (15,768 )     (15,947 )     (18,697 )     (13,880 )     (16,544 )
                                                         
Net loss attributable to common stockholders
  $ (37,046 )   $ (40,269 )   $ (25,866 )   $ (24,748 )   $ (23,190 )   $ (10,982 )   $ (13,039 )
                                                         
Net loss attributable to common stockholders per share:
                                                       
Basic and diluted
  $ (3.70 )   $ (4.02 )   $ (2.58 )   $ (2.46 )   $ (2.30 )   $ (1.09 )   $ (1.28 )
Basic and diluted (pro forma)(1)
    n/a       n/a       n/a       n/a     $ 0.01       n/a     $ 0.07  
Weighted average shares used in computing per share amounts:
                                                       
Basic and diluted
    10,000,000       10,009,906       10,017,162       10,062,587       10,083,721       10,081,180       10,195,440  
Basic (pro forma)(1)
    n/a       n/a       n/a       n/a       106,937,388       n/a       111,581,976  
Diluted (pro forma)(1)
    n/a       n/a       n/a       n/a       107,055,314       n/a       111,621,446  
 
                                                         
          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2002     2003     2004     2005     2006     2006     2007  
    (dollars in thousands)  
 
Other Data:
                                                       
Net cash provided by (used in) operating activities
  $ (35,016 )   $ (15,990 )   $ (8,020 )   $ 9,697     $ 3,625     $ 1,137     $ 7,324  
Depreciation and amortization
  $ 1,770     $ 4,005     $ 4,922     $ 5,509     $ 4,986     $ 3,574     $ 4,618  
Capital expenditures(2)
  $ 2,547     $ 4,677     $ 4,643     $ 5,133     $ 10,842     $ 6,509     $ 10,350  
EBITDA(3)
  $ (28,637 )   $ (23,964 )   $ (1,993 )   $ 2,248     $ 6,832     $ 11,199     $ 13,531  
Average enrollments(4)
    906       5,872       11,158       15,097       20,220       20,183       27,297  
 


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    As of June 30,     As of  
    2002     2003     2004     2005     2006     March 31, 2007  
    (dollars in thousands)  
 
Consolidated Balance Sheet Data:
                                               
Cash and cash equivalents
  $ 6,008     $ 7,727     $ 15,881     $ 19,953     $ 9,475     $ 5,147  
Total assets
    15,755       21,331       42,714       41,968       48,485       64,001  
Total short-term debt
                                  1,500  
Total long-term obligations
    270       1,697       3,432       4,466       4,025       6,112  
Convertible redeemable preferred stock
    70,566       111,634       155,069       176,277       200,825       222,076  
Total stockholders’ deficit
    (59,502 )     (99,762 )     (125,621 )     (150,299 )     (173,451 )     (186,390 )
Working capital
    6,240       6,823       24,130       22,953       15,421       14,617  
 
 
(1) Pro forma net income per common share gives effect to the automatic conversion of all of our outstanding shares of preferred stock into common stock immediately prior to the completion to this offering. Assuming the completion of this offering on March 31, 2007 and June 30, 2006, all of our outstanding shares of preferred stock would convert into 101,386,536 and 96,853,667 shares of common stock respectively.
(2) Capital expenditures consist of the purchase of property and equipment and new capital lease obligations.
(3) EBITDA consists of net income (loss) minus interest income, plus interest expense, plus income tax expense and plus depreciation and amortization. Interest income consists primarily of interest earned on short-term investments or cash deposits. Interest expense primarily consists of interest expense for capital leases, long-term and short-term borrowings. We use EBITDA as a measure of operating performance. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles, or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, net income (loss) as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management’s discretionary use, as it does not consider certain cash requirements such as tax payments.
 
     We believe EBITDA is useful to an investor in evaluating our operating performance because it is widely used to measure a company’s operating performance without regard to items such as depreciation and amortization, which can vary depending upon accounting methods and the book value of assets, and to present a meaningful measure of corporate performance exclusive of our capital structure and the method by which assets were acquired. Our management uses EBITDA:
 
  •  as a measurement of operating performance, because it assists us in comparing our performance on a consistent basis, as it removes depreciation, amortization, interest and taxes; and
 
  •  in presentations to the members of our board of directors to enable our board to have the same measurement basis of operating performance as is used by management to compare our current operating results with corresponding prior periods and with the results of other companies in our industry.
 
The following table provides a reconciliation of net income (loss) to EBITDA:
 
                                                         
          Nine Months Ended
 
    Year Ended June 30,     March 31,  
    2002     2003     2004     2005     2006     2006     2007  
    (dollars in thousands)  
 
Net income (loss)
  $ (30,418 )   $ (28,357 )   $ (7,431 )   $ (3,540 )   $ 1,358     $ 7,231     $ 8,212  
Interest expense, net
    11       388       516       279       488       394       474  
Income tax expense
                                        227  
Depreciation and amortization
    1,770       4,005       4,922       5,509       4,986       3,574       4,618  
                                                         
EBITDA
  $ (28,637 )   $ (23,964 )   $ (1,993 )   $ 2,248     $ 6,832     $ 11,199     $ 13,531  
                                                         
 
(4) To ensure that all schools are reflected in our measure of enrollments, we consider our enrollments as of the end of September to be our opening enrollment level, and the number of students enrolled at the end of May to be our ending enrollment level. To provide comparability, we do not consider enrollment levels for June, July and August as all schools are not open during these months. For each period, average enrollments represent the average of the month end enrollment levels for each month that has transpired between September and the end of the period, up to and including the month of May.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
You should read the following discussion together with our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of the factors we describe under “Risk Factors” and elsewhere in this prospectus.
 
Our Company
 
We are a technology-based education company. We offer proprietary curriculum, software and educational services created for online delivery to students in kindergarten through 12th grade, or K-12. Our mission is to maximize a child’s potential by providing access to an engaging and effective education, regardless of geographic location or socio-economic background. Since our inception, we have invested more than $95 million to develop curriculum and an online learning platform that promotes mastery of core concepts and skills for students of all abilities. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for a virtual school and other educational applications. From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from approximately 11,000 students to 27,000 students, representing a compound annual growth rate of approximately 35%. From fiscal year 2004 to fiscal year 2006, we increased revenues from $71.4 million to $116.9 million, representing a compound annual growth rate of approximately 28%.
 
We deliver our learning system to students primarily through virtual public schools. Many states have embraced virtual public schools as a means to provide families with a publicly funded alternative to a traditional classroom-based education. We offer virtual schools our proprietary curriculum, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions, under long-term contracts. These contracts provide the basis for a recurring revenue stream as students progress through successive grades. Additionally, without the requirement of a physical classroom, virtual schools can be scaled quickly to accommodate a large dispersed student population, and allow more capital resources to be allocated towards teaching, curriculum and technology rather than towards a physical infrastructure.
 
Our proprietary curriculum is currently used by public school students in 16 states and the District of Columbia. Parents can also purchase our curriculum and online learning platform directly to facilitate or supplement their children’s education. Additionally, we have piloted our curriculum in brick and mortar classrooms with promising academic results. We also believe there is additional widespread applicability for our learning system internationally.
 
Our History
 
We were founded in 2000 to utilize the advances in technology to provide children access to a high-quality public school education regardless of their geographic location or socio-economic background. Given the geographic flexibility of technology-based education, we believed that the pursuit of this mission could help address the growing concerns regarding the regionalized disparity in the quality of public school education, both in the United States and abroad. These concerns were reflected in the passage of the No Child Left Behind (NCLB) Act in 2000, which implemented new standards and accountability requirements for public K-12 education. The convergence of these concerns and rapid advances in Internet technology created the opportunity to make a significant impact by deploying a high quality learning system on a flexible, online platform.
 
In September 2001, after 18 months of research and development on our curriculum, we launched our kindergarten through 2nd grade offering. We initially launched our learning system in virtual public schools in Pennsylvania and Colorado, serving approximately 900 students in the two states combined. During the 2002-03 school year, we added our 3rd through 5th grade offering and entered into contracts to operate virtual public schools in California, Idaho, Ohio, Minnesota and Arkansas, increasing our average enrollment to approximately 5,900 students during the 2002-03 school year. During the 2003-04 and 2004-05 school years, we added 7th and 8th grades, respectively, and added contracts with virtual public schools in Wisconsin, Arizona and Florida. By the end of the 2004-05 school year, we had increased enrollment to approximately 15,100 students. In the 2005-06


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school year, we added contracts to operate virtual public schools in Washington, Illinois and Texas. Additionally during the 2006-07 school year, we implemented a hybrid school offering in Chicago that combines face-to-face time in the classroom with online instruction. We recently entered the virtual high school market, enrolling 9th and 10th grade students at the start of the 2005-06 and 2006-07 school years, respectively, and we plan to offer 11th and 12th grades at the start of the 2007-08 school year.
 
We believe we have significant growth potential. Therefore over the last three years, we have put a great deal of effort into developing the infrastructure necessary to scale our business. We further developed our logistics and technological infrastructure and implemented sophisticated financial systems to allow us to more effectively operate a large and growing company.
 
Key Aspects and Trends of Our Operations
 
Revenues
 
We generate a significant portion of our revenues from enrollments in virtual public schools. Revenues consist principally of product and service revenues derived through our contracts with these schools. These contracts provide the channels through which we can enroll students into the school, and we execute marketing and recruiting programs designed to create awareness and generate enrollments for these schools. We generate our revenues by providing each student with access to our online lessons and offline learning kits, including a personal computer. In addition, we provide a variety of management and academic support services to virtual public schools, ranging from turnkey end-to-end management solutions to a single service to meet a school’s specific needs. We also generate revenues from sales of our curriculum and offline learning kits through other channels, including directly to consumers and pilots in a traditional classroom environment.
 
Factors affecting our revenues include: (i) the number of enrollments; (ii) the nature and extent of the management services provided to the schools and school districts; (iii) state or district per student funding levels; and (iv) prices for our products and services.
 
We define an enrollment as a full-time student using our provided courses as their primary curriculum. We consider full-time students to be those utilizing our curriculum regardless of the nature and extent of the management services we provide to the virtual public school. Generally, a full-time student will take five or six courses, except for kindergarten students who participate in half-day programs. We count each half-day kindergarten student as an enrollment.
 
School sessions generally begin in August or September and end in May or June. We consider the duration of a school year to be 10 months. To ensure that all schools are reflected in our measure of enrollments, we consider the number of students on the last day of September to be our opening enrollment level, and the number of students enrolled on the last day of May to be our ending enrollment level. To provide comparability, we do not consider enrollment levels for June, July and August as most schools are not open during these months. For each period, average enrollments represent the average of the month-end enrollment levels for each month that has transpired between September and the end of the period, up to and including the month of May. We continually evaluate our enrollment levels by state, by school and by grade. We track new student enrollments and withdrawals throughout the year.
 
We believe that the number of enrollments depends upon the following:
 
  •  the number of states and school districts in which we operate;
 
  •  the appeal of our curriculum to students and families;
 
  •  the effectiveness of our program in delivering favorable academic outcomes;
 
  •  the quality of the teachers working in the virtual public schools we serve; and
 
  •  the effectiveness of our marketing and recruiting programs.
 
We continually evaluate our trends in revenues by monitoring the number of enrollments in total, by state, by school and by grade, assessing the impact of changes in funding levels and our product pricing. We track


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enrollments throughout the year, as students enroll and withdraw. We also provide our courses for use in a traditional classroom setting and we sell our courses directly to consumers. Our classroom course revenues are generally for single courses. Consumers typically purchase from one to six courses in a year, however, we do not monitor the progress of these students. Therefore, we do not include classroom or consumer students in our enrollment totals.
 
We closely monitor the financial performance of the virtual public schools to which we provide turnkey management services. Under the contracts with these schools, we take responsibility for any operating deficits that they may incur in a given school year. These operating deficits may result from a combination of cost increases or funding reductions attributable to the following: 1) costs associated with new schools including the initial hiring of teachers and the establishment of school infrastructure; 2) school requirements to establish contingency reserves; 3) one-time costs such as a legal claim; 4) funding reductions due to the inability to qualify specific students for funding; and 5) regulatory or academic performance thresholds which may initially restrict the ability of a school to fund all expenses. In these cases, because a deficit may impair our ability to collect our invoices in full, we reduce revenues by the sum of these deficits. Over the past three years, these deficits and the related reduction to revenues have grown substantially faster than overall revenue growth reflecting a significant number of new school start-ups, the time required to meet performance thresholds in certain states and funding adjustments in two states related to the disqualification of certain past enrollments. We expect these deficits to continue to grow faster than overall revenue growth as we expand into new states, continue investment in educational programs, and incur the higher costs associated with our high school offering.
 
Our annual growth in revenues may be materially affected by changes in the level of management services we provide to certain schools. Currently a significant portion of our enrollments are associated with virtual public schools to which we provide turnkey management services. We are responsible for the complete management of these schools and therefore, we recognize as revenues the funds received by the schools, up to the level of costs incurred. These costs are substantial, as they include the cost of teacher compensation and other ancillary school expenses. Accordingly, enrollments in these schools generate substantially more revenues than enrollments in other schools where we provide limited or no management services. In these situations, our revenues are limited to direct invoices and are independent of the total funds received by the school from a state or district. As a result, changes in the number of enrollments associated with schools operating under turnkey arrangements relative to total enrollments may have a disproportionate impact on growth in revenues relative to the growth in enrollments.
 
Our annual growth in revenues will also be impacted by changes in state or district per enrollment funding levels. These funding levels are typically established on an annual basis and generally increase at modest levels from year to year. We expect this trend to continue. Finally, we may generate modest growth in revenues from increases in the prices of our products. We evaluate our product pricing annually against market benchmarks and conditions and raise them as we deem appropriate. We do not expect our price increases to have a significant incremental impact as they are encompassed within increases in per enrollment funding levels.
 
Instructional Costs and Services Expenses
 
Instructional costs and services expenses include expenses directly attributable to the educational products and services we provide. The virtual public schools we manage are the primary drivers of these costs, including teacher and administrator salaries and benefits and expenses of related support services. Instructional costs also include fulfillment costs of student textbooks and materials, and the cost of any third-party online courses. In addition, we include in instructional costs the amortization of capitalized curriculum and related systems. We measure, track and manage instructional costs and services as a percentage of revenues and on a per enrollment basis as these are key indicators of performance and operating efficiency. As a percentage of revenues, instructional costs and services expenses decreased slightly for the nine months ended March 31, 2007, as compared to the nine months ended March 31, 2006 primarily due to lower costs associated with a renewed virtual school contract that no longer includes turnkey management services. This was partially offset by higher school operating costs and the start-up costs of new schools. We expect instructional costs and services expenses as a percentage of revenues to increase as we expand our high school enrollments, develop new delivery models, and incur start-up costs for new schools.
 
Over time, we expect high school enrollments to grow as a percentage of total enrollments. Our high school offering requires increased instructional costs as a percentage of revenues compared to our kindergarten to 8th grade


33


 

offering. This is due to the following: (i) demand for numerous electives which requires licensing of third-party courses to augment our proprietary curriculum; (ii) generally lower student-to-teacher ratios; (iii) higher compensation costs for teachers due to the need for subject-matter expertise; and (iv) ancillary costs for required student support services including college placement, SAT preparation and guidance counseling.
 
We are developing new delivery models, such as the hybrid model, where students receive both face-to-face and online instruction. Development costs may include instructional research and curriculum development. These models necessitate additional costs including facilities related costs and additional administrative support, which are generally not required to operate typical virtual public schools. As a result, instructional costs as a percentage of revenues may be higher than our typical offering. In addition, we are pursuing expansion into new states. If we are successful, we will incur start-up costs and other expenses associated with the initial launch of a virtual public school, which may result in increased instructional costs as a percentage of revenues.
 
Selling, Administrative and Other Operating Expenses
 
Selling, administrative and other operating expenses include the salaries, benefits and related costs of employees engaged in business development, sales and marketing, and administrative functions. We measure and track selling, administrative and other operating expenses as a percentage of revenues to track performance and efficiency of these areas. In addition, we track measures of sales and marketing efficiency including the number of new enrollment prospects for virtual public schools and our ability to convert these prospects into enrollments. We also track various operating, call center and information technology statistics as indicators of operating efficiency and customer service. We expect these expenses, as a percentage of revenues, to decline over time, reflecting the scalability of our corporate infrastructure, partially offset by increased levels of spending on marketing and business development activities.
 
Product Development Expenses
 
Product development expenses include research and development costs and overhead costs associated with the management of projects to develop curriculum and internal systems. In addition, product development expenses include the amortization and internal systems and any impairment charges. We measure and track our product development expenditures on a per course or project basis to measure and assess our development efficiency. In addition, we monitor employee utilization to evaluate our workforce efficiency. We plan to invest in additional curriculum development and related software in the future, primarily to produce additional high school courses, new releases of existing courses and to upgrade our content management system and our Online School (OLS). We capitalize most of the costs incurred to develop our curriculum and software, beginning with application development, through production and testing.
 
We account for impairment of capitalized curriculum development costs in accordance with Statement of Financial Accounting Standard No. 144 (SFAS No. 144,) Accounting for the Impairment or Disposal of Long-Lived Assets. See “Critical Accounting Policies and Estimates”. We did not record any impairment charge in the nine months ended March 31, 2007. Impairment charges recorded were $0.4 million and $3.3 million for the years ended June 30, 2006 and 2005, respectively. In fiscal year 2006, we recognized impairment of capitalized curriculum as the potential to earn revenues from the use of our curriculum in a traditional classroom was uncertain. In 2005, we recognized impairment as we generated a net loss in that year and development costs exceeded future cash flows.
 
Other Factors That May Affect Comparability
 
Public Company Expenses.  Upon consummation of our initial public offering, we will become a public company, and our shares of common stock will be publicly traded on the New York Stock Exchange. As a result, we will need to comply with new laws, regulations and requirements that we did not need to comply with as a private company, including certain provisions of the Sarbanes-Oxley Act of 2002, other applicable SEC regulations and the requirements of the New York Stock Exchange. Compliance with the requirements of being a public company will require us to increase our general and administrative expenses in order to pay our employees, legal counsel and independent registered public accountants to assist us in, among other things, instituting and monitoring a more comprehensive compliance and board governance function, establishing and maintaining internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 and preparing and


34


 

distributing periodic public reports in compliance with our obligations under the federal securities laws. In addition, as a public company, it will make it more expensive for us to obtain directors and officers liability insurance.
 
Stock Option Expense.  The adoption of Statement of Financial Accounting Standard No. 123R, “Share Based Payments” (SFAS No. 123R), requires that we recognize an expense for stock options granted beginning July 1, 2006. We incurred approximately $0.1 million in stock compensation expense for the nine months ended March 31, 2007. We expect stock option expense to increase in the future as we grant additional stock options.
 
Income Tax Benefits Resulting from Decrease of Valuation Allowance.  In the period from our inception through fiscal year 2005, we incurred significant operating losses that resulted in a net operating loss carryforward for tax purposes and net deferred tax assets. Through March 31, 2007, we provided a 100% valuation allowance for all net deferred tax assets based on our limited history of generating taxable income. Our provision for income taxes for the nine months ended March 31, 2007 was $0.2 million, compared to no provision for the nine months ended March 31, 2006. Our tax expense for the nine months ended March 31, 2007 is primarily related to alternative minimum tax liabilities. Effectively, no tax expense was recorded in the nine months ending March 31, 2006 as we were able to utilize net operating loss carryforwards that were fully reserved for in prior periods. We do not expect to record any income tax expense in the next few years other than alternative minimum tax, unless we decrease the valuation allowance on net deferred tax assets of $28.5 million as of March 31, 2007.
 
Public Funding and Regulation.  Our public school customers are financed with federal, state and local government funding. Budget appropriations for education at all levels of government are determined through a political process and, as a result, our revenues may be affected by changes in appropriations. Decreases in funding could result in an adverse affect on our financial condition, results of operations and cash flows.
 
Competition.  The market for providing online education for grades K-12 is becoming increasingly competitive and attracting significant new entrants. If we are unable to successfully compete for new business and contract renewals, our growth in revenues and operating margins may decline. With the introduction of new technologies and market entrants, we expect this competition to intensify.
 
Critical Accounting Policies and Estimates
 
The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. In the preparation of our consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The results of our analysis form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated financial statements. Our critical accounting policies have been discussed with the audit committee of our board of directors.
 
We believe that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements:
 
Revenue Recognition
 
In accordance with SEC Staff Accounting Bulletin No. 104 (SAB No. 104), we recognize revenues when each of the following conditions is met: (1) persuasive evidence of an arrangement exists; (2) delivery of physical goods or rendering of services is complete; (3) the seller’s price to the buyer is fixed or determinable; and (4) collection is reasonably assured. Once these conditions are satisfied, the amount of revenues we record is determined in accordance with Emerging Issues Task Force (EITF 99-19),Reporting Revenue Gross as a Principal versus Net as an Agent.”
 
We generate almost all of our revenues through long-term contracts with virtual public schools. These schools are generally funded by state or local governments on a per student basis. Under these contracts, we are responsible for providing each enrolled student with access to our OLS, our online lessons, offline learning kits and student


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support services required for their complete education. In most cases, we are also responsible for providing complete management and technology services required for the operation of the school. The revenues derived from these long-term agreements is primarily dependent upon the number of students enrolled, the extent of the management services contracted for by the school, and the level of funding provided to the school for each student.
 
We invoice virtual public schools in accordance with the established contractual terms. Generally, this means that we invoice each school for the following items: (1) access to our online school and online lessons; (2) offline learning kits; (3) student personal computers; and (4) management and technology services. We apply SAB No. 104 to each of these items as follows:
 
  •  Access to the K12 Online School and Online Lessons.  Our OLS revenues come primarily from contracts with charter schools and school districts. Students are provided access to the OLS and online lessons at the start of the school year for which they have enrolled. On a per student basis, we invoice schools an upfront fee at the beginning of the school year or at the time a student enrolls and a monthly fee for each month during the school year in which the student is enrolled. A school year generally consists of 10 months. The upfront fee is initially recorded as deferred revenue and is recognized as revenues ratably over the remaining months of the current school year. If a student withdraws prior to the end of a school year, any remaining deferred revenue related to the upfront fee is recognized because service delivery is complete. The monthly fees are recognized in the month in which they are earned.
 
The majority of our enrollments occur at the beginning of the school year in August or September, depending upon the state. Because upfront fees are generally charged at the beginning of the school year, the balance in our deferred revenue account tends to be at its highest point at the end of the first quarter. Generally, the balance will decline over the course of the year and all deferred revenue related to virtual public schools will be fully recognized by the end of our fiscal year on June 30.
 
  •  Offline Learning Kits.  Our offline learning kit revenues come primarily from contracts with virtual public schools and our curriculum blends which online and offline content. The lessons in our online school are meant to be used in conjunction with selected printed materials, workbooks, laboratory materials and other manipulative items which we provide to students. We generally ship all offline learning kits to a student when their enrollment is approved and invoice the schools in full for the materials at that time. Once materials have been shipped, our efforts are substantially complete. Therefore, we recognize revenues upon shipment. Because offline learning kits revenues are recognized near the time of enrollment in its entirety, we generate a majority of these revenues in our first fiscal quarter which coincides with the start of the school year.
 
  •  Student Personal Computers.  In most of our contracts with virtual public schools, we are responsible for ensuring that each enrolled student has the ability to access our online school. To accomplish this, we generally provide each enrolled student with a personal computer, complete technical support through our call center, and reclamation services when a student withdraws or a computer needs to be exchanged. Schools are invoiced on a per student basis for each enrolled student to whom we have provided a personal computer. This may include an upfront fee at the beginning of the school year or at the time a student enrolls and a monthly fee for each month during the school year in which the student is enrolled. A school year generally consists of 10 months. The upfront fee is initially recorded as deferred revenue and is recognized as revenues ratably over the remaining months of the current school year. If a student withdraws prior to the end of a school year, any remaining deferred revenue related to the upfront fee are recognized because service delivery is complete. All deferred revenue will be recognized by the end of our fiscal year, June 30. The monthly fees are recognized in the month in which they are earned.
 
  •  Management and Technology Services.  Under most of our school contracts, we provide the boards of the virtual public schools we serve with turnkey management and technology services. We take responsibility for all academic and fiscal outcomes. This includes responsibility for all aspects of the management of the schools, including monitoring academic achievement, teacher recruitment and training, compensation of school personnel, financial management, enrollment processing and procurement of curriculum, equipment and required services. Management and technology fees are generally determined based upon a percentage


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  of the funding received by the virtual public school. We generally invoice schools for management and technology services in the month in which they receive such funding.
 
We recognize the revenues from turnkey management and technology fees ratably over the course of our fiscal year. We use 12 months as a basis for recognition because administrative offices of the school remain open for the entire year. To determine the amount of revenues to recognize in our fiscal year, we estimate the total funds that each school will receive in a particular school year, and our related fees associated with the estimated funding. We review our estimates of funding periodically, and revise as necessary, amortizing any adjustments over the remaining portion of the fiscal year. Actual school funding may vary from these estimates or revisions, and the impact of these differences could have a material impact on our results of operations.
 
Under most contracts, we provide the virtual schools we manage with turnkey management services and take responsibility for any operating deficits that the schools may incur in a given school year. Such deficits may arise from school start-up costs, from funding shortfalls, from temporary or long-term incremental cost requirements for a particular school, or due to specific one-time expenses that a school may incur. These operating deficits may impair our ability to collect the full amount invoiced in a period. In these cases, since collection cannot be reasonably assured, we reduce revenues by the amount of these deficits. We recognize the impact of these operating deficits by estimating the full year revenues and full year deficits of schools at the beginning of the fiscal year. We amortize the estimated deficits against recognized revenues based upon the percentage of actual revenues in the period to total estimated revenues for the fiscal year. We periodically review our estimates of full year school revenues and full year operating deficits and amortize the impact of any changes to these estimates over the remainder of our fiscal year. Actual school operating deficits may vary from these estimates or revisions, and the impact of these differences could have a material impact on our results of operations. The amount of revenues we record is determined in accordance with Emerging Issues Task Force Reporting Revenue Gross as a Principal versus Net as an Agent, EITF 99-19. For these schools, we have determined that we are the primary obligor for substantially all expenses of the school. Accordingly, we report revenues on a gross basis by recording the associated per student revenues received by the school from its funding state or school district up to the expenses incurred by the school. Revenues are recognized when the underlying expenses are incurred by the school. For the small percentage of contracts where we provide individually selected services for the school, we invoice on a per student or per service basis and recognize revenues in accordance with SAB No. 104. Under these contracts, where we do not assume responsibility for operating deficits, we record revenues on a net basis.
 
We also generate a small percentage of our revenues through the sale of our online courses and offline learning kits directly to consumers. Online course sales are generally subscriptions for periods of 12 to 24 months and customers have the option of paying a discounted amount in full upfront or paying in monthly installments. Payments are generally made with charge cards. For those customers electing to pay these subscription fees in their entirety upfront, we record the payment as deferred revenue and amortize the revenues over the life of the subscription. For customers paying monthly, we recognize these payments as revenues in the month earned. Revenues for offline learning kits are recognized when shipped. Within 30 days of enrollment, customers can receive a full refund, however customers terminating after 30 days will receive a pro rata refund for the unused portion of their subscription less a termination fee. Historically, the impact of refunds has been immaterial.
 
Capitalized Curriculum Development Costs
 
Our curriculum is primarily developed by our employees and to a lesser extent, by independent contractors. Generally, our courses cover traditional subjects and utilize examples and references designed to remain relevant for long periods of time. The online nature of our curriculum allows us to incorporate user feedback rapidly and make ongoing corrections and improvements. For these reasons, we believe that our courses, once developed, have an extended useful life, similar to computer software.
 
We capitalize curriculum development costs incurred during the application development stage in accordance with Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 provides guidance for the treatment of costs associated with computer software


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development and defines those costs to be capitalized and those to be expensed. Costs that qualify for capitalization are external direct costs, payroll, payroll-related costs, and interest costs. Costs related to general and administrative functions are not capitalizable and are expensed as incurred. We capitalize curriculum development costs when the projects under development reach technological feasibility. Many of our new courses leverage off of proven delivery platforms and are primarily content, which has no technological hurdles. As a result, a significant portion of our courseware development costs qualify for capitalization due to the concentration of our development efforts on the content of the courseware. Technological feasibility is established when we have completed all planning, designing, coding, and testing activities necessary to establish that a course can be produced to meet its design specifications. Capitalization ends when a course is available for general release to our customers, at which time amortization of the capitalized costs begins. The period of time over which these development costs will be amortized is generally five years. This is consistent with the capitalization period used by others in our industry and corresponds with our product development lifecycle.
 
Software Developed or Obtained for Internal Use
 
We develop our own proprietary computer software programs to provide specific functionality to support both our unique education offering and the student and school management services. These programs enable us to develop courses, process student enrollments, meet state documentation requirements, track student academic progress, deliver online courses to students, coordinate and track the delivery of course-specific materials to students and provide teacher support and training. These applications are integral to our learning system and we continue to enhance existing applications and create new applications.
 
We capitalize software development costs incurred during the development stage of these applications in accordance with SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. These development costs are generally amortized over three years.
 
Impairment of Long-lived Assets
 
Long-lived assets include property, equipment, capitalized curriculum and software developed or obtained for internal use. In accordance with Statement of Financial Accounting Standards No. 144 (SFAS No. 144), Accounting for the Impairment or Disposal of Long-Lived Assets, we review our recorded long-lived assets for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. We determine the extent to which an asset may be impaired based upon our expectation of the asset’s future usability as well as on a reasonable assurance that the future cash flows associated with the asset will be in excess of its carrying amount. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between fair value and the carrying value of the asset.
 
Accounting for Stock-based Compensation
 
Prior to July 1, 2006, we accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB No. 25 and related interpretations. Accordingly, compensation cost for stock options generally was measured as the excess, if any, of the estimated fair value of our common stock over the amount an employee must pay to acquire the common stock on the date that both the exercise price and the number of shares to be acquired pursuant to the option are fixed. We had adopted the disclosure-only provisions of SFAS No. 123 which was released in May 1995, and used the minimum value method of valuing stock options as allowed for non-public companies.
 
In December 2004, SFAS No. 123R revised SFAS No. 123 and superseded APB No. 25. SFAS No. 123R requires the measurement of the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the measurement date of grant, with the cost being recognized over the applicable requisite service period. In addition, SFAS No. 123R requires an entity to provide certain disclosures in order to assist in understanding the nature of share-based payment transactions and the effects of those transactions on the financial statements. The provisions of SFAS No. 123R are required to be applied as of the beginning of the first interim or annual reporting period of the entity’s first fiscal year that begins after December 15, 2005.


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Effective July 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R using the prospective transition method, which requires the Company to apply the provisions of SFAS No. 123R only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock- based compensation expense recognized beginning July 1, 2006 is based on the fair value of stock awards as of the grant date. As the Company had used the minimum value method for valuing its stock options under the disclosure requirements of SFAS No. 123, all options granted prior to July 1, 2006 continue to be accounted for under APB No. 25.
 
The Company accounts for equity instruments issued to nonemployees in accordance with the provisions of SFAS No. 123 and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.
 
Deferred Tax Asset Valuation Allowance
 
We account for income taxes as prescribed by Statement of Financial Accounting Standards No. 109 (SFAS No. 109), Accounting for Income Taxes. SFAS No. 109 prescribes the use of the asset and liability method to compute the differences between the tax bases of assets and liabilities and the related financial amounts, using currently enacted tax laws. If necessary, a valuation allowance is established to reduce deferred tax assets to the amount that is more likely than not to be realized. Realization of the deferred tax assets, net of deferred tax liabilities, is principally dependent upon achievement of projected future taxable income offset by deferred tax liabilities. We exercise significant judgment in determining our provisions for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefit from our deferred tax assets. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to examination by tax authorities in the ordinary course of business. We periodically assess the likelihood of adverse outcomes resulting from these examinations to determine the impact on our deferred taxes and income tax liabilities and the adequacy of our provision for income taxes. Changes in income tax legislation, statutory income tax rates, or future taxable income levels, among other things, could materially impact our valuation of income tax assets and liabilities and could cause our income tax provision to vary significantly among financial reporting periods.
 
As of March 31, 2007, we had net operating loss carry-forwards of $57.5 million that expire between 2020 and 2027 if unused. We recorded a full valuation allowance against net deferred tax assets, including deferred tax assets generated by net operating loss carry-forwards. The valuation allowance on net deferred tax assets was $29.0 million as of March 31, 2007.


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Results of Operations
 
The following table presents our selected consolidated statement of operations data expressed as a percentage of our total revenues for the periods indicated:
 
                                         
    Year Ended
    Nine Months Ended
 
    June 30,     March 31,  
    2004     2005     2006     2006     2007  
 
Consolidated Statement of Operations Data:
                                       
Revenues
    100 %     100 %     100 %     100 %     100 %
Cost and expenses
                                       
Instructional costs and services
    56       58       55       54       53  
Selling, administrative, and other operating expenses
    36       35       36       32       33  
Product development expenses
    18       11       7       6       6  
                                         
Total costs and expenses
    110       104       98       92       92  
                                         
Income (loss) from operations
    (10 )     (4 )     2       8       8  
Interest expense, net
                (1 )            
                                         
Income (loss) from operations before income taxes
    (10 )     (4 )     1       8       8  
                                         
Income tax benefit (expense)
                             
                                         
Net income (loss)
    (10 )%     (4 )%     1 %     8 %     8 %
                                         
 
Comparison of Nine Months Ended March 31, 2007 to Nine Months Ended March 31, 2006
 
Revenues.  Our revenues for the nine months ended March 31, 2007 were $104.9 million, representing an increase of $14.8 million, or 16.4%, as compared to revenues of $90.1 million for the nine months ended March 31, 2006. Average enrollments increased 35.3% to 27,297 for the nine months ended March 31, 2007 from 20,183 average enrollments for the nine months ended March 31, 2006. Primarily offsetting the increased revenues related to enrollment growth, was a decline in management services revenues resulting from the impact of a substantial reduction in the percentage of enrollments associated with schools to which we provide turnkey management services. For the nine months ended June 30, 2007, 76.2% of our enrollments were associated with these schools, down from 91.7% for the corresponding period in 2006. The increase in average enrollments was primarily attributable to new school openings in Washington, California, and Chicago, where we opened our first hybrid school. In addition, we launched 10th grade in August 2006 attracting new students as well as prior year 9th grade students. Price increases of approximately 2% also generated additional revenues. Finally, increased operating deficits at certain schools partially offset the growth in revenues. These deficits were attributable to greater school operating expenses to support increased enrollment and high school services as well as school funding adjustments stemming from enrollment audits in California and Colorado.
 
Instructional Costs and Services Expenses.  Instructional costs and services for the nine months ended March 31, 2007 were $55.1 million, representing an increase of $6.6 million, or 13.6%, as compared to instructional costs and services of $48.5 million for the nine months ended March 31, 2006. This increase was primarily attributable to increased costs to supply books and materials as well as increased school operating expenses, both primarily a result of the increase in enrollments. As a percentage of revenues, instructional costs and services decreased by 1.3% to 52.5% for the nine months ended March 31, 2007, as compared to 53.8% for the nine months ended March 31, 2006. The decrease in instructional costs and services expenses as a percentage of revenues is primarily due to lower costs associated with a renegotiated management and services agreement, partially offset by a shift in mix of enrollments to schools with higher operating costs and the start-up costs of new schools.
 
Selling, Administrative, and Other Operating Expenses.  Selling, administrative, and other operating expenses for the nine months ended March 31, 2007 were $35.1 million, representing an increase of $6.7 million, or 23.4%, as compared to selling, administrative and other operating expenses of $28.4 million for the nine months ended March 31, 2006. This increase is primarily attributable to increases in marketing staff as well as increased spending on advertising and other marketing tactics. In addition, expenses increased in finance, legal and school services as the Company increased its capabilities in these areas. As a percentage of revenues, selling,


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administrative, and other operating expenses increased to 33.4% for the nine months ended March 31, 2007 compared to 31.5% for the nine months ended March 31, 2006.
 
Product Development Expenses.  Product development expenses for the nine months ended March 31, 2007 were $5.9 million, representing an increase of $0.3 million, or 5.4%, as compared to product development expenses of $5.6 million for the nine months ended March 31, 2006. Contributing to this increase are increases in employee headcount and contract labor offset by greater utilization of these resources for capitalized curriculum. As a percentage of revenues, product development expenses were relatively stable at 5.6% for the nine months ended March 31, 2007 compared to 6.2% for the nine months ended March 31, 2006.
 
Net Interest Expense.  Net interest expense for the nine months ended March 31, 2007 was $0.5 million, an increase of $0.1 million, or 25.0%, from $0.4 million for the nine months ended March 31, 2006. The increase in net interest expense is primarily due to interest charges on increased capital lease obligations.
 
Income Taxes.  Our provision for income taxes for the nine months ended March 31, 2007 was $0.2 million, compared to no provision for the nine months ended March 31, 2006. Our tax expense for the nine months ended March 31, 2007 is primarily related to alternative minimum tax liabilities. Effectively no tax expense was recorded in the nine months ending March 31, 2006 as we were able to utilize net operating loss carry-forwards that were fully reserved for in prior periods.
 
Net Income.  Net income for the nine months ended March 31, 2007 was $8.2 million, representing an increase of $1.0 million, or 13.9%, as compared to net income of $7.2 million for the nine months ended March 31, 2006. Net income as a percentage of revenues was relatively stable at to 7.8% for the nine months ended March 31, 2007, as compared to 8.0% for the nine months ended March 31, 2006, as a result of the factors discussed above.
 
Comparison of Years Ended June 30, 2006 and 2005
 
Revenues.  Our revenues for the year ended June 30, 2006 were $116.9 million, representing an increase of $31.6 million, or 37.0%, as compared to revenues of $85.3 million for the year ended June 30, 2005. Average enrollments increased 33.9% to 20,220 for the year ended June 30, 2006 from 15,097 average enrollments for the year ended June 30, 2005. Our enrollment growth was driven by the addition of the 9th grade which attracted new students in addition to students enrolled in 8th grade in the prior year. Also, average price increases of approximately 4% were implemented in July 2005. Partially offsetting growth in revenues as compared to enrollment growth was growth in the percentage of enrollments attributable to schools where we earn limited or no services revenues. Enrollments associated with schools to which we provide turnkey management services declined from 92.3% for the year ended June 30, 2006 from 94.3% for the corresponding period in 2005. Finally, increased operating deficits at certain schools partially offset the growth in revenues. These deficits were primarily attributable to greater school operating expenses to support increased enrollment and high school services.
 
Instructional Costs and Services Expenses.  Instructional costs and services expenses for the year ended June 30, 2006 were $64.8 million, representing an increase of $15.7 million, or 31.9%, as compared to instructional costs and services of $49.1 million for the year ended June 30, 2005. This increase was primarily attributable to increased costs to supply books, educational materials and computers to students and school operating expenses as a result of the increase in enrollments. As a percentage of revenues, instructional costs and services decreased to 55.5% for the year ended June 30, 2006, as compared to 57.6% for the year ended June 30, 2005. The decrease in instructional costs and services as a percentage of revenues is primarily due to economies in scale in the operation of the virtual public schools partially offset by higher costs for books and materials.
 
Selling, Administrative, and Other Operating Expenses.  Selling, administrative, and other operating expenses for the year ended June 30, 2006 were $41.7 million, representing an increase of $11.7 million, or 38.7%, as compared to selling, administrative and other operating expenses of $30.0 million for the year ended June 30, 2005. This increase is primarily attributable to increases in employee headcount in sales and marketing staff as well as increased spending on advertising and other marketing tactics. In addition, contract labor increased in information technology and employee headcount increased in finance and human resources as the company increased its capabilities in these areas. As a percentage of revenues, selling, administrative, and other operating expenses remained relatively stable at 35.6% for the year ended June 30, 2006 compared to 35.2% for the year ended June 30, 2005.


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Product Development Expenses.  Product development expenses for the year ended June 30, 2006 were $8.6 million, representing a decrease of $0.8 million, or 8.9%, as compared to product development expenses of $9.4 million for the year ended June 30, 2005. This decrease is primarily attributable to a year over year decrease of $2.9 million in impairment charges. Offsetting this decrease is an increase in personnel and contract labor. As a percentage of revenues, product development expenses decreased to 7.3% for the year ended June 30, 2006 compared to 11.0% for the year ended June 30, 2005. This decrease is primarily attributable to the factors described above and our ability to leverage these costs over an increasing number of enrollments.
 
Net Interest Expense.  Net interest expense for the year ended June 30, 2006 was $0.5 million, an increase of $0.2 million, or 66.7%, from $0.3 million for the year ended June 30, 2005. The increase in interest expense is primarily due to debt of $4.0 million borrowed in June 2005.
 
Income Taxes.  Our provision for income taxes for the year ended June 30, 2006 was zero as we were able to utilize net operating loss carry-forwards that were fully reserved for in prior periods. We also recorded no income tax expense for the year ended June 30, 2005 as the Company had a net loss.
 
Net Income (Loss).  Net income for the year ended June 30, 2006 was $1.4 million, representing an increase of $4.9 million as compared to a net loss of $3.5 million for the year ended June 30, 2005. Net income as a percentage of revenues was 1.2% for the year ended June 30, 2006, as compared to a net loss of 4.1% for the year ended June 30, 2005, as a result of the factors discussed above.
 
Comparison of Years Ended June 30, 2005 and 2004
 
Revenues.  Our revenues for the year ended June 30, 2005 were $85.3 million, representing an increase of $13.9 million, or 19.4%, as compared to revenues of $71.4 million for the year ended June 30, 2004. Average enrollments increased 35.3% to 15,097 for the year ended June 30, 2006 from 11,158 average enrollments for the year ended June 30, 2004. Partially offsetting growth in revenues as compared to growth in enrollments was growth in enrollments at schools where we earn limited or no services revenues. In 2004, all of our enrollments were associated with schools where we provided complete turnkey services. In 2005, we began to offer schools the opportunity to use our curriculum without purchasing any services. In fiscal year 2005, 5.7% of enrollments were associated with schools to which we provided limited or no management services. Fiscal year 2005 was the first year in which we offered limited services. Our enrollment growth benefited from the addition of the 8th grade in September 2004 which attracted new students in addition to students enrolled in 7th grade in the prior year. Average price increases of 7% were implemented in July 2004. In addition, increased operating deficits partially offset the growth in revenues. These increased deficits were primarily attributable to a higher percentage of enrollments associated with schools in the early stages of development.
 
Instructional Costs and Services Expenses.  Instructional costs and services expenses for the year ended June 30, 2005 were $49.1 million, representing an increase of $9.2 million, or 23.0%, as compared to instructional costs and services expenses of $39.9 million for the year ended June 30, 2004. This increase was primarily attributable to increased expenses incurred to operate the schools. Also contributing to the increase were increased costs to supply computers to students as a result of the increase in enrollments. As a percentage of revenues, instructional costs and services expenses increased to 57.6% for the year ended June 30, 2005, as compared to 55.9% for the year ended June 30, 2004. The increase in instruction costs and services expenses as a percentage of revenues is primarily due to increased costs to provide computers to students partially offset by a reduction in fulfillment costs for materials to students.
 
Selling, Administrative, and Other Operating Expenses.  Selling, administrative, and other operating expenses for the year ended June 30, 2005 were $30.0 million, representing an increase of $4.3 million, or 17.1%, as compared to selling, administrative and other operating expenses of $25.7 million for the year ended June 30, 2004. This increase is primarily attributable to increases in employee headcount in operations and marketing as well as increased spending on advertising and other marketing tactics. These increases are partially offset by a decrease in information technology operating expenses. As a percentage of revenues, selling, administrative, and other operating expenses remained relatively stable at 35.2% for the year ended June 30, 2005 compared to 35.9% for the year ended June 30, 2004.


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Product Development Expenses.  Product development expenses for the year ended June 30, 2005 were $9.4 million, representing a decrease of $3.4 million, or 26.6%, as compared to product development expenses of $12.8 million for the year ended June 30, 2004. The decrease is primarily attributable to a year over year decrease of $1.7 million in impairment charges, a decrease in employee headcount and an increase in the utilization of labor for capitalized curriculum. As a percentage of revenues, product development expenses decreased to 11.0% for the year ended June 30, 2005 compared to 17.8% for the year ended June 30, 2004. This decrease is primarily attributable to the factors described above and our ability to leverage these costs over an increasing number of enrollments.
 
Net Interest Expense.  Net interest expense for the year ended June 30, 2005 was $0.3 million, a decrease of $0.2 million, or 40.0%, from $0.5 million for the year ended June 30, 2004. The decrease is primarily attributable to lower interest charges from lower outstanding balances of capital lease obligations.
 
Income Taxes.  We also recorded no income tax expense for the years ended June 30, 2005 and 2004 as the company had a net loss.
 
Net Loss.  Net loss for the year ended June 30, 2005 was $3.5 million as compared to a net loss of $7.4 million for the year ended June 30, 2004. Net loss as a percentage of revenues was 4.1% for the year ended June 30, 2005, as compared to 10.4% for the year ended June 30, 2004, as a result of the factors discussed above.
 
Quarterly Results of Operations
 
The following tables set forth selected unaudited quarterly consolidated statement of operations data for the seven most recent quarters, as well as each line item expressed as a percentage of total revenues. The information for each of these quarters has been prepared on the same basis as the audited consolidated financial statements included in this prospectus and, in the opinion of management, includes all adjustments necessary for the fair presentation of the results of operations for such periods. This data should be read in conjunction with the audited consolidated financial statements and the related notes included in this prospectus. These quarterly operating results are not necessarily indicative of our operating results for any future period
 
                                                         
    Three Months Ended  
    Sep 30, 2005     Dec 31, 2005     Mar 31, 2006     Jun 30, 2006     Sep 30, 2006     Dec 31, 2006     Mar 31, 2007  
 
Revenues
  $ 31,176     $ 28,245     $ 30,667     $ 26,814     $ 37,743     $ 32,356     $ 34,831  
Cost and expenses
                                                       
Instructional costs and services
    17,416       15,696       15,361       16,355       19,177       18,022       17,904  
Selling, administrative, and other
    8,742       8,402       11,259       13,257       11,385       11,030       12,644  
Product development expenses
    1,864       1,862       1,861       2,981       2,206       1,566       2,083  
                                                         
Total costs and expenses
    28,022       25,960       28,481       32,593       32,768       30,618       32,631  
                                                         
Income (loss) from operations
    3,154       2,285       2,186       (5,779 )     4,975       1,738       2,200  
Interest expense, net
    (135 )     (127 )     (132 )     (94 )     (94 )     (263 )     (117 )
                                                         
Income (loss) before income taxes
    3,019       2,158       2,054       (5,873 )     4,881       1,475       2,083  
Income tax expense
                            (146 )     (30 )     (51 )
                                                         
Net income (loss)
  $ 3,019     $ 2,158     $ 2,054     $ (5,873 )   $ 4,735     $ 1,445     $ 2,032  
                                                         


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The following table sets forth statements of operations data as a percentage of revenues for each of the periods indicated:
 
                                                         
    Three Months Ended  
    Sep 30, 2005     Dec 31, 2005     Mar 31, 2006     Jun 30, 2006     Sep 30, 2006     Dec 31, 2006     Mar 31, 2007  
 
Revenues
    100 %     100 %     100 %     100 %     100 %     100 %     100 %
Cost and expenses
                                                       
Instructional costs and services
    56       56       50       61       51       56       52  
Selling, administrative, and other
    28       30       37       50       30       34       36  
Product development expenses
    6       6       6       11       6       5       6  
                                                         
Total costs and expenses
    90       92       93       122       87       95       94  
                                                         
Income (loss) from operations
    10       8       7       (22 )     13       5       6  
                                                         
Interest expense, net
                                  (1 )      
                                                         
Income (loss) before income taxes
    10       8       7       (22 )     13       4       6  
Income tax expense, net
                                         
                                                         
Net income (loss)
    10 %     8 %     7 %     (22 )%     13 %     4 %     6 %
                                                         
 
Discussion of Quarterly Results of Operations
 
Our revenues and operating results normally fluctuate as a result of seasonal variations in our business, principally due to the number of months that our virtual public school are fully operational and serving students in a fiscal quarter. While school administrative offices are generally open year round, a school typically serves students during a 10 month academic year. A school’s academic year will typically start in August or September, our first fiscal quarter, and finish in May or June, our fourth fiscal quarter. Consequently, our first and fourth fiscal quarters may have fewer than three months of full operations when compared to the second and third fiscal quarters.
 
In the first and fourth fiscal quarters, online curriculum and computer revenues are generally lower as these revenues are primarily earned during the school academic year which may provide for only one or two months of these revenues in these quarters versus the second and third fiscal quarters. In addition, we ship materials to students in the beginning of the school year, our first fiscal quarter, generally resulting in higher materials revenues and margin in the first fiscal quarter versus other quarters. The overall impact of these factors is partially offset by students enrolling after the start of the academic year. The seasonality of our business produces higher revenues in the first fiscal quarter.
 
Operating expenses are also seasonal. Instruction costs and services expenses will increase in the first fiscal quarter primarily due to the costs incurred to ship student materials at the beginning of the school year. Instructional costs may increase significantly quarter-to-quarter as school operating expenses increase. For example, enrollment growth will require additional teaching staff, thereby increasing salary and benefits expense. School events may be seasonal, (e.g. professional development and community events,) impacting the quarterly change in instructional costs. The majority of our marketing and selling expenses are incurred in the first and fourth fiscal quarters, as our primary enrollment season is July through September.
 
Financial Condition
 
There are several factors that create seasonal variations in our balance sheet. In the first fiscal quarter, we ship materials to students from inventory, generally reducing inventory over this period. In addition, we invoice for products and services in the first fiscal quarter, coinciding with the start of the school year. This creates a significant increase in our accounts receivable and deferred revenue balances for the quarter. The virtual schools generally receive their funding over the course of the school year and we receive payments from them accordingly. Finally, we increase our inventory for the fall enrollments beginning in the fourth fiscal quarter.
 
Liquidity and Capital Resources
 
As of March 31, 2007 and June 30, 2006, we had cash and cash equivalents of $5.1 million and $9.5 million, respectively. Net cash provided by operating activities during the nine months ended March 31, 2007, was


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$7.3 million, primarily due to net income of $8.2 million, depreciation and amortization of $4.6 million, an increase in deferred revenues of $5.9 million and a decrease in inventory of $4.4 million. This was primarily offset by an increase in accounts receivable of $12.4 million, a change in accounts receivable allowance of $1.0 million, and a decrease in accounts payable and accrued liabilities of $1.7 million.
 
We financed our operating activities and capital expenditures during the nine months ended March 31, 2007 through cash provided by operating activities, capital lease financing and short-term debt. During the years ended June 30, 2006 and 2005, we financed our operating activities and capital expenditures through a combination of cash provided by operating activities, long-term debt and capital lease financing. Prior to 2005, we financed our operating activities and capital expenditures primarily with sales of equity to private investors. From the Company’s founding in 2001 through December 2003, we raised over $115 million from the sale of equity.
 
In December 2006, we entered into a $15 million revolving credit agreement with PNC Bank (the Credit Agreement). Pursuant to the terms of the Credit Agreement, we agreed that the proceeds of the term loan facility were to be used primarily for working capital requirements and other general business or corporate purposes. Because of the seasonality of our business and timing of funds received, the school expenditures are higher in relation to funds received in certain periods during the year. The Credit Agreement provides the ability to fund these periods until cash is received from the schools; therefore, borrowings against the Credit Agreement are primarily going to be short-term.
 
Borrowings under the Credit Agreement bear interest based upon the term of the borrowings. Interest is charged, at our option, either at: (i) the higher of (a) the rate of interest announced by PNC Bank from time to time as its “prime rate” and (b) the federal funds rate plus 0.5%; or (ii) the applicable London interbank offered rate (LIBOR) divided by a number equal to 1.00 minus the maximum aggregate reserve requirement which is imposed on member banks of the Federal Reserve System against “eurocurrency liabilities” plus the applicable margin for such loans, which ranges between 1.250% and 1.750%, based on the leverage ratio (as defined in the Credit Agreement). We pay a quarterly commitment fee which varies between 0.150% and 0.250% on the unused portion of the credit agreement (depending on the leverage ratio). The working capital line includes a $5.0 million letter of credit facility. Issuances of letters of credit reduce the availability of permitted borrowings under the Credit Agreement.
 
The Credit Agreement contains a number of financial and other covenants that, among other things, restrict our and our subsidiaries’ abilities to incur additional indebtedness, grant liens or other security interests, make certain investments, become liable for contingent liabilities, make specified restricted payments including dividends, dispose of assets or stock, including the stock of its subsidiaries, or make capital expenditures above specified limits and engage in other matters customarily restricted in senior secured credit facilities. We must also maintain a minimum net worth (as defined in the credit agreement) and maximum debt leverage ratios. These covenants are subject to certain qualifications and exceptions. Through March 31, 2007, we were in compliance with these covenants.
 
As of March 31, 2007, $1.5 million of borrowings were outstanding on the working capital line of credit and approximately $2.3 million outstanding for letters of credit. In July 2007, we borrowed an additional $3.0 million.
 
One of our subsidiaries has an equipment lease line of credit for new purchases with Hewlett-Packard Financial Services Company that expires on July 31, 2007 for new purchases on the line of credit. We expect to renew this facility. The interest rate on new borrowings under the equipment lease line is set quarterly. For the nine months ended March 31, 2007, we borrowed $6.6 million to finance the purchase of student computers and related equipment at interest rates ranging from 8.5% to 8.8%. These leases include a 36-month payment term with a bargain purchase option at the end of the term. Accordingly, we include this equipment in property and equipment and the related liability in capital lease obligations. In addition, we have pledged the assets financed with the equipment lease line to secure the amounts outstanding.
 
A substantial portion of our revenues are generated through our contractual arrangements with virtual public schools. The virtual public schools are generally funded on a per student basis by their state and local governments and the timing of funding varies by state. Funding receipts by an individual school may vary over the year and may be in arrears. Because our receivables represent obligations indirectly due from governments, we have not historically had an issue with non-payment and believe the risk of non-payment is minimal although we cannot guarantee this will continue.


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Our operating requirements consist primarily of day-to-day operating expenses, capital expenditures and contractual obligations with respect to facility leases, capital equipment leases and other operating leases. Capital expenditures are expected to increase in the next several years as we invest in additional courses, new releases of existing courses and purchase computers to support increases in virtual school enrollments. We expect our capital expenditures in the next 12 months will be approximately $17 million to $25 million for curriculum development and related systems as well as computers for students. We expect to be able to fund these capital expenditures with cash generated from operations, short-term debt and capital lease financing. We lease all of our office facilities. We expect to make future payments on existing leases from cash generated from operations. We believe that our existing cash balances and continued cash generated from operations, our revolving credit facility, and in-part, the net proceeds from this offering, will provide sufficient resources to meet our projected operating requirements, start-up costs to open new schools, and planned capital expenditures for at least the next 12 months.
 
Operating Activities
 
Net cash provided by operating activities during the nine months ended March 31, 2007, was $7.3 million. Net cash provided by operating activities in fiscal year 2006 and 2005 was $3.6 million and $9.7 million, respectively, as compared to net cash used in operating activities in fiscal year 2004 of $8.0 million.
 
The cash provided by operations in the nine months ended March 31, 2007 was primarily due to net income of $8.2 million, depreciation and amortization of $4.6 million, an increase in deferred revenues of $5.9 million and a decrease in inventory of $4.4 million. This was primarily offset by an increase in accounts receivable of $12.4 million, a change in accounts receivable allowance of $1.0 million, and a decrease in accounts payable and accrued liabilities of $1.7 million.
 
The cash provided by operations in fiscal year 2006 was primarily due to net income of $1.4 million, depreciation and amortization of $5.0 million, an increase in accounts payable of $1.6 million, an increase of accrued compensation and benefits of $1.8 million, and an increase in deferred rent of $1.6 million. This was primarily offset by an increase in inventory of $5.4 million and an increase of accounts receivable of $2.7 million.
 
The cash provided by operations in fiscal year 2005 was primarily due to depreciation and amortization of $5.5 million, a decrease in accounts receivable of $3.4 million, impairment charges of $3.3 million, an increase in accrued liabilities of $1.2 million, and an increase in accrued compensation and benefits of $1.0 million. This was primarily offset by a net loss of $3.5 million and an increase in inventories, prepaid and other assets of $1.5 million.
 
The cash used in operations in fiscal year 2004 was primarily due to a net loss of $7.4 million, an increase in accounts receivable of $10.6 million, and an increase in inventory and other assets of $2.2 million. This was primarily offset by depreciation and amortization of $4.9 million, impairment charges of $5.0 million, an increase in accrued compensation and benefits of $1.3 million, and an increase in accrued liabilities of $0.7 million.
 
Investing Activities
 
Net cash used in investing activities for the nine months ended March 31, 2007 was $10.8 million. Net cash used in investing activities for the fiscal year 2006, 2005 and 2004 was $11.5 million, $8.5 million and $5.4 million, respectively.
 
Net cash used in investing activities for the nine months ended March 31, 2007 was due to capitalized curriculum of $7.0 million and purchases of property and equipment of $3.8 million. This does not include $6.6 million of student computers financed with capital leases. Purchases of property and equipment for the fiscal year ended 2006, 2005 and 2004 were $10.8 million, $4.7 million, and $0.5 million, respectively. In fiscal year 2005 and 2004, we also financed with capital leases, purchases of student computers in the amount of $0.4 million and $4.1 million, respectively. Capitalized curriculum the fiscal year ended 2006, 2005 and 2004 were $0.7 million, $3.8 million, and $4.9 million, respectively.
 
Financing Activities
 
Net cash used in financing activities for the nine months ended March 31, 2007 was $0.9 million. This was primarily due to a payment on a related party note payable of $4.0 million and repayments for capital lease obligations of $0.7 million. This was partially offset by the release of cash from a restricted escrow account of


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$2.3 million and net borrowings from our revolving credit facility of $1.5 million. Net cash used in financing activities for fiscal year 2006 was $2.6 million primarily attributable to cash invested in a restricted escrow account of $2.2 million and repayments for capital lease obligations of $0.4 million.
 
Net cash provided by financing activities for the fiscal year 2005 was $2.9 million primarily due to proceeds from a related party note payable of $4.0 million and the release of cash from a restricted escrow account of $2.2 million. This was partially offset by repayments of capital lease obligations of $3.4 million. Net cash provided by financing activities for fiscal year 2004 was $21.6 million primarily due to proceeds from the sale of redeemable convertible preferred stock of $25.0 million. This was partially offset by repayments of capital lease obligations of $2.4 million and cash invested in a restricted escrow account of $1.0 million.
 
Contractual Obligations
 
Our contractual obligations consist primarily of leases for office space, capital leases for equipment and other operating leases. The following summarizes our long-term contractual obligations as of March 31, 2007:
 
                                                         
    For the Twelve Months Ending March 31,  
    Total     2008     2009     2010     2011     2012     Thereafter  
    (dollars in thousands)  
 
Contractual Obligations at March 31, 2007
                                                       
Capital leases(1)
  $ 6,583     $ 2,476     $ 2,475     $ 1,632     $     $     $  
Operating leases
    18,221       2,174       2,106       2,147       1,451       1,372       8,971  
Line of credit(2)
    1,500       1,500                                          
Long-term obligations
    245       153       92                                  
Other commitments(3)
    120       120                                
                                                         
Total
  $ 26,669     $ 6,423     $ 4,673     $ 3,779     $ 1,451     $ 1,372     $ 8,971  
                                                         
 
(1) Includes interest expense.
(2) Pertains to revolving line of credit and excludes interest expense due to short-term repayment period.
(3) For employment agreement.
 
Under most contracts, we provide the virtual schools we manage with turnkey management services and take responsibility for any operating deficits that the school may incur. These deficits are recorded as a reduction in revenues, and therefore are not included as a commitment or obligation in the above table.
 
In connection with our service agreement with the Northern Ozaukee School District (and the Wisconsin Virtual Academy), there is an indemnification provision which arguably could be asserted by the school district for certain expenses in the event the plaintiff prevails and the Court enjoins open enrollment payments to the district that otherwise would cover those expenses. We have assessed the likelihood of a claim as remote, and therefore it has not been included as a commitment or obligation in the table above.
 
Off-Balance Sheet Arrangements
 
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
 
Impact of Inflation
 
We believe that inflation has not had a material impact on our results of operations for any of the years in the three year period ended June 30, 2006 or the nine months ending March 31, 2007. We cannot assure you that future inflation will not have an adverse impact on our operating results and financial condition.
 
Quantitative and Qualitative Disclosures About Market Risk
 
Interest Rate Risk
 
We had unrestricted cash and cash equivalents totaling $5.1 million and $9.5 million as of March 31, 2007 and June 30, 2006, respectively. Unrestricted cash and cash equivalents are maintained primarily in non-interest bearing


47


 

accounts and are used for working capital purposes. Because we currently do not have balances in interest bearing accounts, fluctuations in interest rates would not have a material impact on our investment income.
 
Our interest rate exposure is related to short-term debt obligations under our revolving credit facility. A significant portion of our interest expense is based upon changes in the LIBOR benchmark interest rate. Due to the short-term nature of our outstanding debt subject to variable interest rates as of March 31, 2007 of $1.5 million, fluctuations in the LIBOR rate would not have a material impact on our interest expense.
 
Foreign Currency Exchange Risk
 
We currently do not operate in a foreign country or transact business in a foreign currency and therefore we are not subject to fluctuations due to changes in foreign currency exchange rates. However, we intend to pursue opportunities in international markets in the future. If we enter into any material transactions in a foreign currency or establish or acquire any subsidiaries that measure and record their financial condition and results of operation in a foreign currency, we will be exposed to currency transaction risk and/or currency translation risk. Exchange rates between U.S. dollars and many foreign currencies have fluctuated significantly over the last few years and may continue to do so in the future. Accordingly, we may decide in the future to undertake hedging strategies to minimize the effect of currency fluctuations on our financial condition and results of operations.
 
Recent Accounting Pronouncements
 
In December 2004, the FASB issued SFAS No. 123R, which revised SFAS No. 123, and supersedes APB Opinion No. 25. The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25 and requires that the compensation costs relating to such transactions be recognized in the statements of operations. We adopted SFAS No. 123R for the fiscal year ended June 30, 2007.
 
In February 2006, FASB issued Statement of Financial Accounting Standard No. 155 (SFAS No. 155), Accounting for Certain Hybrid Financial Instruments — An Amendment of FASB Statements No. 133 and 140. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative effect adjustment to beginning retained earnings. We do not believe that the adoption of SFAS No. 155 will have a material impact on our consolidated financial statements.
 
In June 2006, the FASB issued FASB Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effect that the adoption of FIN 48 will have on our financial position and results of operations.
 
In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157 (SFAS No. 157), Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are in the process of evaluating the impact of this statement on our consolidated financial statements.
 
In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159 (SFAS No. 159), The Fair Value Option for Financial Assets and Financial Liabilities. This statement permits companies and not-for-profit organizations to make a one-time election to carry eligible types of financial assets and liabilities at fair value, even if fair value measurement is not required under GAAP. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted if the decision to adopt the standard is made after the issuance of this statement but within 120 days after the first day of the fiscal year of adoption, provided no financial statements have yet been issued for any interim period and provided the requirements of SFAS No. 157, Fair Value Measurements, are adopted concurrently with SFAS No. 159. The Company does not believe that it will adopt the provisions of this statement.


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BUSINESS
 
Our Company
 
We are a technology-based education company. We offer proprietary curriculum, software and educational services created for online delivery to students in kindergarten through 12th grade, or K-12. Our mission is to maximize a child’s potential by providing access to an engaging and effective education, regardless of geographic location or socio-economic background. Since our inception, we have invested more than $95 million to develop curriculum and an online learning platform that promotes mastery of core concepts and skills for students of all abilities. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for a virtual school and other educational applications. From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from approximately 11,000 students to 27,000 students, representing a compound annual growth rate of approximately 35%. From fiscal year 2004 to fiscal year 2006, we increased revenues from $71.4 million to $116.9 million, representing a compound annual growth rate of approximately 28%.
 
We believe we are unique in the education industry because of our direct involvement in every component of the educational development and delivery process. Most educational content, software and service providers typically concentrate on only a portion of that process, such as publishing textbooks, managing schools or providing testing and assessment services. This traditional segmented approach has resulted in an uncoordinated and unsatisfactory education for many students. Unburdened by legacy, we have taken a holistic approach to the design of our learning system. We have developed an engaging curriculum which includes online lessons delivered over our proprietary school platform. We combine this with a rigorous system to test and assess students and processes to manage school performance and compliance. In addition, our professional development programs enable teachers to better utilize technology for instruction. Our end-to-end learning system is designed to maximize the performance of the schools we serve and enhance student academic achievement.
 
As evidence of the benefit of our holistic approach, the virtual public schools we serve generally test near or above state averages on standardized achievement tests. These results have been achieved despite the enrollment of a significant number of new students each school year who have had limited exposure to our learning system prior to taking these required state tests. Students using our learning system for at least three years usually perform better on standardized tests relative to state averages than students using it for one year or less. The efficacy of our learning system has also helped us achieve high levels of customer satisfaction. According to a 2006 internal survey of parents of students enrolled in virtual public schools we serve, approximately 97% of respondents stated that they were either satisfied or very satisfied with our curriculum and 95% of respondents stated that they would recommend our curriculum to other families.
 
We deliver our learning system to students primarily through virtual public schools. As with any public school, these schools must meet state educational standards, administer proctored exams and are subject to fiscal oversight. The fundamental difference is that students attend virtual public schools primarily over the Internet instead of traveling to a physical classroom. In their online learning environment, students receive assignments, complete lessons, and obtain instruction from certified teachers with whom they interact online, telephonically, and face-to-face. Many states have embraced virtual public schools as a means to provide families with a publicly funded alternative to a traditional classroom-based education. For parents who believe their child is not thriving and for whom relocating or private school is not an option, virtual public schools can provide a compelling choice. This widespread availability makes them the “most public” of schools. From an education policy standpoint, virtual public schools often represent a savings to the taxpayers when compared with traditional public schools because they are generally funded at a lower per pupil level than the per pupil state average reported by the U.S. Department of Education. Finally, because parents are not required to pay tuition, virtual public schools make our learning system available to the broadest range of students.
 
We offer virtual schools our proprietary curriculum, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions, under long-term contracts. These contracts provide the basis for a recurring revenue stream as students progress through successive grades. Additionally, without the requirement of a physical classroom, virtual schools can be scaled quickly to accommodate a large dispersed student population, and allow more capital resources to be allocated towards teaching, curriculum and technology rather than towards a physical infrastructure.


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Our proprietary curriculum is currently used by public school students in 16 states and the District of Columbia. Parents can also purchase our curriculum and online learning platform directly to facilitate or supplement their children’s education. Additionally, we have piloted our curriculum in brick and mortar classrooms with promising academic results. We also believe there is additional widespread applicability for our learning system internationally.
 
Families that choose our learning system for their children come from a broad range of social, economic and academic backgrounds. They share, however, the desire for an individualized learning program to maximize their children’s potential. Examples include, but are not limited to, families with: (i) students seeking to learn faster or slower than they could in a “one size fits all” traditional classroom; (ii) safety concerns about their local school; (iii) students with disabilities for which traditional classrooms are problematic; (iv) students with geographic or travel constraints; and (v) student athletes and performers who are not able to attend regularly scheduled classes. Our individualized learning approach allows students to optimize their individual academic performance and, therefore, their chances of achieving their goals.
 
Our History
 
We were founded in 2000 to utilize the advances in technology to provide children access to a high-quality public school education regardless of their geographic location or socio-economic background. Given the geographic flexibility of technology-based education, we believed that the pursuit of this mission could help address the growing concerns regarding the regionalized disparity in the quality of public school education, both in the United States and abroad. These concerns were reflected in the passage of the No Child Left Behind (NCLB) Act in 2000, which implemented new standards and accountability requirements for public K-12 education. The convergence of these concerns and rapid advances in Internet technology created the opportunity to make a significant impact by deploying a high quality learning system on a flexible, online platform.
 
In September 2001, after 18 months of research and development on our curriculum, we launched our kindergarten through 2nd grade offering. We initially launched our learning system in virtual public schools in Pennsylvania and Colorado, serving approximately 900 students in the two states combined. During the 2002-03 school year, we added our 3rd through 5th grade offering and entered into contracts to operate virtual public schools in California, Idaho, Ohio, Minnesota and Arkansas, increasing our average enrollment to approximately 5,900 students during the 2002-03 school year. During the 2003-04 and 2004-05 school years, we added 7th and 8th grades, respectively, and added contracts with virtual public schools in Wisconsin, Arizona and Florida. By the end of the 2004-05 school year, we had increased enrollment to approximately 15,100 students. In the 2005-06 school year, we added contracts to operate virtual public schools in Washington, Illinois and Texas. Additionally during the 2006-07 school year, we implemented a hybrid school offering in Chicago that combines face-to-face time in the classroom with online instruction. We recently entered the virtual high school market, enrolling 9th and 10th grade students at the start of the 2005-06 and 2006-07 school years, respectively, and we plan to offer 11th and 12th grades at the start of the 2007-08 school year.
 
We believe we have significant growth potential. Therefore over the last three years, we have put a great deal of effort into developing the infrastructure necessary to scale our business. We further developed our logistics and technological infrastructure and implemented sophisticated financial systems to allow us to more effectively operate a large and growing company.
 
Our Market
 
The U.S. market for K-12 education is large and growing. For example:
 
  •  According to the National Center for Education Statistics (NCES), a division of the U.S. Department of Education, there were more than 47 million students in K-12 public schools during the 2005-06 school year. In addition, according to National Home Education Research, approximately two million students are home schooled and, according to a March 2006 NCES report, approximately five million students are enrolled in private schools.
 
  •  According to the NCES, the public school system alone encompassed more than 97,000 schools and 17,000 districts during the 2005-06 school year.


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  •  According to the NCES, total spending in the public K-12 market was $536 billion for the 2004-05 school year.
 
Parents and lawmakers are demanding increased standards and accountability in an effort to improve academic performance in U.S. public schools. As a result, each state is now required to establish performance standards and to regularly assess student progress relative to these standards. We expect continued focus on academic standards, assessments and accountability in the near future.
 
Many parents and educators are also seeking alternatives to traditional classroom-based education that can help improve academic achievement. Demand for these alternatives is evident in the growing number of choices available to parents and students. For example, charter schools emerged in 1988 to provide an alternative to traditional public schools. Currently, 40 states and the District of Columbia have passed charter school legislation and there are approximately 4,000 charter schools in the U.S. with an estimated enrollment of over 1.1 million students according to the Center for Education Reform. Similarly, acceptance of online education as an effective, alternative form of education is growing. As of September 2006, 38 states had authorized some form of online education, and Michigan recently became the first state to pass legislation mandating that high school students take part in an “online learning experience” in order to graduate.
 
Virtual public schools represent another approach to online education that is gaining acceptance. According to the Center for Education Reform, as of January 2007 there were 173 virtual schools with total enrollment exceeding 92,000 students, operating in 18 states. Virtual schools can offer a comprehensive curriculum and flexible delivery model; therefore, we believe that a growing number of families will pursue virtual public schools as an attractive public school alternative. Given these statistics and the nascence of this market, we believe there is a significant opportunity for a high-quality, trusted, national education provider to serve virtual public schools.
 
Our Competitive Strengths
 
We believe the following to be our key competitive strengths:
 
Proprietary Curriculum Specifically Designed for a Technology-Enabled Environment.  We specifically designed our curriculum for online learning, in contrast to other online curriculum providers who often just digitize classroom textbooks for transmission over the Internet. Our lessons utilize a combination of innovative technologies, including flash animations, online interactivity and real-time individualized feedback, which we combine with textbooks and other offline course materials to create an engaging and highly effective curriculum. Our curriculum contains more than 11,000 discrete lessons, each of which addresses specific learning objectives and can be utilized in the manner most appropriate for each student. We continuously measure student performance and use this information to improve our curriculum and drive greater, more consistent academic achievement, a valuable competitive advantage we enjoy by virtue of our integration into all aspects of the educational development and delivery process. We believe our curriculum is the most advanced cognitive research-based curriculum in K-12 education.
 
Flexible, Integrated Online Learning Platform.  Our online learning platform provides a highly flexible and effective means for delivering educational content to students. Our platform offers assessment capabilities to identify the current and targeted academic level of achievement for each individual student, and then incorporates this information into a detailed lesson plan. As students progress through their studies, our learning platform measures mastery of each learning objective to ensure that students grasp each concept prior to proceeding to the next lesson. Additionally, our learning platform updates each student’s lesson plan for completed lessons and enables us to track the effectiveness of each lesson with each student on a real-time basis. Finally, the fact that our learning system is Internet-based allows us to update our proprietary content and incorporate user feedback on a real-time basis. For example, our content for the 2006-07 school year reflected the fact that Pluto is no longer considered a planet, which was announced in August 2006.
 
Expertise in Opening Channels for Virtual Schooling.  Our education policy experts and established relationships with key educational authorities have allowed us to participate effectively in advocating for virtual public schools. Specifically, we have demonstrated our expertise in helping individual educational policymakers understand the benefits of virtual schools and in managing the regulatory requirements once new virtual schools are


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opened. Since our inception, we have partnered with individual state governing bodies to establish highly effective, publicly funded education alternatives for parents and their children. Our experience in opening up these new channels gives us a valuable first-mover advantage over potential competitors.
 
Track Record of Student Achievement and Customer Satisfaction.  The virtual public schools we serve generally test near or above state averages on standardized achievement tests. These results have been achieved despite the enrollment of a significant number of new students each school year who have had limited exposure to our learning system prior to taking these required state tests. Students using our learning system for at least three years usually perform better on standardized tests relative to state averages than students using it for one year or less. A comprehensive analysis of individual student progression conducted during the 2006-07 school year in Ohio, the first state to conduct such an analysis, concluded that a virtual public school using our learning system outperformed 97% and 60% of participating public schools in reading and mathematics, respectively. Additionally, in California, the only state to adjust standardized test scores for student demographics, the virtual public schools we serve performed in the 70th to 90th percentile of all public schools in the state during the 2005-06 school year. Among statewide virtual public schools, those using the K12 learning system outperform other providers in terms of academic performance. The efficacy of our learning system has also helped us achieve high levels of customer satisfaction. According to a 2006 internal survey of parents of students enrolled in virtual public schools we serve, approximately 97% of respondents stated that they were either satisfied or very satisfied with our curriculum and 95% of respondents stated that they would recommend our curriculum to other families. This high degree of customer satisfaction has been a strong contributor to our growth, helps drive new student referrals and leads to re-enrollments.
 
Highly Scalable Model.  We have built our educational model systems and management team to successfully and efficiently serve the academic needs of a large dispersed student population. We generate high levels of recurring revenue as a result of our long-term contracts with schools (typically five years in length), the extended duration over which an individual student can utilize our learning system (kindergarten through 12th grade) and our high level of customer satisfaction. Since our inception, we have invested over $95 million to develop our learning system, incurring significant losses. Our ability to leverage this historical investment in our learning system and our ability to deliver our offering over the Internet enables us to successfully serve a greater number of students at a reduced level of capital investment.
 
Our Growth Strategy
 
We intend to pursue the following strategies to drive our future growth:
 
Generate Enrollment Growth at Existing Virtual Public Schools.  From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from more than 11,000 students to more than 27,000 students. In the 2007-08 school year, we will serve virtual public schools in 16 states and the District of Columbia. We intend to continue to drive increased enrollments at the virtual public schools we serve through targeted marketing and recruiting efforts as well as through referrals. Our marketing and recruiting efforts utilize both traditional and online media as well as community events to communicate the effectiveness of our solution to parents who are evaluating educational alternatives for their children. Historically, we have also enrolled a significant number of new students each year through referrals from families who have had a positive experience with our learning system and recommended K12 to their friends and family members.
 
Enhance Curriculum to Include a Complete High School Offering.  We believe the high school market represents a significant growth opportunity for online education delivery given the increased independence of high school students and the wide variance in academic achievement levels and objectives of students who are entering high school. America’s Digital Schools 2006, a survey conducted by Discovery Education and Pearson Education, projects that the percentage of U.S. high school students enrolled in online courses will increase from 3.8% in 2006 to 15.6% in 2011. We believe that our market-leading position in the K-8 virtual public schools positions us well for growth in the high school market. In the 2005-06 and 2006-07 school years, we began enrolling 9th and 10th grade students, respectively, and with the planned launch of our 11th and 12th grades in the 2007-08 school year, we will be able to provide a complete high school offering. We are developing our high school curriculum to satisfy the


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broad range of high school student interests with a broad variety of required and elective courses, supplemented by selected courses from other content providers.
 
Expand Virtual Public School Presence into Additional States.  We work closely with state policymakers and school districts to assist them in considering virtual public schools as an effective educational choice for parents and students. A virtual public school program can help state administrations or school districts quickly establish and offer an alternative to traditional classroom-based education, expanding the range of choices available to parents and students. The flexibility and comprehensiveness of our learning system allows us to efficiently adapt our curriculum to meet the individual educational standards of any state with minimal capital investment. We intend to continue to seek opportunities to assist states in establishing virtual public schools and to contract with them to provide our curriculum, online learning platform and related services.
 
Strengthen Awareness and Recognition of the K12 Brand.  Within the virtual public school community, we enjoy strong brand recognition among parents and students as a leading provider of virtual education. Outside of this community, however, the K12 brand is not as well recognized. We have developed a comprehensive brand strategy and intend to invest in further developing awareness of both the K12 brand and the core philosophy behind our learning system. The recent launch of our “Unleash the xPotential” campaign is a strong first step towards this goal of creating broader brand awareness. We believe that a strong and recognized brand will result in an increased presence among virtual public schools, attract more student applications and facilitate our entry into adjacent markets.
 
Pursue International Opportunities to Offer Our Learning System.  We believe there is strong worldwide demand for high-quality, flexible education alternatives. In many countries, students seek a U.S. accredited education to gain access to higher education and improved employment opportunities. Given the highly flexible design and technology-based nature of our platform, it can be adapted to other languages and cultures efficiently and with modest capital investment. Additionally, our ability to operate virtually is not constrained by the need for a physical classroom or local teachers, which makes our learning system ideal for use internationally.
 
Develop Additional Channels Through Which to Deliver our Learning System.  We believe there are many additional channels through which the K12 learning system can be offered. These include direct classroom instruction, hybrid models, and as a supplemental educational offering. For example, in an urban public school in Philadelphia, we piloted our K-5 curriculum in traditional classrooms and were able to generate meaningful improvements in academic performance. Additionally, we have recently implemented a hybrid offering in Chicago that combines face-to-face time in the classroom with online instruction. Outside the public school channels, the flexibility of our learning system enables us to package lessons to be sold as individual products directly to parents and students. We intend to regularly evaluate additional delivery channels and to pursue opportunities where we believe there is likely to be significant demand for our offering.
 
Educational Philosophy
 
The design, development and delivery of our learning system is based on the following set of guiding principles:
 
  •  Apply “Tried and True” Educational Approaches for Instruction. Our learning system is designed to utilize both “tried” and “true” methods to drive academic success. “True” methodologies are based on cognitive research regarding the way in which individuals learn. We also supplement our learning system with teaching tools and methodologies that have been tested, or “tried,” and proven to be effective. This “tried and true” philosophy allows us to benefit from both decades of research about learning, and effective methods of teaching.
 
  •  Employ Technology Appropriately for Learning. While all of our courses are delivered primarily through an online platform and generally include a significant amount of online content, we employ technology only where we feel it is appropriate and can enhance the learning process. In addition to online content, our curriculum includes a rich mix of offline course materials, including engaging textbooks and hands-on materials such as phonics kits and musical instruments. We believe our balanced use of technology and offline materials helps to maximize the effectiveness of our learning system.


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  •  Base Learning Objectives on Rich Content and “Big Ideas.” We refer to “big ideas” as the key, subconscious frameworks that serve as the foundation to a student’s future understanding of a subject matter. For example, an understanding of waves is fundamental to a physicist’s understanding of quantum mechanics; therefore, we teach 1st graders the fundamentals of waves. We use these “big ideas” to organize and provide the master objectives of every course we develop. We then utilize rich, engaging content to best communicate these concepts to students to promote mastery of the topics.
 
  •  Assess Every Objective to Ensure Mastery. Ongoing assessments are the most effective way to evaluate a student’s mastery of a lesson or concept. To facilitate effective assessment, our curriculum establishes clear objectives for each lesson. Throughout a course, each student’s progress is assessed and evaluated by a teacher at a point when each objective is expected to be mastered, providing direction for appropriate pacing. These periodic and well-timed assessments reinforce learning and promote mastery of a topic before a student moves to the next lesson or course.
 
  •  Facilitate Flexibility as the Level, Pace and Hours Spent on Each Objective Vary by Child. We believe that each student should be challenged appropriately. Generally, adequate progress for most students is to complete one academic year’s curriculum within a nine-month school year. Each individual student may take greater or fewer instructional hours and more or less effort than the average student to achieve this progress. Our learning system is designed to facilitate this flexibility in order to ensure that the appropriate amount of time and effort is allocated to each lesson.
 
  •  Prioritize Important, Complex Objectives. We have developed a clear understanding of those subjects and concepts that are difficult for students. Greater instructional effort is focused on the most important and difficult concepts and skills. We use existing research, feedback from parents and students and experienced teacher judgments to determine these priorities, and to modify our learning system to guide the allocation of each student’s time and effort.
 
Products and Services
 
Our Products
 
K12 Curriculum
 
Our curriculum consists of the K12 online lessons, offline learning kits and teachers’ guides. We have developed an extensive catalogue of proprietary courses, consisting of more than 11,000 lessons, designed to teach concepts to students from kindergarten through 10th grade. Each lesson is designed to last approximately 45 to 60 minutes, although students are able to work at their own pace. A single course generally consists of 120 to 180 individual lessons.
 
Online Lessons.  Our online lessons are accessed through our Online School (OLS) platform. Each online lesson provides the roadmap for the entire lesson including direction to specific online and offline materials, online lesson content and a summary of the major objectives for the lesson. Lessons utilize a combination of innovative technologies including flash animations and online interactivity, coordinated textbooks and hands-on materials and individualized feedback to create an engaging, responsive and highly effective curriculum. Each lesson also contains an online assessment to ensure that students have mastered the material and are ready to proceed to the next lesson, allowing them to work at their own pace. Pronunciation guides for key words and references to suggested additional resources, specific to each lesson and each student’s assessment, are also included.
 
Offline Learning Kits.  All of our courses utilize a series of offline learning kits in conjunction with the online lessons to help maximize the effectiveness of our learning system. In addition to receiving access to our online lessons through the Internet, each student receives a shipment of offline materials, including textbooks, art supplies, laboratory supplies (e.g. microscopes and scales) and other reference materials which are incorporated throughout our curriculum. This approach is consistent with our guiding principle to utilize technology where appropriate in our learning system. Most of the textbooks we use are proprietary textbooks that are written in a way that is designed to be engaging to students and to compliment the online experience. We believe that our ability to combine online lessons and offline materials so effectively is a competitive advantage.


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Teachers’ Guides.  All of our courses are paired with a teacher’s guide. Each guide outlines the course objectives, refers back to all of the course content that is contained in the online and offline course materials, includes answers and explanations to the exercises that the students complete and contains suggestions for explaining difficult concepts to students.
 
Courses Offered
 
The following table provides a list of our proprietary courses and selected third-party courses that we expect to offer during 2007-08 school year. We also expect to offer an additional 33 third-party courses at the high school level.
 
                 
       
English and Language Arts
 
Mathematics
 
Science
 
   






Elementary School








Middle School



High School









Elementary School






Middle School



High School
  Kindergarten Language Arts
Kindergarten Phonics
1st Grade Language Arts
1st Grade Phonics
2nd Grade Language Arts
3rd Grade Language Skills
3rd Grade Spelling
3rd Grade Literature
4th Grade Language Skills
4th Grade Spelling
4th Grade Literature
5th Grade Language Skills
5th Grade Spelling
5th Grade Literature

Intermediate Language Skills A
Intermediate Language Skills B
Intermediate Literature A
Intermediate Literature B
Literary Analysis and Composition

Literary Analysis and Composition I Foundations
Literary Analysis and Composition I
Literary Analysis and Composition II
American Literature
AP English Literature and Composition
World Literature and Language

History
Kindergarten History
1st Grade History
2nd Grade History
3rd Grade History
4th Grade History
American History Before 1865



American History Since 1865
Intermediate World History A
Intermediate World History B



Modern World Studies
World History
U.S. History
AP U.S. History
American Government and Economics
Macroeconomics
  Kindergarten Math
1st Grade Math
2nd Grade Math
3rd Grade Math
4th Grade Math
5th Grade Math









Pre-Algebra A
Pre-Algebra B
Algebra I



Pre-Algebra
Algebra Foundations
Algebra I
Algebra II
Geometry


Art
Kindergarten Art
1st Grade Art
2nd Grade Art
3rd Grade Art
4th Grade Art
Intermediate Art: American A



Intermediate Art: American B
Intermediate Art: World A
Intermediate Art: World B



Art History
Fine Art and Art Appreciation

  Kindergarten Science
1st Grade Science
2nd Grade Science
3rd Grade Science
4th Grade Science
5th Grade Science
Kindergarten Science (classroom)
1st Grade Science (classroom)
2nd Grade Science (classroom)
3rd Grade Science (classroom)





Earth Science
Life Science
Physical Science



Earth Science Foundations
Physical Science Foundations
Biology Foundations
Earth Science
Physical Science
Biology

Music/Other
Preparatory Music
Beginning 1 Music
Beginning 2 Music
Introduction to Music
Intermediate 1 Music
Intermediate 2 Music
Intermediate 3 Music
Exploring Music

Music Concepts A
Music Concepts B




Learning Online
Spanish I, II, III, AP
French I, II, III, AP
German I, II
Latin I, II
Chinese I
Courses that appear in italics are licensed from third-parties.


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K-8 Courses. From kindergarten through 8th grade, our courses are categorized into six major subject areas: English and Language Arts, Mathematics, Science, History, Art and Music. Our proprietary curriculum includes all of the courses that students need to complete their core kindergarten through 8th grade education. These courses focus on developing fundamental skills and teaching the key knowledge building blocks or schemas that each student will need to master the major subject areas, meet state standards and complete more advanced coursework. Unlike a traditional classroom education, our learning system offers the flexibility for each student to take courses at different grade levels in a single academic year, providing flexibility for students to progress at their own level and pace within each subject area. In addition, the flexibility of our learning system allows us to tailor our curriculum to state specific requirements. For example, we have developed eight courses specifically for use in Texas public schools.
 
High School Courses. The curriculum sought by students in each of the high school grades is much broader and varies from student to student, largely as a result of the increased flexibility in course selection required for high school students. In order to offer a full suite of courses, including the many elective courses required to meet the needs of high school students, we offer a combination of proprietary courses and selected rigorously tested courses licensed from third-parties. We have six proprietary high school courses and are currently developing 10 additional high school courses for the 2007-08 school year. We expect the high school students we serve using our proprietary courses to account for approximately 60% of the total course enrollment of our high school students in the 2007-08 school year.
 
Online School Platform
 
Our Online School (OLS) platform is an intuitive, web-based software platform that provides access to our online lessons as well as our lesson planning and scheduling tools and our progress tracking tool, both of which serve a key role in assisting parents and teachers in managing each student’s progress. Because the OLS is a web-based platform, students, parents and teachers can access our online tools and lessons through the OLS from anywhere with an Internet connection at any time of the day or night.
 
  •  Lesson Planning and Scheduling Tools. In a school year, a typical student will complete between 800 and 1,200 lessons across six or more subject areas. Our lesson planning and scheduling tools enable teachers and parents to establish a master plan for completing these lessons. These tools are designed to dynamically update the lesson plan as a student progresses through each lesson and course, allowing flexibility to increase or decrease the pace at which the student moves through the curriculum while ensuring that the student progresses towards completion in the desired time frame. For example, the schedule can easily be adapted to accommodate a student who desires to attend school six days a week, a student who is interested in studying during the winter holidays to take time off during the spring, or a student who chooses to take two math classes a day for the first month of the school year and delay art classes until the second month of the school year. Moreover, changes can be made to the schedule at any point during the school year and the remainder of the student’s schedule will automatically adjust in the OLS.
 
  •  Progress Tracking Tools. Once a master schedule has been established, the OLS delivers lessons based upon the specified parameters. Each day, a student is initially directed to a screen listing the syllabus for that particular day and begins the school day by selecting one of the listed lessons. As each lesson is completed, the student returns to the day’s syllabus to proceed to the next subject. If a student does not complete a lesson during the session, the lesson will be rescheduled to the next day and will resume at the point where the student left off. Our progress tracking tool allows students, parents and teachers to monitor student progress. In addition, information collected by our progress tracking tool regarding student performance, attendance and other data is transferred to our proprietary management system for use in providing administrative support services.
 
Student Administration Management System
 
Our Student Administration Management System (SAMS) organizes, updates and reports information that is automatically collected through interfaces with our OLS and related management systems. SAMS collects and provides us with all of the information required to manage student enrollment and monitor student performance.


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SAMS is also central to collecting and managing all administrative data required to operate a virtual public school. In addition, the information provided by SAMS feeds our our proprietary Order Management System (OMS) that generates orders for offline learning kits and computers to be delivered to students.
 
Student Community Tools
 
We place a strong emphasis on the importance of building a sense of community in the schools we manage. Accordingly, we offer a combination of tools that foster communication and interaction among virtual public school students and parents. Our K12 Community Chest website for virtual public school students includes discussion boards, blogs, games, competitions and other functions. Additionally, our K12 Family Directory web-based tool enables parents of virtual public school students to organize online and offline social activities for their children. Parents can run searches based on criteria such as their child’s location, age or interests (such as hobbies or sports) to locate and contact other parents of children with similar interests to facilitate student interaction.
 
Our Services
 
We provide a wide array of services to students and their families as well as directly to virtual public schools. Our services can be categorized broadly into academic support services and management and technology services.
 
Academic Support Services
 
Teachers and Related Services.  Teachers are critical to the educational success of students in virtual public schools. Teachers in the virtual public schools that we serve are generally employed by the school, with the ultimate authority over these teachers residing with the school’s governing body. Under our service agreements, we recruit, train and provide management support for these teachers. Historically, we have seen significant demand for teaching positions in the virtual public schools that we serve. For example, for the virtual public schools we serve in California, we recently received approximately six applications for each teaching position filled for the 2006-07 school year.
 
We use a rigorous evaluation program for making hiring recommendations to the virtual public schools we serve. We hire teachers who, at a minimum, are state certified and meet the federal requirements for designation as a “Highly Qualified Teacher,” and generally have at least three years of teaching experience. We also seek to recruit teachers who have the skill set necessary to be successful in a virtual public school environment. Teaching in a virtual public school is characterized by heightened one-on-one student-teacher and parent-teacher interaction, so virtual public school teachers must have strong interpersonal communications skills. Additionally, a virtual public school teacher must be creative in finding ways to effectively connect with their students and integrate themselves into the daily lives of the students’ families.
 
New virtual public school teachers attend our comprehensive training program during which, among other things, they are introduced to our educational philosophy, our curriculum and our OLS and other technology applications, and are provided strategies for communicating and connecting with students and their families in a virtual public school environment. We also provide ongoing training opportunities for teachers so that they may stay abreast of changing educational standards and key learning trends, which we believe enhances their teaching abilities and effectiveness.
 
Gifted and Special Education Services.  We believe that our individualized learning system is able to effectively address the educational needs of gifted and special education students because it is self-paced and employs flexible teaching methods. For students requiring special attention, we employ a national director who is an expert on the delivery of special education services in a virtual public school environment and who oversees and directs the special education programs at the virtual public schools we serve. We direct and facilitate the development and implementation of “individualized education plans” for students with special needs. Our special education program is compliant with the federal Individuals with Disabilities Education Act and all state special education requirements. Each special needs student is assigned a certified special education teacher who arranges for any required ancillary services, including speech and occupational therapy, and any required assistive technologies, such as special computer displays or speech recognition software.


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Student Support Services.  We provide students attending virtual public schools that we serve and their families with a variety of support services to ensure that we effectively meet their educational needs and goals. Each student is assigned a guidance counselor to assist them with academic achievement planning. Additionally, we provide tutors as necessary to help students with courses that they find difficult. We also plan and coordinate social events to offer students opportunities to meet and socialize with their virtual public school peers. Finally, we offer our “K12 HUG” (Help, Understanding and Guidance) program to address any other questions or concerns that students and their parents have during the course of their matriculation.
 
Management Services
 
Under many of our contracts, we provide virtual public schools with turnkey management services. In these circumstances, we take responsibility for all aspects of the management of the schools, including monitoring academic achievement, teacher hiring and training, compensation of school personnel, financial management, enrollment processing and procurement of curriculum, equipment and required services. In 2007, the Commission on International and Trans-regional Accreditation (CITA), a leading worldwide education accreditation agency, thoroughly evaluated our school management services and we ultimately received the prestigious CITA accreditation.
 
Compliance and Tracking Services.  Operating a virtual public school entails most of the compliance and regulatory requirements of a traditional public school. We have developed management systems and processes designed to ensure that schools we serve are in compliance with all applicable requirements, including tracking appropriate student information and meeting various state reporting requirements. For example, we collect enrollment related information, monitor attendance and administer proctored state tests. As we have expanded into 16 states and the District of Columbia, our processes have grown increasingly robust, and we believe our compliance and tracking processes provide us with a distinct competitive advantage.
 
Financial Support Services.  We provide each school we serve with a dedicated business manager who oversees the preparation of the annual budget and coordinates with the school’s directors to determine their annual objectives. In addition, we implement an internal control framework, develop policies and procedures, provide accounting services and payroll administration, oversee all federal entitlement programs and arrange for external audits.
 
Facility, Operations and Technology Support Services.  We operate administrative offices and all other facilities on behalf of the virtual public schools we serve. We provide these schools with a complete technology infrastructure. In addition, we provide a comprehensive student help desk solution.
 
Human Resources Support Services.  We are actively involved in hiring virtual public school administrators, teachers and staff, through a thorough interview and orientation process. To better facilitate the hiring process, we review and analyze the profiles of teachers that have been highly effective in our learning system to identify the attributes desired in future new hires. We also negotiate and secure employment benefits for teachers on behalf of virtual public schools and administer employee benefit plans for virtual public school employees. Additionally, we assist the virtual schools we serve in drafting and implementing administrative policies and procedures.
 
Product Development
 
We develop our products and related service offerings through a highly collaborative process that blends cognitive research with an innovative development approach by utilizing best practices from the education industry and other industries. Our approach provides for effective content and rapid time to market. Unlike many traditional content companies that may take several years to develop a new course, our course development process usually takes between six and 12 months, depending upon grade and subject. Our development team includes professionals from the following disciplines:
 
  •  Cognitive Scientists, Evaluation and Research Specialists — conduct and review cognitive research to determine how students master the key ideas in a subject area, the common misconceptions that present obstacles to mastery and available techniques that can effectively address common misconceptions.


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  •  Curriculum and Teaching Specialists — bring deep subject matter knowledge and experience with a variety of pedagogical approaches to our course design process.
 
  •  Writers and Editors — script out the text of the lessons, ensuring that the information is accurate, meaningful and suitable for the age group we are trying to reach.
 
  •  Instructional Designers — weave together all elements of a lesson and determine the extent to which online, multi-media components, textbooks and other offline materials, and activities can be integrated to achieve the desired learning outcomes.
 
  •  Graphic Artists/Media Specialists/Flash Designers — ensure overall visual integrity of each lesson and build creative and interactive content.
 
  •  Print Designers — design and publish our proprietary textbooks and printed learning materials.
 
  •  User Experience Specialists — work closely with our design teams to ensure that lessons are easy for students to navigate and understand.
 
  •  Training Specialists — concurrent with the development of the courses, develop training materials and programs to support the effective delivery of our curriculum by teachers.
 
  •  Project Managers — coordinate all of the activities, including the work of the above-listed resources to develop the product as designed, on time, and on budget.
 
Using these highly skilled resources, we follow a six-stage product development process beginning with idea-generation and carrying through to post-production evaluation. Our ability to continually modify our products based upon student, parent and teacher feedback and assessment data is one of the significant advantages of our online curriculum. All of our lessons contain a user feedback button that allows us to identify learning issues on a real-time basis. In a given week, we receive hundreds of feedback items from students, parents and teachers. The related descriptions below illustrate each stage in our product development process.
 
Blueprint Stage.  During this stage of development, we gather the key requirements for a new product, which may be a new course or a group of related courses. We conduct a thorough review to identify all of the cognitive research related to learning of the subject and gain an understanding of the stages a student will go through in mastering the subject material. We also look at how experts perform in the subject. Expert-novice research has shown that an experts’ knowledge of a domain is contained in a subconscious framework, the components of which can help guide the development of a course. During this stage, we also analyze state standards to confirm that we are encompassing the elements of the nation’s highest state standards and that we are building courses which meet or surpass all state standards.
 
Design Stage. We begin the design stage by developing the learning environment in which the product will be used. This includes understanding the types of students that will be using the product, how the course will be taught, the learning objectives within the course and what online and offline materials can be utilized. We then produce a design document and our creative teams develop a work plan for every aspect of the product, including the look and feel of the product, level of functionality and length of the course. We produce, test and refine prototypes with focus groups of students, teachers and parents.
 
Pre-production Stage. With the work plan complete, a pre-production team is assembled to develop the scope and sequence of the course. The scope and sequence is an ordered collection of learning objectives based on cognitive research and state standards. These learning objectives, once organized, guide the production team in the creation of the individual course lessons. The pre-production team also creates the list of materials that will be required and provides this list to our logistics group for sourcing.
 
Production Stage. During this stage, the product is built in accordance with the work plan. First, manuscripts, storyboards and lesson design specifications are created. Online screens, offline materials such as textbooks, simulations, photographs, and other reference materials are then created, reviewed and refined. Rights for licensed materials are cleared at this point, if needed. Each lesson then goes through a rigorous quality review before being released.


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Support Stage. The goal during this stage is to support the initial launch and ongoing utilization of our lessons and to enhance the products during the course of their useful life. We break this stage down into three components: (i) content development, where we design and develop teacher and student training packages; (ii) alignment and standards analysis, where we examine performance on state tests to determine the extent to which we should refine or adjust the standard alignments initially developed during the blueprint stage; and (iii) long-term maintenance, where we maintain and update the online and offline materials on an ongoing basis based upon feedback from teachers, parents and students.
 
Evaluation Stage. The final stage of the product development cycle is the evaluation stage. During this phase, we evaluate the overall performance of our product against the original design specifications. We obtain measurement feedback from a number of sources, including:
 
  •  User Feedback — we receive a substantial amount of feedback from teachers, parents and students. Some feedback is directly incorporated into course modifications. In addition, we observe students in our usability labs and visit students and parents to better understand how our products are being used;
 
  •  Progress Reports — through our OLS, we are able to monitor each student’s progress through a course. This data helps us identify portions of a course that may be especially difficult for students, and may require revision or enhancements; and
 
  •  State Test Scores — students in the virtual public schools we serve participate in proctored state exams. These tests provide an impartial assessment of how these students are performing against established benchmarks and within their state.
 
Using these sources of feedback, we can revise our courses as necessary to achieve the desired learning objectives. We believe that this ability to proactively respond to feedback and other data in an efficient manner is a key competitive advantage within the educational industry.
 
Channel Development
 
K12 receives numerous inquiries from school districts, legislators, community leaders, educators and parents who express the desire to offer a virtual public school alternative. Our school development and public affairs groups work together with these interested parties to identify and pursue opportunities to expand the use of our products and services through new channels and in new jurisdictions. Where interested parties seek to offer a virtual public school alternative in their state, our public affairs group works with them to establish the legal framework, advocate for appropriate legislation and explain the educational and fiscal benefits of our learning system. Our public affairs group also seeks to increase public awareness and ensure transparency in virtual schooling by supporting accountability standards for virtual public schools.
 
Once there is legal and regulatory authorization for, as well as sufficient interest in, a virtual public school, our school development group engages state and school district officials, legislators, community leaders, educators and parent groups seeking to open a virtual public school, and initiates a dialog with these interested parties to explain the steps necessary to pursue this public school alternative in their jurisdiction. Our school development group works with these officials and parent groups in planning, developing and launching the virtual school. We also offer assistance to independent school boards with charter application and authorization processes.
 
After virtual public schools are approved and established, our school development group engages school administrators and maintains relationships with school officials in order to ensure that they are aware of our product and services offerings and that we understand their specific needs and goals.
 
Distribution Channels
 
We distribute our products and services primarily to virtual public schools and directly to consumers. We derive revenues from virtual public schools by providing access to our OLS, offline learning kits, student computers and a variety of management and academic support services, ranging from turnkey end-to-end management solutions to a single service to meet a school’s specific needs.


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In fiscal year 2005, we had contracts with five schools that constituted approximately 32%, 17%, 11%, 10% and 6% of our revenues. In fiscal year 2006, these same schools constituted approximately 28%, 16%, 10%, 8%, and 7% of our revenues, respectively. During the nine months ended March 31, 2007, these same schools constituted approximately 12%, 17%, 11%, 7% and 10% of our revenues, respectively.
 
Our direct-to-consumer product is purchased through our customer call center or online by parents, who are looking either to educate their children outside the public school system or as a supplement to their child’s existing public school curriculum. The flexibility of our curriculum combined with the assessment capabilities of our online delivery platform enables us to modularize and repackage lesson modules that can be sold as individual products. For example, if a child has particular difficulties with fractions, the parent could purchase our fractions module. The ability to rebundle individual lessons is highly scalable and we believe this opportunity is significant.
 
In addition to these primary distribution channels, we are continuously pursuing additional channels through which to offer our learning system, including direct classroom instruction and hybrid models. For example, we have piloted select grades and subjects of our curriculum in classrooms in 11 states. Although our in-class offering business is at a nascent stage, we believe that this distribution channel offers significant potential. Additionally, we have recently implemented a hybrid offering in Chicago that combines some face-to-face time for students and teachers in a traditional classroom setting along with online instruction. In addition to expanding our offering to additional jurisdictions within the United States, we intend to pursue international opportunities where we believe there is significant demand for a quality online education.
 
Student Recruitment and Marketing
 
Our student recruitment and marketing team consisted of 38 employees as of March 31, 2007, and is responsible for promoting our corporate brand, generating new student enrollments and enhancing the experience of students and families enrolled in the virtual public schools we serve. This team employs a variety of strategies designed to better understand and address the requirements of our target markets. First, this team is responsible for defining our brand image and associating our brand with the many positive attributes of our learning system. We believe that a strong brand provides the basis for our expansion into new states and other markets.
 
Second, our student recruitment and marketing team generates new enrollments in the virtual public schools we serve through targeted recruiting programs, which utilize coordinated direct mailings, email marketing, print and radio advertising and search engine marketing. In addition, our marketing team conducts information sessions and workshops that provide teachers and parents with the opportunity to learn about K12 and the products and services that we offer. We conducted more than 2,500 such events during fiscal year 2007. We have found that effectively communicating the details and benefits of our learning system is an important first step towards building a core group of interested parties. Additionally, we believe that our consistently high customer satisfaction rates serve as the foundation for word-of-mouth referrals which supplement our other recruiting efforts.
 
Finally, this team is responsible for enhancing our relationship with students enrolled in the virtual public schools that we serve to complement the relationship that these students have with their teachers and school. In order to maintain a sense of community, we host the K12 Community Chest website for students to interact online with our Chief Learning Officer and with each other. We also send welcome packages, conduct art contests, survey parents and provide support to students through assigned support counselors under our K12 HUG program.
 
Technology
 
As of March 31, 2007, we employed 46 employees in our technology department. Our learning system, along with our back office systems supporting order management, logistics and e-commerce, are built on our proprietary Service Oriented Architecture, or SOA, to ensure high availability and redundancy and allow flexibility and security to be core principles of our systems’ foundation.
 
Service Oriented Architecture.  All of our systems leverage our SOA built on top of Enterprise Java that separates an implemented capability from a request flow that utilizes those capabilities. This leverage provides us with the ability to deliver different presentations against a single request workflow. Additionally, this flexibility allows iterative solutions to be developed expeditiously to meet both present and future market needs. Our high


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availability and scalability are also facilitated by this architecture. The SOA also enables seamless integration with third-party solutions in our platform with ease and efficiency.
 
Availability and Redundancy.  Our SOA allows for a hardware topology where primary and secondary equipment can be utilized at all network and application tiers. Each application layer is load balanced across multiple servers, which, along with our sophisticated state management capabilities, allows for additional hardware to be inserted into our network providing us with impressive scalability and availability as evidenced by our greater than 99.9999% uptime with our ever growing user base. We regularly backup critical data and store this backup data at an offsite location.
 
Security.  Our security measures and policies include dividing application layers into multiple zones controlled by firewall technology. Sensitive communications are encrypted between client and server and our server-to-server accessibility is strictly controlled and monitored.
 
Physical Infrastructure.  We utilize the best of breed hardware from industry leading vendors including Cisco, F5, Oracle, Sun, Microsoft, Dell, Intel, and NetApp to provide a foundation for our SOA. Our systems are housed offsite in a state of the art data center that provides robust, redundant network backbone and power. We vigilantly monitor our physical infrastructure for security, availability, and performance.
 
Competition
 
We face varying degrees of competition from a variety of education companies because our learning system encompasses many components of the educational development and delivery process. We compete primarily with companies that provide online curriculum and school support services to K-12 virtual public schools. These companies include Connections Academy, LLC, White Hat Management, LLC and National Network of Digital Schools. We also face competition from curriculum developers, including traditional textbook publishers such as the McGraw-Hill Companies, Harcourt, Inc., Pearson plc and Houghton Mifflin Riverdeep Group plc. Additionally, we expect increased competition from post-secondary and supplementary education providers that have begun to establish a presence in the K-12 virtual school sector, including Apollo Group, Pearson plc and Kaplan, Inc.
 
We believe that the primary factors on which we compete are:
 
  •  track record of academic results and customer satisfaction;
 
  •  quality of curriculum and online delivery platform;
 
  •  qualifications and experience of teachers;
 
  •  comprehensiveness of school management and student support services; and
 
  •  cost of the solution.
 
Intellectual Property
 
Since our inception, we have invested more than $95 million to develop our proprietary curriculum and OLS. We continue to invest in our intellectual property as we develop more courses for new grades and expand into adjacent education markets, both in the U.S. and overseas. These intellectual property assets are critical to our success and we avail ourselves of the full protections provided under the patent, copyright, trademark and trade secrets laws. We also routinely utilize confidentiality and licensing agreements with our employees, students, the virtual public schools that we serve, direct-to-consumer customers, independent contractors and other businesses and persons with which we have commercial relationships.
 
On May 1, 2007, the United States Patent and Trademark Office (USPTO) granted us the patent for our “System and Method of Virtual Schooling” (Patent No. 7,210,938), which provides us with a period of exclusive use until January 26, 2024. In general terms, this patent covers the hardware and network infrastructure of our online school, including the system components for creating and administering assessment tests, the planner, lesson progress tracker and instructional sequencer. We also have four additional international and five additional U.S. patents pending, and several pending provisional U.S. patent applications.


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We own the copyright in over 11,000 lessons contained in 87 courses that make up our proprietary curriculum, including our online lessons and offline learning kits, and we register this growing lesson portfolio with the U.S. Copyright Office as each new course is completed or updated. We own and use the domain names K12 (.com, .org) and K-12 (.com, .net, .org) as well as the trademark and service mark, K12. In addition, we have applied to the USPTO to register the trademark “Unleash the xPotential.”
 
Students who enroll in the virtual public schools we serve are granted a license to use our software in order to access our learning system. Similarly, virtual public schools are granted a license to use our learning system in order to access SAMS and our other systems. These licenses are intended to protect our ownership and the confidentiality of the embedded information and technology contained in our software and systems. We also own the trademarks and service marks that we use as part of the student recruitment and branding services we provide to virtual public schools. Those marks are licensed to the schools for use during the term of the products and services agreements.
 
Our employees, contractors and other parties with access to our confidential information sign agreements that prohibit the unauthorized use or disclosure of our proprietary rights, information and technology.
 
Operations
 
An essential component of the K12 courses are the offline learning kits that accompany our online lessons. A student enrolling in one of our courses receives multiple textbooks, art supplies, laboratory supplies (e.g. microscopes and scales) and other reference materials designed to enhance the learning experience. We package these books and materials into course-specific learning kits. Because each student’s curriculum is customized, the combination of kits for each student must also be customized. In fiscal year 2007, we assembled approximately 2.5 million items into more than 200,000 kits.
 
Over our six years of operation, we believe that we have gained significant experience in the fulfillment of offline materials and that this experience provides us with an advantage over many of our current and potential future competitors. We have developed strong relationships with partners allowing us to source goods at favorable price, quality and service levels. Through our fulfillment partner located in Harrisonburg, Virginia, we store our inventory, build our learning kits and ship the kits to students throughout the United States. We have invested in systems including our Order Management System (OMS), to automatically translate the curriculum selected by each enrolled student into an order to build the corresponding learning kit. In 2008, we plan to establish a second logistics and fulfillment center in the western portion of the United States to support our growth and to mitigate single-location fulfillment risk.
 
For many of our virtual public school customers, we attempt to reclaim any materials that are not consumed during the course of the school year. These items, once returned to our fulfillment center, are refurbished and included in future learning kits. This reclamation process allows us to maintain lower materials costs.
 
In order to ensure that students in virtual public schools have access to our OLS, we often provide students with a computer and all necessary support. We source computers and ship them to students when they enroll and reclaim the computers at the end of a school year or upon termination of their enrollment or withdrawal from the virtual public school in which they are enrolled. As of March 31, 2007, we had approximately 17,800 personal computers deployed for use by students.
 
Our fulfillment activities are highly seasonal, and are centered around the start of school in August or September. Accordingly, approximately 70% of our annual materials receiving occurs between March and May, approximately 75% of our annual offline learning kit assembly is accomplished between May and July, and approximately 75% of customer item fulfillment and shipping occurs between July and October.
 
Properties
 
The Company’s headquarters are located in approximately 70,000 square feet of office space in Herndon, Virginia under a lease that expires in April 2013 and a sublease that expires in September 2009.


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Employees
 
As of March 31, 2007, we had 558 employees. In addition, there are more than 650 teachers who are employed by virtual schools we serve, but who we manage under turnkey solution contracts with those schools. No K12 employees are union employees; however, certain virtual public schools we serve employ unionized teachers. We believe that our employee relations are good.
 
We have an agreement with a professional employer organization (PEO), to manage all payroll processing, workers’ compensation, health insurance, and other employment-related benefits for our employees. The PEO is a co-employer of our employees along with us. Although the PEO processes our payroll and pays our workers’ compensation, health insurance and other employment-related benefits, we are ultimately responsible for such payments and are responsible for complying with state and federal employment regulations. We pay the PEO a fee based on the number of employees we have.
 
Legal Proceedings
 
In the ordinary conduct of our business, we are subject to lawsuits and other legal proceedings from time to time. There are currently two pending lawsuits in which we are involved, Johnson v. Burmaster and Illinois v. Chicago Virtual Charter School that, in each case, have been brought by teachers’ unions seeking the closure of the virtual public schools we serve in Wisconsin and Illinois, respectively.
 
While we prevailed on summary judgment at the circuit court level in Johnson v. Burmaster, and recently won a preliminary motion in Illinois v. Chicago Virtual Charter School, it is not possible to predict the final outcome of these matters with any degree of certainty. Even so, we do not believe at this time that a loss in either case would have a material adverse financial impact on our business. Depending on the legal theory advanced by the plaintiffs, however, there is a risk that a loss in these cases could have a negative precedential effect if like claims were to be advanced and succeed under similar laws in other states where we operate. The cumulative effect under those circumstances could be material.
 
Johnson v. Burmaster
 
In 2003, the Northern Ozaukee School District (NOSD) in the State of Wisconsin established a virtual public school, the Wisconsin Virtual Academy (WIVA), and entered into a service agreement with us for online curriculum and school management services. On January 6, 2004, Stan Johnson, et al., and the Wisconsin Education Association Council (WEAC) filed suit in the Circuit Court of Ozaukee County against the Superintendent of the Department of Public Instruction (DPI), Elizabeth Burmaster, the NOSD and K12 Inc. The plaintiffs alleged that the NOSD violated the state charter school, open enrollment and teacher-licensure statutes when it authorized WIVA.
 
On March 16, 2006, the Circuit Court issued a Decision and Order upholding on Summary Judgment that WIVA complies with applicable law (No. 04-CV-12 ). WEAC and DPI filed an appeal in the Wisconsin Court of Appeals, District II (No. 2006-AP/01380). On July 3, 2007, the Court of Appeals certified the case to the Wisconsin Supreme Court for its review because the questions involved in the case are of first impression and will have a significant statewide impact on education finance and policy. Should the plaintiff prevail and state funding of open enrollment payments to the NOSD are enjoined, a claim could be made that the Company must indemnify the NOSD for expenses approximating $2.5 million.
 
Illinois v. Chicago Virtual Charter School
 
On October 4, 2006, the Chicago Teachers Union (CTU) filed a citizen taxpayers lawsuit in the Circuit Court of Cook County challenging the decision of the Illinois State Board of Education to certify the Chicago Virtual Charter School (CVCS) and to enjoin the disbursement of state funds to the Chicago Board of Education under its contract with the CVCS. Specifically, the CTU alleges that the Illinois charter school law prohibits any “home-based” charter schools and that CVCS does not provide sufficient “direct instruction” by certified teachers of at least five clock hours per day to qualify for funding. K12 Inc. and K12 Illinois LLC were also named as defendants. On May 16, 2007, the Court dismissed K12 Inc. and K12 Illinois LLC from the case and on June 15, 2007, the plaintiffs filed a second amended complaint. We continue to participate in the defense of CVCS under an indemnity obligation in our service agreement with that school.
 


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REGULATION
 
The authority to operate a virtual public school is dependent on the laws and regulations of each state. Laws and regulations vary significantly from one state to the next and are constantly evolving. In states that have implemented specific legislation to support virtual public schools, the schools are able to operate under these statutes. Other states provide for virtual public schools under existing charter school legislation or provide that school districts and/or state education agencies may authorize them. Some states do not currently have legislation that provides for virtual public schools or have requirements that effectively prohibit virtual public schools and, as a result, may require new legislation before virtual public schools can open in the state. Virtual public schools are typically funded by state or local governments on a per student basis. To the extent a virtual school obtains federal funds, such as through a grant program or financial support dedicated for the education of low-income families, these schools then become subject to additional federal regulation.
 
State Laws and Regulations Applicable to Virtual Public Schools.  Virtual public schools that purchase our curriculum and management services are often governed and overseen by a non-profit or local or state education agency, such as an independent charter school board, local school district or state education authority. We generally receive funds for products and services rendered to operate virtual schools under detailed service agreements with that governing authority. A virtual school that fails to comply with the state laws and regulations applicable to it may be required to repay these funds and could become ineligible for receipt of future state funds.
 
To be eligible for state funding, some states require that virtual schools be organized under not-for-profit charters exempt from taxation under Section 501(c)(3) of the Internal Revenue Code. The schools must then be operated exclusively for charitable educational purposes, and not for the benefit of private, for-profit management companies. The board or governing authority of the not-for-profit virtual school must retain ultimate accountability for the school’s operations to retain its tax-exempt status. It may not delegate its responsibility and accountability for the school’s operations. Our service agreements with these virtual schools are therefore structured to ensure the full independence of the not-for-profit board and preserve its ability to exercise its fiduciary obligations to operate a virtual public school.
 
Laws and regulations affect many aspects of operating a virtual public school. They can dictate the content and sequence of the curriculum, the requirements to earn a diploma, use of approved textbooks, the length of the school year and the school day, the assessment of student performance, and any accountability requirements. In addition, a virtual public school may be obligated to comply with state requirements to offer programs for specific populations, such as students at risk of dropping out of school, gifted and talented students, non-English speaking students, pre-kindergarten students, and students with disabilities. Tutoring services and the use of technology may also be regulated. Other state laws and regulations may affect the school’s compulsory attendance requirements, treatment of absences and make-up work, and access by parents to student records and teaching and testing materials. Additionally, states have various requirements concerning the reporting of extensive student data that may apply to the school. A virtual public school may have to comply with state requirements that school campuses report various types of data as performance indicators of the success of the program.
 
States have laws and regulations concerning certification, training, experience and continued professional development of teachers and staff with which a virtual public school may be required to comply. There are also numerous laws pertaining to employee salaries and benefits, statewide teacher retirement systems, workers’ compensation, unemployment benefits, and matters related to employment agreements and procedures for termination of school employees. A virtual public school must also comply with requirements for performing criminal background checks on school staff, reporting criminal activity by school staff and reporting suspected child abuse.
 
As with any public school, virtual public schools must comply with state laws and regulations applicable to governmental entities, such as open meetings laws, which may require the board of trustees of a virtual public school to hold its meetings open to the public unless an exception in the law allows an executive session. Failure to comply with these requirements may lead to personal civil and/or criminal penalties for board members or officers. Virtual public schools must also comply with public information or open records laws, which require them to make school records available for public inspection, review and copying unless a specific exemption in the law applies.


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Additionally laws pertaining to records privacy and retention and to standards for maintenance of records apply to virtual public schools.
 
Other types of regulation applicable to virtual public schools include restrictions on the use of public funds, the types of investments made with public funds, the collection of and use of student fees, and controlling accounting and financial management practices.
 
There remains uncertainty about the extent to which we may be required to comply with state laws and regulations applicable to traditional public schools because the concept of virtual public schools is relatively new. Although we receive state funds indirectly, according to the terms of each service agreement with the local public school entity, our receipt of state funds subjects us to extensive state regulation and scrutiny. Several states have commenced audits, some of which are still pending, to verify enrollment, attendance, fiscal accountability, special education services, and other regulatory issues. While we may believe that a virtual public school we serve is compliant with state law, an agency’s different interpretation of law in a particular state could result in non-compliance, potentially affecting funding.
 
Regulations Restricting Virtual Public School Growth and Funding.  As a new public schooling alternative, some state and regulatory authorities have elected to proceed cautiously with virtual public schools while providing opportunities for taxpayer families seeking this alternative. Regulations that control the growth of virtual public schools range from prescribing the number of schools in a state to limiting the percentage of time students may receive instruction online. Funding regulations can also have this effect.
 
Regulations that hinder our ability to serve certain jurisdictions include: restrictions on student eligibility (such as mandating attendance at a traditional public school prior to enrolling in a virtual public school or course completion); caps on the total number of students in a virtual school; geographic limitations on enrollments; fixing the percentage of per pupil funding that must be paid to teachers; state-specific curriculum requirements; and limits on the number of charters that can be granted in a state.
 
Funding regulations for virtual schools can take a variety of forms. These regulations include: (i) attendance — some state daily attendance rules were designed for traditional classroom procedures and applying them to track daily attendance and truancy in an online setting can cause disputes to arise over interpretation and funding; (ii) enrollment eligibility— some states place restrictions on the students seeking to enroll in virtual schools, resulting in lower aggregate funding levels; and (iii) teacher contact time — some states have regulations that specify minimum levels of teacher-student face-to-face time, which can create logistical challenges for statewide virtual schools, reduce funding and eliminate some of the economic, academic and technological advantages of virtual learning.
 
Federal and State Grants.  We have worked with certain entities to secure public and grant funding that flows to virtual public schools that we serve. These grants are awarded to the not-for-profit entity that holds the charter of the virtual public school on a competitive basis in some instances and on an entitlement basis in other instances. Grants awarded to public schools and programs — whether by a federal or state agency or nongovernmental organization — often include reporting requirements, procedures, and obligations.
 
Federal Laws and Regulations Applicable to Education Programs.  Some of the virtual public schools we serve may receive federal funds under Title I (funding for education of children from low-income families), Title II (funding for the professional development of teachers), Title III (funding for technology programs), Title VII (funding for bilingual education programs) and Title X (start-up funding for charter schools) of the Elementary and Secondary Education Act. The schools must comply with applicable federal laws and regulations to remain eligible for receipt of federal funds. The schools we manage could lose all or part of these funds if they fail to comply with the applicable statutes or regulations, if the federal authorities reduce the funding for the programs or if the schools are determined to be ineligible to receive funds under such programs. Under the terms of our service agreements, we assist virtual public schools in fulfilling these reporting requirements.


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Four primary federal laws are directly applicable to the day-to-day provision of educational services we provide to virtual public schools:
 
  •  No Child Left Behind (NCLB) Act.  Through the funding of the Title I programs for disadvantaged students under NCLB, the federal government requires public schools to develop a state accountability system based on academic standards and assessments developed by the state, which are applicable to all public school students. Each state must determine a proficiency level of academic achievement based on the state assessments, and must determine what constitutes adequate yearly progress (AYP) toward that goal. NCLB has a timeline to ensure that no later than the 2013-14 school year, all students, including those in all identified subgroups (such as economically disadvantaged, limited English proficient and minority students,), will meet or exceed the state proficient level of academic achievement on state assessments. The progress of each school is reviewed annually to determine whether the school is making adequate yearly progress. If a Title I school does not make adequate yearly progress as defined in the state’s plan, the local education agency (LEA) is required to identify the school as needing school improvement, and to provide all students enrolled in the school with the option to transfer to another public school served by the LEA, which may include a virtual public school. The LEA must develop a school improvement plan for each school identified as needing improvement in consultation with parents, staff and outside experts and this plan must be implemented not later than the beginning of the next full school year. If the school does not make adequate yearly progress in subsequent years, the school transfer option remains open to students and other corrective action must be taken ranging from providing supplemental education services to the students who remain in the school to taking corrective action including, but not limited to, replacing school staff, implementing a new curriculum, appointing outside experts to advise the school, extending the school year or the school day, reopening the school as a public charter school with a private management company or turning over the operation of the school to the state educational agency.
 
Another provision of NCLB requires public school programs to ensure that all teachers are highly qualified. A highly qualified teacher means one who has: (1) obtained full state certification or licensure as a teacher and who has not had certification or licensure requirements waived on an emergency, temporary or provisional basis; (2) obtained a bachelor’s degree; and (3) demonstrated competence in the academic subject the teacher teaches. All teacher aides working in a school supported with Title I funds must be highly qualified which means the person must have a high school diploma or its equivalent and one of the following: completed at least two years of study in an institution of higher education, obtained an associate’s or higher degree, or met a rigorous standard of quality demonstrated through a formal state or local assessment. Virtual public schools using our products and services may be required to meet these requirements for any persons who perform instructional services.
 
Virtual schools that receive Title I funding and use our products and services may be required to provide parents of Title I students with a variety of notices regarding the teachers and teachers aides that teach their children. In addition, if these schools serve limited English proficient (LEP) children, they may be required to provide a variety of notices to the parents regarding the identification of the student as LEP and certain information about the instruction to be provided to the student, as well as the right to remove or refuse to enroll the student in the LEP program. Finally, these schools may also be required annually to develop, with input from parents of Title I students, and implement a written policy on parental involvement in the education of their children, to hold annual meetings with these parents and to provide these parents with assistance in various areas to help the parents to work with their children to improve student achievement.
 
Under NCLB, even schools that do not receive Title I funding must provide certain notices to parents. For example, schools may be required to provide a school report card and identify whether any school has been identified as needing improvement and for how long. Parents also must be provided data that will be used to determine adequate yearly progress. Virtual public schools may be contacted by military recruiters who have the right to access the names, addresses and telephone numbers of secondary school students for military recruiting purposes. Additionally, virtual public schools may be required to notify parents that they have the option to request that this information not be released to military recruiters or to institutions of higher education.


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  •  Individuals with Disabilities Education Act (IDEA).  The IDEA is implemented through regulations governing every aspect of the special education of a child with one or more of the specific disabilities listed in the act. The IDEA created a responsibility on the part of a school to identify students who may qualify under the IDEA and to perform periodic assessments to determine the students’ needs for services. A student who qualifies for services under the IDEA must have in place an individual education plan, which must be updated at least annually, created by a team consisting of school personnel, the student, and the parent. This plan must be implemented in a setting where the child with a disability is educated with non-disabled peers to the maximum extent appropriate. The act provides the student and parents with numerous procedural rights relating to the student’s program and education, including the right to seek mediation of disputes and make complaints to the state education agency. The schools we manage are responsible for ensuring the requirements of this act are met. The virtual schools could be required to comply with requirements in the act concerning teacher certification and training. We or the virtual public school could be required to provide additional staff, related services and supplemental aids and services at our own cost to comply with the requirement to provide a free appropriate public education to each child covered under the IDEA. If we fail to meet this requirement, we or the virtual public school could lose federal funding and could be liable for compensatory educational services, reimbursement to the parent for educational service the parent provided, and payment of the parent’s attorney’s fees.
 
  •  Section 504 of the Rehabilitation Act of 1973.  A virtual public school receiving federal funds is subject to Section 504 of the Rehabilitation Act of 1973 (Section 504) insofar as the regulations implementing the act govern the education of students with disabilities as well as personnel and parents. Section 504 prohibits discrimination against a person on the basis of disability in any program receiving federal financial assistance if the person is otherwise qualified to participate in or receive benefit from the program. Students with disabilities not specifically listed in the IDEA may be entitled to specialized instruction or related services pursuant to Section 504 if their disability substantially limits a major life activity. There are many similarities between the regulatory requirements of Section 504 and the IDEA; however this is a separate law which may require a virtual public school to provide a qualified student with a plan to accommodate his or her disability in the educational setting. If a school fails to comply with the requirements and the procedural safeguards of Section 504, it may lose federal funds even though these funds flow indirectly to the school through a local board. In the case of bad faith or intentional wrongdoing, some courts have awarded monetary damages to prevailing parties in Section 504 lawsuits.
 
  •  Family Educational Rights and Privacy Act.  Virtual public schools are subject to the Family Educational Rights and Privacy Act which protects the privacy of a student’s educational records and generally prohibits a school from disclosing a student’s records to a third-party without the parent’s prior consent. The law also gives parents certain procedural rights with respect to their minor children’s education records. A school’s failure to comply with this law may result in termination of its eligibility to receive federal education funds.
 
If we fail to comply with other federal laws, including federal civil rights laws not specific to education programs, we could be determined ineligible to receive funds from federal programs or face criminal or civil penalties.


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MANAGEMENT
 
Directors, Executive Officers and Other Key Employees
 
The following table sets forth information concerning our directors, executive officers and other key members of our management team as of July 12, 2007:
 
             
Name
 
Age
 
Position
 
Executive Officers
       
Ronald J. Packard
  43   Chief Executive Officer, Founder and Director
John F. Baule
  43   Chief Operating Officer and Chief Financial Officer
Bruce J. Davis
  42   Executive Vice President, School Services
Bror V. H. Saxberg
  47   Chief Learning Officer
Key Employees
       
Bryan W. Flood
  41   Senior Vice President, Public Affairs
Nancy Hauge
  53   Senior Vice President, Human Resources
Howard D. Polsky
  55   Senior Vice President, General Counsel and Secretary
Peter G. Stewart
  38   Senior Vice President, School Development
Celia M. Stokes
  43   Chief Marketing Officer
Maria A. Szalay
  41   Senior Vice President, Product Development
Ray Williams
  45   Senior Vice President, Systems and Technology
Nonemployee Directors
       
Andrew H. Tisch
  57   Chairman
Liza A. Boyd
  32   Director
Guillermo Bron
  55   Director
Steven B. Fink
  55   Director
Thomas J. Wilford
  64   Director
 
Executive Officers
 
Ronald J. Packard, Chief Executive Officer, Founder and Director
 
Ronald J. Packard started K12 in 2000 and has served as Chief Executive Officer since May 2007 after having served as Chairman of the Board of Directors. Previously, Mr. Packard served as Vice President of Knowledge Universe from 1997 to 2000, and he served as Chief Executive Officer of Knowledge Schools, a provider of early childhood education and after school companies, from 1998 to 2002. Mr. Packard has also held positions at McKinsey & Company from 1989 to 1993 and Goldman Sachs in mergers and acquisitions from 1986 to 1988. Additionally, Mr. Packard has served on the Advisory Board of the Department of Defense Schools since 2002, and from 2004 to 2006 served as a director of Academy 123. Mr. Packard holds B.A. degrees in Economics and Mechanical Engineering from the University of California at Berkeley, an M.B.A. from the University of Chicago, and he was a Chartered Financial Analyst.
 
John F. Baule, Chief Operating Officer and Chief Financial Officer
 
John F. Baule joined us in March 2005, and serves as Chief Operating Officer and Chief Financial Officer. Previously, Mr. Baule spent five years at Headstrong, a global consultancy services firm, first serving as Senior Vice President of Finance from 1999 until 2001 and later as Chief Financial Officer from 2001 to 2004. Prior to Headstrong, Mr. Baule worked for Bristol-Myers Squibb (BMS) from 1990 to 1999, initially joining their corporate internal audit division. He then spent six years with BMS based in the Asia Pacific region, first as the Director of Finance for BMS Philippines, and then as the Regional Finance Director for BMS Asia-Pacific. He later served as


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Director of International Finance for the BMS Nutritional Division. Mr. Baule began his career working in the audit services practice at KPMG from 1986 to 1990. Mr. Baule holds a B.B.A. in Accounting from the College of William and Mary and he is a Certified Public Accountant.
 
Bruce J. Davis, Executive Vice President, School Services
 
Bruce J. Davis joined us January 2007, and serves as Executive Vice President, School Services. From 2002 until joining us, Mr. Davis ran his own strategy consultancy where his clients included Laureate Education, Discovery Communications, Pearson Publishing, Sylvan Learning Systems, Educate Inc., AICPA, and USAID. Mr. Davis previously held the position of Chief Executive Officer at Medasorb Technologies, a biotechnology company, from 2001 to 2002 and at Mindsurf Networks, a wireless educational system provider, from 1999 to 2000. He also served as Chief Operating Officer of Prometric, a computer test administration company, from 1994 to 1999. Prior to Prometric, he was a senior consultant with Deloitte and Touche from 1985 to 1991 in the Information Systems Strategy group where he managed their IT practice in Egypt. Mr. Davis holds a B.S. in Computer Science from Loyola College and an M.B.A. from Columbia University.
 
Bror V. H. Saxberg, Chief Learning Officer
 
Bror V.H. Saxberg joined us in February 2000, and serves as Chief Learning Officer. From 1998 to 2000, Dr. Saxberg served as Vice President of Operations at Knowledge Testing Enterprises, a developer of web-based assessments for IT skills owned by Knowledge Universe; he was a Vice President at Knowledge Universe from 1997 through 2000 as well. Prior to Knowledge Universe, Dr. Saxberg held the position of Publisher and General Manager at DK Multimedia, the North American subsidiary of educational and reference publisher Dorling Kindersley, from 1995 to 1997. Previously, Dr. Saxberg also worked as a consultant at McKinsey & Company from 1990 to 1995. Dr. Saxberg holds B.S. degrees in Electrical Engineering and Mathematics from the University of Washington, an M.A. in Mathematics from Oxford University, an M.A. and Ph.D. in Electrical Engineering and Computer Science from Massachusetts Institute of Technology, and an M.D. from Harvard University.
 
Key Employees
 
Bryan W. Flood, Senior Vice President, Public Affairs
 
Bryan W. Flood joined us in June 2002, and serves as Senior Vice President, Public Affairs. From 1996 to 2001, Mr. Flood served as Vice President of the MPGH Agency, a public affairs consulting firm. Mr. Flood previously served as National Spokesman for the Lamar Alexander for President campaign from 1995 to 1996. Prior to that, Mr. Flood served as spokesman for the reelection campaign for Gov. John Engler (MI) in 1994. Additionally, Mr. Flood held the positions of Director of Communications for the Michigan Republicans State Committee from 1991 to 1993 and as Spokesman for Rinfret for Governor (NY). Mr. Flood started his career as a Legislative Aide for the Town of Brookhaven, New York. Mr. Flood holds a B.A. in Public Policy from New College of Florida.
 
Nancy Hauge, Senior Vice President, Human Resources
 
Nancy H. Hauge joined us in February 2006, and serves as Senior Vice President, Human Resources. From 2004 to 2006, Ms. Hauge served as Chief Customer Advocate and Senior Vice President of Human Resources for Ruckus Network, a digital media company. Prior to Ruckus, she founded and operated 54th Street Partners, an international management consulting company, from 1999 to 2004. Ms. Hauge has also held the position of Vice President of Human Resources at Ridge Technologies, Crag Technologies, Noah’s New York Bagels, and Gymboree Corporation. Previously, Ms. Hauge held multiple senior management positions in human resources, strategic planning and quality at Sun Microsystems from 1984 to 1994.
 
Howard D. Polsky, Senior Vice President, General Counsel and Secretary
 
Howard D. Polsky joined us in June 2004, and serves as Senior Vice President, General Counsel and Secretary. Mr. Polsky previously held the position of Vice President and General Counsel of Lockheed Martin Global Telecommunications from 2000 to 2002. Prior to Lockheed Martin, Mr. Polsky worked at COMSAT Corporation from 1992 to 2000, initially serving as Vice President and General Counsel of COMSAT’s largest operating


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division, and subsequently serving on the executive management team as Vice President of Federal Policy and Regulation. From 1983 to 1992, Mr. Polsky was a partner at Wiley, Rein & Fielding after having worked at Kirkland & Ellis. Mr. Polsky began his legal career at the Federal Communications Commission. Mr. Polsky received a B.A. in Government from Lehigh University, and a J.D. from Indiana University.
 
Peter G. Stewart, Senior Vice President, School Development
 
Peter G. Stewart joined us in September 2000, and serves as Senior Vice President, School Development. From 1990 to 2000, Mr. Stewart worked at urban, rural, and international schools in various roles including teacher, school principal, head of school and curriculum director. Mr. Stewart holds a B.A. in English from Williams College and a M.A. from Columbia University Teachers College.
 
Celia M. Stokes, Chief Marketing Officer
 
Celia M. Stokes joined us in March 2006, and serves as Chief Marketing Officer. Before joining K12, Ms. Stokes served as Vice President of Marketing at Independence Air from 2003 to 2006. Previously, Ms. Stokes ran her own marketing firm providing consulting services to organizations such as Fox TV, PBS, the National Gallery of Art, JWalter Thompson, and ADP. From 1993 to 1998, Ms. Stokes served in successive roles leading to Vice President of Marketing at Bell Atlantic and at a joint venture of Bell Atlantic and two other Regional Bell Operating Companies. From 1990 to 1993, Ms. Stokes was Manager of Marketing at Software AG, and from 1988 to 1990, was Client Group Manager at Targeted Communications, an Ogilvy & Mather Direct company. Ms. Stokes holds a B.A. in Economics from the University of Virginia.
 
Maria A. Szalay, Vice President, Product Development
 
Maria A. Szalay joined us in March 2001, and serves as Vice President, Product Development. From 1999 to 2001, Ms. Szalay served as Practice Director at Operon Partners, an e-business consulting firm. Prior to that, Ms. Szalay worked at Telecom New Zealand from 1994 to 1999 and served as a management consultant at KPMG from 1990 to 1994. Previously, Ms. Szalay served as a Client Portfolio Analyst at Shearson Lehman from 1988 to 1990. Ms. Szalay holds a B.S. in Finance and a B.A. in German Literature from Virginia Polytechnic Institute & State University and an M.B.A. from American University.
 
Ray Williams, Senior Vice President, Systems and Technology
 
Ray Williams joined us in August 2006, and serves as Senior Vice President, Systems and Technology. From 2005 to 2006, Mr. Williams served as Senior Vice President of Product Development and Operations for Ruckus Network, a digital media company. From 1993 to 2004, Mr. Williams held in multiple technology positions at America Online leading up to Senior Technical Director. Mr. Williams previously served as a software developer at Software A.G., a software infrastructure solutions company from 1988 to 1993. Mr. Williams holds a B.S. in Computer Science from Rochester Institute of Technology.
 
Nonemployee Directors
 
Andrew H. Tisch, Chairman
 
Andrew H. Tisch joined us as director in August 2001, and has served as Chairman of the Board of Directors since May 2007. Since 1985, Mr. Tisch has been a director of Loews Corporation, and is Co-Chairman of its Board, Chairman of its Executive Committee and, since 1999, has been a member of its Office of the President. In addition, Mr. Tisch has served as past Chairman of the board of directors of Bulova Corporation and a director since 1979. Mr. Tisch has also served as director on the board of directors of CNA Financial Corporation since 2006, at Texas Gas Transmission, LLC and Boardwalk Pipelines, LLC since 2005 and Lord & Taylor, Inc. since 2006. Mr. Tisch holds a B.S. in Hotel Administration from Cornell University and an M.B.A. from Harvard University.


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Liza A. Boyd, Director
 
Liza A. Boyd joined us as director in April 2006. Ms. Boyd has been employed with Constellation Ventures, a venture capital fund affiliated with The Bear Stearns Companies, Inc. investing in early to mid-stage companies, since 2000, and has been a Managing Director since 2006. At Constellation Ventures, Ms. Boyd focuses on investments in software and services and online media technologies. Ms. Boyd has served as a director on the board of directors of Widevine Technologies since 2004, Fathom Online since August 2005, Siperian since 2006, Avolent since 2006 and Orchestria since 2006. Ms Boyd holds a B.A. in Mathematical Economics from Colgate University.
 
Guillermo Bron, Director
 
Guillermo Bron joined us as a director in July 2007. Mr. Bron has served as Chairman of the Board and a director of United Pan Am Financial Corp. (UPFC) since April 1994, and as a director of Pan American Bank, FSB (Pan American), a federally chartered savings association and former wholly owned subsidiary of UPFC, from 1994 until its dissolution in February 2005. Mr. Bron is a Managing Director of Acon Funds Management LLC, a private equity firm, and the Managing Member of PAFGP, LLC, the sole general partner of Pan American Financial, L.P. From 2000 to 2002, Mr. Bron was a director of Telemundo Group, Inc. Mr. Bron founded UPFC and organized a Hispanic investor group that acquired certain assets and assumed certain liabilities of Pan American’s predecessor from the Resolution Trust Corporation in April 1994. From 1994 to 2003, Mr. Bron was an officer, director and principal stockholder of a general partner of Bastion Capital Fund, L.P., a private equity investment fund primarily focused on the Hispanic Market. Previously, Mr. Bron was a Managing Director of Corporate Finance and Mergers and Acquisitions at Drexel Burnham Lambert. Mr. Bron holds a B.S. in Electrical Engineering and Management from Massachusetts Institute of Technology and an M.B.A. from Harvard University.
 
Steven B. Fink, Director
 
Steven B. Fink joined us as director in October 2003. Since 2000, Mr. Fink has been the Chief Executive Officer of Lawrence Investments, LLC, a technology and biotechnology private equity investment firm, and since 1996, Mr. Fink has served as a Vice Chairman of Knowledge Universe (now Mounte LLC), a private company focused on building leading companies in areas relating to education, technology and career management. Since 1995, Mr. Fink has also served as Chairman and Vice Chairman of Heron International, a European real estate development company. Mr. Fink has served as non-executive Chairman of Spring Group PLC, an information technology services company in the United Kingdom affiliated with Knowledge Universe, from 1997 to 2000 and again from 2002 to the present, and has served as a director of Leapfrog, Inc. since 1999 and as Chairman of the board since 2004. Mr. Fink has also served as a director of Nextera Enterprises, Inc. since 1997. Mr. Fink holds a B.S. in Psychology from the University of California, Los Angeles and a J.D. and an L.L.M. from New York University.
 
Thomas J. Wilford, Director
 
Thomas J. Wilford joined us as director in November 2002. Since 1993, Mr. Wilford has served as director of Alscott, Inc., privately held a real estate investment company, and since 1997 has served as President. Since 2003, Mr. Wilford has served as Chief Executive Officer of the J.A. and Kathryn Albertson Foundation, a foundation focused on education within Idaho. Mr. Wilford has served as director on the board of directors of Idacorp, Inc. since 2004, and has served on its Audit Committee since 2005. Previously, Mr. Wilford served as an Office Managing Partner of Ernst & Young LLP from 1979 to 1993. Mr. Wilford holds a B.S., and a M.S. in Business from the University of Minnesota and he is a Certified Public Accountant.
 
Board of Directors and Director Independence
 
Our board of directors is authorized to have nine members and is currently composed of five nonemployee members and our Chief Executive Officer, Ronald J. Packard. Our executive officers and key employees serve at the discretion of our board of directors.


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Upon completion of this offering, we expect that our amended and restated certificate of incorporation will provide for a classified board of directors consisting of three classes of directors, each serving staggered three-year terms. As a result, a portion of our board of directors will be elected each year. To implement the classified structure, prior to the consummation of this offering, each of the nominees to the board will be either appointed to one, two or three-year terms. We expect that the additional independent directors that we will add in the year following completion of this offering will replace existing members of our audit, compensation, and nominating and corporate governance committees to the extent necessary to comply with the applicable rules of the New York Stock Exchange and applicable law. Additionally, our stockholders will have the ability to remove directors with or without cause by the affirmative vote of a majority of the common stock.
 
Board Committees
 
Our board directs the management of our business and affairs as provided by Delaware law and conducts its business through meetings of the board of directors, an audit committee and a compensation committee. Additionally, upon completion of this offering, we will establish a nominating and governance committee. Further, from time to time, other committees may be established under the direction of the board when necessary to address specific issues. The composition of the board committees will comply, when required, with the applicable rules of the New York Stock Exchange and applicable law.
 
Audit Committee.  Our audit committee is responsible for, among other things, making recommendations concerning the engagement of our independent public accountants, reviewing with the independent public accountants the plans and results of the audit engagement, approving professional services provided by the independent public accountants, reviewing the independence of the independent public accountants, considering the range of audit and non-audit fees, and reviewing the adequacy of our internal accounting controls. Our audit committee comprises Steven B. Fink, Liza A. Boyd and Thomas J. Wilford, each of whom is a nonemployee member of our board of directors. Steven B. Fink is the chairman of the audit committee.
 
Nominating and Governance Committee.  Upon completion of this offering, we will establish a nominating and governance committee, which will be responsible for assisting the board of directors in selecting new directors, evaluating the overall effectiveness of the board of directors, and reviewing developments in corporate governance compliance.
 
Compensation Committee.  The compensation committee is responsible for determining compensation for our executive officers and administering our amended and restated stock option plans and other compensation programs. The compensation committee is also charged with establishing, periodically re-evaluating and, where appropriate, adjusting and administering policies concerning compensation of management personnel, including the Chief Executive Officer and all of our other executive officers. Our compensation committee currently comprises Andrew H. Tisch and Liza A. Boyd, each of whom is a nonemployee member of our board of directors. Andrew H. Tisch is the chairman of the compensation committee.
 
Compensation Committee Interlocks and Insider Participation
 
None of the members of our compensation committee at any time has been one of our executive officers or employees. None of our executive officers currently serves, or in the past year has served, as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving on our board of directors or compensation committee. Our entire board of directors made all compensation decisions prior to the creation of our compensation committee.
 
Limitation of Liability and Indemnification of Officers and Directors
 
As permitted by Section 102 of the Delaware General Corporation Law, upon consummation of this offering, we expect that our amended and restated certificate of incorporation and amended and restated bylaws will limit or eliminate the personal liability of our directors for a breach of their fiduciary duty of care as directors. The duty of care generally requires that when acting on behalf of the corporation, directors exercise an informed business judgment based on all material information reasonably available to them. Consequently, a director will not be


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personally liable to us or our stockholders for monetary damages or breach of fiduciary duty as a director, except for liability for:
 
  •  any breach of the director’s duty of loyalty to us or our stockholders;
 
  •  any act or omission not in good faith or that involves intentional misconduct or a knowing violation of law;
 
  •  any act related to unlawful stock repurchases, redemptions or other distributions or payment of dividends; or
 
  •  any transaction from which the director derived an improper personal benefit.
 
These limitations of liability do not alter liability under the federal securities laws and do not affect the availability of equitable remedies such as injunction or rescission. As permitted by Section 145 of the Delaware General Corporation Law, upon consummation of this offering, we expect that our amended and restated certificate of incorporation and amended and restated bylaws will authorize us to indemnify or officers, directors and other agents to the fullest extent permitted under Delaware law and provide that:
 
  •  we may indemnify our directors, officers and employees to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions;
 
  •  we may advance expenses to our directors, officers and employees in connection with a legal proceeding to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions; and
 
  •  the rights provided in our amended and restated bylaws are not exclusive.
 
Contemporaneously with the completion of this offering, we intend to enter into indemnification agreements with each of our executive officers and directors which will be in addition to and may be broader than the indemnification provided for in our charter documents. These agreements will provide that we will indemnify each of our directors to the fullest extent permitted by law and advance expenses to each indemnitee in connection with any proceeding in which indemnification is available.
 
We also maintain general liability insurance that covers certain liabilities of our directors and officers arising out of claims based on acts or omissions in their capacities as directors or officers and intend to obtain a policy of directors and officers liability insurance that will be effective upon completion of this offering which will also cover certain liabilities arising under the Securities Act of 1933, as amended. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers, or persons controlling the registrant pursuant to the foregoing provisions, we have been informed that in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.
 
These provisions may discourage stockholders from bringing a lawsuit against our directors for breach of their fiduciary duty. These provisions may also have the effect of reducing the likelihood of derivative litigation against directors and officers, even though such an action, if successful, might otherwise benefit us and our stockholders. Furthermore, a stockholder’s investment may be adversely affected to the extent we pay the costs of settlement and damage awards against directors and officers pursuant to these indemnification provisions. We believe that these provisions, the indemnification agreements and the insurance are necessary to attract and retain talented and experienced directors and officers.
 
At present, there is no pending litigation or proceeding involving any of our directors, officers, employees or agents in which any of them is seeking indemnification from us, nor are we aware of any threatened litigation or proceeding that may result in a claim for indemnification.


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COMPENSATION DISCUSSION AND ANALYSIS
 
Objectives and Philosophy of Executive Compensation
 
The Compensation Committee, composed entirely of independent directors, administers our executive compensation programs. The Compensation Committee’s role as described in its charter is to discharge the board’s responsibilities relating to compensation of our executives, including the named executive officers, and to oversee and advise the board on the adoption of policies that govern our compensation and benefit programs. Our executive compensation programs are designed to:
 
  •  Attract and retain individuals of superior ability and managerial talent;
 
  •  Ensure senior executive compensation is aligned with our corporate strategies, business objectives and the long-term interests of our stockholders;
 
  •  Provide an incentive to achieve key strategic and financial performance measures by linking incentive award opportunities to the achievement of performance goals in these areas; and
 
  •  Enhance the executives’ incentive to increase our stock price and maximize stockholder value, as well as promote retention of key people, by providing a portion of total compensation opportunities for senior management in the form of direct ownership in our stock through stock options.
 
To achieve these objectives, the Compensation Committee has implemented and maintains compensation plans that tie a substantial portion of the executives’ overall compensation to key strategic financial and operational goals such as our annual revenues and operating earnings. The Compensation Committee also evaluates individual executive performance with the goal of setting compensation at levels the Compensation Committee believes are comparable with executives in other companies of similar size and stage of development that operate in the major education and high-technology industries, taking into account our relative performance and our strategic goals.
 
Determination of Compensation Awards
 
The Compensation Committee has the authority to determine and recommend the compensation awards available to our named executive officers. Historically, we have set base salaries and annual incentive targets based on both individual performance and position. Base salaries and annual incentive targets for the named executive officers are determined as of the date of hire. Base salaries and annual incentive targets are reviewed annually by the Compensation Committee and may be adjusted to reflect individual performance and any changes in position within the Company to both reward the executives for superior performance and to further our goals of attracting and retaining managerial talent. To aid the Compensation Committee in making its determination, the CEO and COO/CFO provide recommendations annually to the Compensation Committee regarding the compensation of all executive officers, excluding themselves. Each named executive officer other than our CEO and COO/CFO, in turn, participates in an annual performance review with either the CEO or the COO/CFO to provide input regarding the named executive officer’s contributions to our success for the period being assessed. The performance of our CEO and COO/CFO is reviewed annually by the Compensation Committee.
 
In 2007, the Compensation Committee retained an independent compensation consultant, Radford Surveys + Consulting, to assist the Compensation Committee with determining the key elements of our compensation programs for fiscal year 2008 and future fiscal years. Radford Surveys + Consulting is an independent consultant specializing in compensation matters in both the technology and education industries. The compensation consultant provides advice to the Compensation Committee with respect to competitive practices and the amounts and nature of compensation paid to the named executive officers. The compensation consultant also advises us on, among other things, structuring our various compensation programs and determining the appropriate levels of salary, bonus and other incentive awards payable to our named executive officers. Based upon the compensation consultant’s recommendations, our executive compensation package continues to consist of a fixed base salary and variable cash and option-based incentive awards, with a significant portion weighted towards the variable components to ensure that total compensation reflects our overall success or failure and to motivate executive officers to meet appropriate performance measures, thereby maximizing total return to stockholders. Within our performance-based compensation program, we aim to compensate the named executive officers in a manner that is tax effective for us.


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Compensation Benchmarking and Peer Group
 
For the fiscal year ending in 2008, we set base salary structures and annual incentive targets at slightly above the median of a peer group of major education and high-technology companies. An important component of setting and structuring compensation for our named executive officers is determining the compensation packages offered by leading education and high-technology companies in order for us to offer competitive compensation within that group of companies. With the assistance of the compensation consultant, we surveyed the compensation practices of a peer group of companies in the United States to assess our competitiveness. The peer group generally consists of 15 leading education companies. This “Peer Group” of companies for our fiscal year ending in 2008 includes: Audible, Inc; Blackboard Inc; Capella Education Company; CNET Networks, Inc; Corinthian Colleges, Inc.; Courier Corporation; DeVry Inc.; eCollege.com; Educate, Inc.; IHS Inc.; ITT Educational Services, Inc.; Learning Tree International, Inc.; PLATO Learning, Inc.; Renaissance Learning, Inc.; and Strayer Education. Overall, our independent compensation consultant determined that our compensation programs, as structured, achieve our market philosophy relative to our Peer Group.
 
Elements of Compensation
 
Base Salary
 
Base salaries for our named executive officers are generally established based on the scope of their responsibilities, taking into account competitive market compensation paid by other companies for similar positions, and recognizing cost of living considerations. Base salaries are reviewed at least annually, and are adjusted from time to time based on performance and inflation and to realign salaries with market levels. Salaries were adjusted in the first quarter of fiscal year 2007 after review of fiscal year 2006 performance by the Compensation Committee. For our fiscal year ending in 2008, the base salaries of our named executive officers generally fall around the median of the Peer Group.
 
Annual Performance Bonus
 
We maintain an annual cash performance bonus program, the Executive Bonus Plan, that is intended to reward executive officers based on our performance and the individual named executive officer’s contribution to that performance. In determining the performance-based compensation awarded to each named executive officer, the Compensation Committee may generally evaluate our performance and the executive’s performance in a number of areas, which could include revenues, operating earnings, student retention, efficiency in product and systems development, marketing investment efficacy, new enrollment and developing company leaders. For our fiscal year ending in 2007, the amounts payable under our annual cash performance bonus program were primarily determined based upon actual performance measured against our achievement of revenues and earnings targets.
 
For our fiscal year ending in 2007, Mr. Packard’s target bonus was 100% of base salary, Mr. Baule’s target bonus was 50% of base salary, Mr. Davis’ target bonus was 40% of base salary and Mr. Saxberg’s target bonus was 30% of base salary. The Compensation Committee believes that the performance bonus program provides incentives necessary to retain executives and reward them for our short-term performance. The performance goals for the fiscal year ending in 2007 were difficult to achieve and the results of performance are set forth in the section entitled “Summary Compensation Table” below.
 
Stock Options
 
The Company’s named executive officers, along with a large portion of our employees, are eligible to participate in our stock option plan, pursuant to which we grant awards of stock options. We have also granted stock options to some of our named executive officers pursuant to stand-alone agreements. Initial stock option grants are typically made as of the date of hire and then additional stock options may be granted to realign the recipient’s stock option holdings with the stock option holdings of similarly situated employees. Participants, including the named executive officers, become eligible for stock option grants based on individual performance, as determined by the Compensation Committee; however, historically the amount of stock options granted to each participant has generally been determined using a procedure approved by the Compensation Committee based upon several factors, including our performance (based on achievement of revenues and earnings targets), the value of the stock option at


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the time of grant and the recipient’s contributions to the Company. As a result, additional grants may be made following a significant change in job responsibility or in recognition of a significant achievement. In addition, since we hired an independent compensation consultant, we have begun to review external factors such as market data and equity award policies of comparable companies when determining the grants of stock options to participants, including the named executive officers. Providing long-term incentive awards through the grant of stock options enhances our goal of aligning executive compensation with the long-term interests of our stockholders by linking compensation to our stock price and maximizing stockholder value.
 
Stock options granted under our Amended and Restated Stock Option Plan generally have a four-year vesting schedule in order to provide an incentive for continued employment. The exercise price of options granted under the stock plan is equal to or greater than 100% of the fair market value of the underlying stock on the date of grant. During the fiscal year ending in 2007, Messrs. Packard and Davis received stock option grants pursuant to stand-alone agreements. Mr. Davis’ option grant is subject to a time-based vesting schedule. However, to align Mr. Packard’s equity compensation with our success, certain of Mr. Packard’s stock options vest based upon the Company’s achievement of performance metrics or upon the fair market value of our common stock reaching a certain price. In addition, certain options for common stock granted to Mr. Packard and Mr. Davis have exercise prices in excess of the fair market value of the underlying stock on the date of grant. For the fiscal year ending in 2007, we granted 4,850,000 stock options to Mr. Packard, and 500,000 stock options to Mr. Davis as part of their respective employment arrangements. Messrs. Baule and Saxberg did not receive option grants during our fiscal year ending in 2007.
 
Deferred Compensation Plan
 
While we do not currently maintain a deferred compensation plan, effective January 2008, members of our senior executive management team (including our named executive officers) and all vice presidents will be eligible to defer up to 100% of any cash component of the annual incentive bonus earned. The amounts may be deferred up to a maximum of 10 years and are expected to earn a fixed interest rate.
 
Defined Contribution Plan
 
We maintain a Section 401(k) Savings/Retirement Plan (the 401(k) Plan), which covers our eligible employees, including our named executive officers. The 401(k) Plan allows participants to defer up to 50% of their annual compensation, subject to certain limitations imposed by the Internal Revenue Code. The employees’ elective deferrals are immediately vested and nonforfeitable upon contribution to the 401(k) Plan. We currently provide matching contributions equal to $0.25 for each dollar of participant contributions, up to a maximum of 4% of the participant’s annual salary and subject to certain other limits. Our matching contributions are subject to a four-year vesting schedule.
 
Employment, Severance and Change in Control Arrangements
 
We currently have employment agreements in place with each of our named executive officers that provide for severance payments in connection with certain terminations of employment. During our fiscal year ending in 2007, Mr. Packard had an employment agreement with us that provided for salary continuation for 450 days following a termination of his employment without cause by us or due to constructive termination. On July 12, 2007, our board of directors approved an amended and restated employment agreement for Mr. Packard, which is discussed below. In addition, each of the other named executive officers have employment agreements with us that provide for employment on an “at will” basis and provide for severance payments ranging from six months to 12 months (plus benefit continuation in certain cases) generally in connection with terminations of employment without cause by us or for good reason by the executive.
 
While the named executive officers are generally not entitled to receive payments solely as a result of a change in control of the Company, upon certain corporate transactions (including a sale of all or substantially all of the assets, certain mergers or consolidations and certain sales of our outstanding stock) all outstanding options will become fully vested and exercisable.


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We believe that providing the named executive officers with severance payments upon certain terminations of employment and accelerated vesting of stock options upon a change in control are key retention tools that assist us with remaining competitive with the companies in our Peer Group and further our goal of attracting and retaining key executives with superior ability and managerial talent. These employment agreements, including the revised terms of Mr. Packard’s agreement approved by the board of directors and change in control arrangements are further described below under the section entitled “Potential Payments Upon Termination or Change in Control.”
 
Summary Compensation Table for 2007
 
The following table provides information regarding the compensation that we paid to our named executive officers during the fiscal year ended June 30, 2007.
 
                                                         
                    Nonequity
       
                Option
  Incentive Plan
  All Other
   
Name and Principal Position
  Year   Salary   Bonus   Awards(1)   Compensation(2)   Compensation(3)   Total
 
Ronald J. Packard
    2007     $ 410,000     $     $ 116,436     $    205,000     $     2,050     $    733,486  
Chief Executive Officer
                                                       
John F. Baule
    2007       300,000                   150,000       1,646       451,646  
Chief Operating Officer and Chief Financial Officer
                                                       
Bruce J. Davis
    2007       144,423       120,000 (5)     4,791                   269,214  
Executive Vice President of School Services(4)
                                                       
Bror Saxberg
    2007       310,000                   85,000       2,713       397,713  
Chief Learning Officer
                                                       
 
 
(1) This column represents the dollar amount recognized by us for financial statement reporting purposes of the fair value of stock options granted in fiscal year ended June 30, 2007, and prior years in accordance with FAS 123R, assuming no forfeitures. For additional information, including information regarding the assumptions used when valuing the stock options, refer to note 7 of our condensed consolidated financial statements filed herewith. The amounts set forth in this column reflect our accounting expense for these awards and do not correspond to the actual value that may be realized by the named executive officer receiving the awards. See the Grants of Plan-Based Awards Table for additional information on stock options granted during fiscal year ended June 30, 2007.
(2) This column represents cash awards to the named executive officers for performance with respect to fiscal year ended June 30, 2007, under our Executive Bonus Program. These awards are expected to be paid in September 2007. See “Grants of Plan-Based Awards Table” for additional information regarding these cash awards earned during fiscal year ended June 30, 2007.
(3) The amounts in this column consist of 401(k) matching contributions paid by us.
(4) Mr. Davis commenced his employment with us on January 8, 2007. Amounts included in the table reflect Mr. Davis’ compensation from his date of hire through the end of the fiscal year ended on June 30, 2007.
(5) Pursuant to the terms of his employment agreement, Mr. Davis is entitled to a guaranteed bonus of $120,000 for fiscal year 2007 paid on July 8, 2007.


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Grants of Plan-Based Awards During 2007
 
The following table provides information regarding grants of plan-based awards to our named executive officers during the fiscal year ended June 30, 2007. The awards described in the following table were granted under our Executive Bonus Plan and stand-alone stock option agreements. The performance metrics considered when the awards were granted, if any, are described in previous subsections of the Compensation Discussion and Analysis above. No awards were granted to any named executive officer under our Amended and Restated Stock Option Plan during the fiscal year ended June 30, 2007.
 
                                                                       
        Estimated
                           
        Possible
              All
           
        Payouts
              Other
          Grant
        Under
              Option
          Date
        Nonequity
              Awards:
      Closing
  Fair
        Incentive
  Estimated Future Payouts
  Number of
  Exercise or
  Market
  Value
        Plan
  Under Equity
  Securities
  Base
  Price
  of
        Awards(1)   Incentive Plan Awards(2)   Underlying
  Price
  on Date
  Option
    Grant
  Target
  Threshold
  Target
  Maximum
  Options(3)
  of Option
  of
  Awards
Name and Principal Position
  Date   ($)   (#)   (#)   (#)   (#)   Awards   Grant   ($/Sh)
 
Ronald J. Packard
          $    410,000                                          
Chief Executive
    7/27/2006                     350,000               $     1.50     $     0.58     $    17,255  
Officer
    7/27/2006                     600,000                 1.50       0.58       53,589  
      7/27/2006                     150,000                 1.50       0.58       7,213  
      7/27/2006                     200,000                 1.50       0.58       12,033  
      7/27/2006                     200,000                 1.50       0.58       14,775  
      7/27/2006                     50,000                 1.50       0.58       3,694  
      7/27/2006               150,000       1,200,000                 1.50       0.58       105,061  
      7/27/2006               75,000       600,000                 1.50       0.58       52,531  
      7/27/2006                     1,500,000                 6.00       0.58       26,002  
John F. Baule
            150,000                                          
Chief Operating Officer and Chief Financial Officer
                                                                     
Bruce J. Davis
    2/1/2007                             500,000       1.80       0.58       45,992  
Executive Vice President of School Services
                                                                     
Bror Saxberg
            93,000                                          
Chief Learning Officer
                                                                     
 
 
(1) This column shows the target payout for 2007 performance under our Executive Bonus Program as described in the section titled “Annual Performance Bonus” in the Compensation Discussion and Analysis. There were no threshold or maximum amounts for these performance bonuses. The bonuses were earned for fiscal year ended June 30, 2007, and expected to be paid in September 2007. For each named executive officer other than Mr. Davis, the performance bonuses were based on such named executive officer’s target bonus amount set forth in the named executive officer’s employment agreement, and achievement of performance metrics as described above in the Compensation Discussion and Analysis. These bonus amounts are set forth in the column titled “Nonequity Incentive Plan Compensation” in the Summary Compensation Table. Mr. Davis’ employment with us commenced on January 8, 2007, and pursuant to the terms of his employment agreement, Mr. Davis will receive a guaranteed bonus of $120,000 for the period January 8, 2007 through the end of the fiscal year ended June 30, 2007. Mr. Davis will be entitled to a performance-based annual bonus similar to the other named executive officers commencing in our fiscal year ending June 30, 2008.
(2) Stock options were granted pursuant to stand-alone stock option agreements with exercise prices in excess of the fair market value of a share of our common stock subject to such option on the date of grant, expire on December 31, 2012, and are subject to performance vesting schedules, as further described in the footnotes to the Outstanding Equity Awards at Fiscal Year End Table. The stock options with performance vesting schedules do not have maximum payout amounts.
(3) Stock options were granted pursuant to stand-alone stock option agreements with exercise prices in excess of the fair market value of a share of our common stock subject to such option on the date of grant, expire on December 31, 2014 and are subject to a four year time-based vesting schedule.


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Outstanding Equity Awards at Fiscal Year End for 2007
 
The following table provides information regarding outstanding equity awards held by our named executive officers as of June 30, 2007. All such equity awards consist of stock options granted pursuant to our Amended and Restated Stock Option Plan or stand-alone stock option agreements, and no restricted stock awards have been granted to any of the named executive officers. The section titled “Stock Options” in this Compensation Discussion and Analysis section provides additional information regarding the outstanding equity awards set forth in this table.
 
                                         
    Option Awards  
                Equity Incentive Plan
             
    Number of
    Number of
    Awards: Number of
             
    Securities Underlying
    Securities Underlying
    Securities Underlying
    Option
    Option
 
    Unexercised Options
    Unexercised Options
    Unexercised Unearned
    Exercise
    Expiration
 
Name and Principal Position   Exercisable     Unexercisable     Options     Price     Date  
 
Ronald J. Packard
    350,000                 $  1.50       7/27/2014  
Chief Executive Officer(1)
    600,000                   1.50       7/27/2014  
      150,000                   1.50       7/27/2014  
                  200,000       1.50       7/27/2014  
                  200,000       1.50       7/27/2014  
                  50,000       1.50       7/27/2014  
                  1,200,000       1.50       7/27/2014  
      300,000             300,000       1.50       7/27/2014  
                  1,500,000       6.00       7/27/2014  
      675,000                   1.34       7/1/2011  
      900,000                   1.34       7/23/2010  
John F. Baule
    100,000       300,000             1.50       6/1/2014  
Chief Operating Officer
    450,000       350,000             1.34       3/24/2013  
and Chief Financial Officer(2)
                                       
Bruce J. Davis
          500,000             1.80       2/1/2015  
Executive Vice President of School Services(3)
                                       
Bror Saxberg
    75,000       225,000             1.34       4/26/2014  
Chief Learning Officer(4)
    50,625       39,375             1.34       3/1/2013  
 
 
(1) Mr. Packard’s outstanding unvested options are subject to performance-based vesting. 200,000 options with exercise prices of $1.50 per share will vest in each of fiscal year ending June 30, 2008 and 2009 contingent upon our attaining revenues and EBITDA goals during each of the respective preceeding fiscal years. 50,000 options with exercise prices of $1.50 per share will vest in fiscal year ending June 30, 2009 contingent upon Mr. Packard attaining leadership goals during the preceeding fiscal year. 150,000 options with exercise prices of $1.50 per share will vest contingent upon jurisdictional expansion and related EBITDA goals. 300,000 options with vesting schedules contingent upon jurisdictional expansion and enrollment targets and with exercise prices of $1.50 per share have fully vested as of June 30, 2007. 1,500,000 options with exercise prices of $6.00 per share will vest upon the fair market value of a share of our common stock equaling $6.00.
(2) Mr. Baule’s outstanding unvested options are subject to time-based vesting. 25,000 options with exercise prices of $1.50 per share will vest every three months beginning on September 1, 2007 through June 1, 2010. 50,000 options with exercise prices of $1.34 per share will vest every three months beginning on September 24, 2007 through March 24, 2009.
(3) Mr. Davis’s outstanding unvested options are subject to time-based vesting. 125,000 options will vest on February 1, 2008 and 31,250 options will vest every three months thereafter beginning on May 1, 2008 through February 1, 2011.
(4) Mr. Saxberg’s outstanding unvested options are subject to time-based vesting. 18,750 options will vest every three months beginning on July 27, 2007 through April 27, 2010, and 5,625 will vest every three months beginning on September 24, 2007 through March 24, 2009.


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Option Exercises and Stock Vested
 
The following table provides information for the named executive officers regarding the stock options each named executive officer exercised, and the value realized, if any, during fiscal year ended June 30, 2007.
 
                 
    Option Awards  
    Number of
       
    Shares
       
    Acquired
    Value Realized
 
Name and Principal Position   on Exercise(1)     on Exercise  
 
Ronald J. Packard
        $      —  
Chief Executive Officer
               
John F. Baule
           
Chief Operating Officer and Chief Financial Officer
               
Bruce J. Davis
           
Executive Vice President of School Services
               
Bror Saxberg
    300,000       0 (2)
Chief Learning Officer
               
 
 
(1) None of the named executive officers other than Mr. Saxberg exercised any stock options during fiscal year ended June 30, 2007.
(2) The exercise price of each of the stock options exercised by Mr. Saxberg was higher than the fair market value of a share of K12’s common stock subject to each stock option on the date of exercise.
 
Potential Payments Upon Termination or Change in Control
 
The Company has employment agreements with each of our named executive officers that provide for severance payments and, in some cases, other benefits upon certain terminations of employment.
 
Employment Agreements
 
Mr. Packard’s employment agreement, effective as of January 1, 2006, provides for a term of employment through January 1, 2009, unless terminated earlier pursuant to the terms of the agreement. Upon a termination of Mr. Packard’s employment by us without cause or due to a “constructive termination” (generally, a material reduction in Mr. Packard’s duties, responsibilities or title), Mr. Packard is entitled to salary continuation for 450 days following termination and he may exercise his outstanding vested stock options until the earlier of 90 days following the expiration of any lock-up period applicable to our initial underwritten public offering, or the expiration of the option term. Upon termination of Mr. Packard’s employment due to his death, his estate will receive salary continuation payments for 180 days following his death. The agreement also provides that Mr. Packard is subject to restrictive covenants during the term of the agreement and for certain periods following termination of employment, including confidentiality restrictive covenants during the term and for three years following termination, intellectual property restrictive covenants during the term, and nonsolicitation and noncompetition restrictive covenants during the period that Mr. Packard receives any compensation from us (including severance) and one year thereafter.
 
On July 12, 2007, our board of directors approved an amended and restated employment agreement for Mr. Packard. This amended and restated agreement extends the term of Mr. Packard’s employment until January 1, 2011, and provides for (i) an annual base salary of $425,000, (ii) an annual cash bonus to be awarded by the board of directors in its discretion with a target amount of 100% of base salary, (iii) additional stock option grants subject to both time-based and performance-based vesting, (iv) full vesting of all outstanding stock options upon a change in control of the Company, and (v) severance upon a termination of Mr. Packard’s employment without cause by us equal to 18 months of base salary and the extension of the exercise date for Mr. Packard’s outstanding stock options to the earlier of 90 days following expiration of any lock-up period in connection with the Company’s initial public offering and the expiration of the term of the stock options.


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Mr. Baule’s employment agreement, dated March 4, 2005, provides for his employment with us on an “at-will” basis. Upon a termination of Mr. Baule’s employment for “good reason” (generally, a material reduction in Mr. Baule’s compensation, assignment of a materially different title and responsibilities effectively resulting in a demotion, relocation of Mr. Baule’s place of work more than 50 miles from our headquarters, or we otherwise materially breach the employment agreement), or by us for any reason other than cause, death or disability, Mr. Baule is entitled to severance equal to 365 days of his then-current salary, paid in six monthly installments following termination, and medical and dental benefit continuation for 365 days, or if earlier, until eligible for benefits elsewhere (or reimbursement of COBRA costs to the extent our employee benefit plans do not allow post-termination participation by Mr. Baule). The agreement also provides that Mr. Baule will be subject to the terms of the Company’s Confidentiality, Proprietary Rights and Non-Solicitation Agreement, which generally prohibits the unauthorized disclosure of our confidential information during and after the period of employment, ensures our right of ownership of any intellectual property developed during the period of employment, prohibits the solicitation of employees for one year following termination of employment and requires that any disputes regarding employment or termination of employment be subject to binding arbitration.
 
Mr. Davis’ employment agreement, effective as of January 3, 2007, provides for his employment with us on an “at-will” basis. Upon a termination of Mr. Davis’ employment for “good reason” (generally, a material breach of the employment agreement by us that is not cured within 60 days, a reduction in base salary, a diminution or adverse change to title or the person to whom Mr. Davis reports prior to a change in control of the Company, a material diminution in authority, responsibilities or duties, a relocation of place of employment more than 25 miles from our headquarters, a material reduction in Mr. Davis’ compensation, assignment of a materially different title and responsibilities effectively demoting Mr. Davis, or if the employment agreement is not assumed by the successor within 90 days following a change in control of the Company), or by us without cause, Mr. Davis is entitled to 180 days of salary continuation if the termination occurs prior to January 1, 2008, and 365 days of salary continuation if the termination occurs after January 1, 2008. The agreement also provides that Mr. Davis will be subject to the terms of our Confidentiality, Proprietary Rights and Non-Solicitation Agreement which generally prohibits the unauthorized disclosure of our confidential information during and after the period of employment, ensures our right of ownership of any intellectual property developed during the period of employment, prohibits the solicitation of employees for one year following termination of employment and requires that any disputes regarding employment or termination of employment be subject to binding arbitration.
 
Mr. Saxberg’s employment agreement, dated June 1, 2006, provides for his employment with us on an “at-will” basis. Upon a termination of Mr. Saxberg’s employment for “good reason” (Mr. Saxberg’s resignation within 40 days after his discovery of a material breach of the agreement by us which is not cured within 30 days after written notice from Mr. Saxberg), or by us without “cause,” Mr. Saxberg is entitled to 180 days of salary continuation, reduced by any compensation resulting from new employment. The agreement also provides that Mr. Saxberg will be subject to the terms of our Confidentiality, Proprietary Rights and Non-Solicitation Agreement which generally prohibits the unauthorized disclosure of our confidential information during and after the period of employment, ensures our right of ownership of any intellectual property developed during the period of employment, prohibits the solicitation of employees for one year following termination of employment and requires that any disputes regarding employment or termination of employment be subject to binding arbitration.
 
Change in Control Arrangements
 
Except for certain stock options granted to Mr. Packard and Mr. Baule during our fiscal year ending in 2007, the stock option agreements for outstanding stock options generally provide for accelerated and full vesting of unvested stock options upon certain corporate events. As described above, on July 12, 2007, our board of directors approved an amended and restated employment agreement for Mr. Packard, which provides that all of his outstanding options will become fully vested upon a change in control of the Company. Additionally, on July 12, 2007, our board of directors also approved the terms of a new option agreement for Mr. Baule, which provides that all of his outstanding options will become fully vested upon a change in control of the Company. Those events include a sale of all or substantially all of our assets, a merger or consolidation which results in the Company’s stockholders immediately prior to the transaction owning less than 50% of our voting stock immediately after the transaction, and a sale of our outstanding securities (other than in connection with an initial public offering) which


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results in our stockholders immediately prior to the transaction owning less than 50% of our voting stock immediately after the transaction.
 
In addition, as described above, Mr. Davis is entitled to voluntarily terminate his employment and receive the severance payments described above if his employment agreement is not assumed by the successor entity within 90 days following a change in control of the Company. Other than the foregoing, none of the named executive officers is entitled to any additional payments upon a change in control of the Company.
 
Potential Value of Termination and Change in Control Benefits
 
The following table provides the dollar value of potential payments and benefits that each named executive officer would be entitled to receive upon certain terminations of employment and upon a change in control of the Company, assuming that the termination or change in control occurred on June 30, 2007, and the price per share of our common stock subject to the stock options equaled $1.82, the value of a share on June 30, 2007.
 
                                     
              Without
    Good
    Change in
 
Name
  Payment   Death     Cause     Reason     Control  
 
Ronald J. Packard
  Salary continuation   $ 202,192     $ 505,479     $ 505,479     $  
    Benefit continuation                        
    Option vesting                       756,000  
                                     
John F. Baule
  Salary continuation           300,000       300,000        
    Benefit continuation           16,734       16,734        
    Option vesting                       264,000  
                                     
Bruce J. Davis
  Salary continuation           147,945       147,945        
    Benefit continuation                        
    Option vesting                       10,000  
                                     
Bror Saxberg
  Salary continuation           152,877       152,877        
    Benefit continuation                        
    Option vesting                       90,900  
 
Director Compensation
 
For fiscal year ended June 30, 2007, and prior fiscal years, we compensated our nonemployee directors solely through grants of stock options. Directors who are also our employees receive no additional compensation for serving on the board or its committees.
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