UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

/X/ Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934

For the fiscal year ended December 31, 2001; or

/ / Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934

For the transition period from ___________ to _________________

COMMISSION FILE NO. 000-24547

SCIENTIFIC LEARNING CORPORATION
(Exact name of registrant as specified in its charter)

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

Securities registered pursuant to Section 12 (g) of the Act: COMMON STOCK,
PAR VALUE
$0.001 PER SHARE
(Title of Class)

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

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on March 8, 2002 as reported on the Nasdaq National Market, was approximately $9,696,700. Shares of Common Stock held by each executive officer and director and by certain persons who owned 5% or more of the registrant’s outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of Friday, March 8, 2002 the Registrant had outstanding 15,577,292 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant’s 2002 Annual Meeting of Stockholders to be held on May 21, 2002, at 300 Frank H. Ogawa Plaza, Suite 500, Oakland, CA 94612-2040 are incorporated by reference in Part III.

TABLE OF CONTENTS

2

PART I

ITEM 1. BUSINESS

We develop, market and sell products and services that are based on more than 25 years of brain, language and reading research. Our goal is to become the leading provider of software and other educational products and services based on the study of how the brain learns. To date, our primary focus has been on training programs that build the language and reading skills that are the foundation for learning. We have developed and introduced a suite of software programs, the Fast ForWord^® Family, designed to help children, adolescents and adults with language comprehension, learning how to read and becoming better readers. BrainConnection.com is a comprehensive Web-based information source about the brain and learning, which provides a wide range of written, graphical, audio and interactive content, skill assessments and targeted e-commerce resources for educators, parents, and others interested in the learning process.

In 2001, over 70,000 students enrolled in one of our Fast ForWord training programs, bringing the total number of individuals who have enrolled to over 120,000.

We assist educators, parents and speech and language and other professionals with integrating our programs into existing educational programs. We provide professional training, installation and implementation services and technical and other support. We also provide ongoing performance analysis to those supervising training program participants.

We are a Delaware corporation. We incorporated in 1995 in California under the name Scientific Learning Principles Corporation and reincorporated in 1997 in Delaware under our present name, Scientific Learning Corporation.

MARKETS

PUBLIC SCHOOLS — Our primary market is K-12 public schools in the United States. In 2001, sales to K-12 public schools represented approximately 76% of revenue.

Many studies have indicated that improvements in student achievement have been limited over the past twenty years. Parents, educators and government officials at the local, state and federal levels are increasingly focused on demonstrating the results of educational instruction. A key element of the No Child Left Behind Act of 2002, which reauthorized, increased and imposed new rules on federal funding for public schools, is its focus on funding products and approaches that have been proven to work and are based on scientific research.

Spending on U.S. K-12 education technology was estimated to be $7.5 billion in 2001 according to Education Market Research. Spending on educational software was estimated to be $1.4 billion in 2001 and is expected to grow more rapidly than overall education spending according to Simba Information, Inc.

There are over 110,000 public elementary and secondary schools in the United States according to Market Data Retrieval. To date, our programs have been used in approximately 1,400 schools, less than 2% of the total. In 2001, over 60% of our sales to public schools were to districts who had previously purchased our software and services.

PRIVATE PRACTICE CHANNEL — We also sell to the private practice channel, which accounted for approximately 24% of 2001 revenue. Private practice professionals, primarily speech and language professionals, recommend the use of our products in appropriate cases and then administer the program in connection with providing traditional services. We also sell to private schools. In 2001, over 90% of our private practice channel sales were made at the recommendation of private practice professionals or schools who have previously recommended or used our software.

SOFTWARE PROGRAMS

We combine more than 25 years of brain and language research with technological advancements to create innovative learning products and information services. Our current suite of products assess language comprehension and reading skills, prepare individuals for reading, assist in learning to read and aid in becoming better readers. The Fast ForWord family of programs helps students rapidly improve language and reading skills. They provide a valuable supplement to schools’ reading curricula, preparing and enabling students to take advantage of good curricula and good instruction in the classroom. The programs are sold both on an individual basis and bundled with service packages to suit schools’ needs.

3

Most of our family of language and reading training programs use intensive, computer-controlled training exercises that automatically adapt to each user’s performance to modify the manner in which the brain processes language. In addition, they provide cross-training in key executive function skills, which are the organizational skills necessary for thinking, such as short-term memory and determining the sequence of events.

FAST FORWORD LANGUAGE™

Fast ForWord Language, launched in 1997, is an intensive, computer-based training program, which has the look and feel of a computer game. Fast ForWord Language is designed to keep students engaged and entertained during the thousands of repetitions necessary to improve a student’s language skills. The words and sentences used in the Fast ForWord Language exercises have been electronically modified to expand and enhance the rapidly changing phonetic elements within natural speech. As a student’s skill level advances, the exercises become increasingly difficult, driving the student to continually improve his or her oral language skills. At the most difficult level of each exercise, the student is presented with natural, unmodified speech. The exercises also cross-train the student in executive function skills, which are necessary for a solid foundation for learning to read or becoming a better reader. The program adjusts to the student’s skill level and ongoing performance so that the student is making correct responses approximately 80% of the time. This adjustment is designed to keep the program challenging and engaging, while allowing the student to generate a feeling of accomplishment and to avoid failure, which can be discouraging and detrimental to learning.

The Fast ForWord Language program is designed to be used for 100 minutes per day, five days a week for four to eight weeks. The professional supervising the individual’s use of the program can follow and analyze the participant’s data through the ProgressTracker™ and SLc Lesson monitoring tools, which use our patented Internet and database technology.

Field studies we conducted of Fast ForWord Language with an aggregate of approximately 900 participants show that 90% of participants identified as having language and reading problems showed statistically significant gains in language comprehension skills, achieving, on average, one to two years of improvement in language and related reading skills after four to eight weeks of Fast ForWord Language training. Recent independent and third party studies have confirmed the positive impact of Fast ForWord Language. Based on extensive interviews with parents and educators, students who have completed the Fast ForWord Language program are generally reported to have shown substantial improvements in both self-esteem and confidence as their communication skills improved. We believe our training programs can help improve the language and related reading skills of most users.

FAST FORWORD LANGUAGE TO READING™

Fast ForWord Language to Reading was launched in 1998 and is a computer-based training program that trains reading and oral language skills. Fast ForWord Language to Reading provides focused practice in language comprehension skills for students who have basic oral language proficiency. Building on that foundation, Fast ForWord Language to Reading also trains reading skills such as word decoding, sound-letter recognition and visual tracking. Word decoding enables a student to build associations between word sounds, written representations of words and meaning. Sound-letter recognition is the ability to translate letters into spoken words. We believe that being able to process rapid sound-letter associations is critical to being able to read. Fast ForWord Language to Reading also provides training exercises that reinforce left-to-right reading patterns for students who may need to improve their visual tracking.

The Fast ForWord Language to Reading program is designed to be used for 90 minutes per day, five days a week for four to eight weeks. As with Fast ForWord, Fast ForWord Language to Reading results can be monitored through SLc Lesson.

FAST FORWORD MIDDLE AND HIGH SCHOOL™

Fast ForWord Middle and High School was launched in 1999 and is a computer-based training program that is designed specifically for middle and high school students and adults. Fast ForWord Middle and High School offers the same benefits of Fast ForWord Language but with graphics, story lines and content tailored for an older population. Fast ForWord Middle and High School combines electronically modified speech with cross-training in critical language and reading skills in a manner that automatically adjusts to each user’s performance. This program enables participants to track their own cumulative progress without connecting to the Internet as well as permitting results to be monitored through SLc Lesson.

4

FAST FOR WORD READING™

Fast ForWord Reading, introduced in 2000, is a computer-based training program that is designed to systematically and rapidly build reading skills, focusing on the skills that correlate directly to school curriculum standards, including: word recognition and fluency, advanced decoding, spelling and vocabulary, and passage comprehension. The Fast ForWord Reading training schedule is flexible, allowing educators to choose exercises and training times that match the needs of each student. The exercises adjust automatically to a student’s skill level, and the program’s Progress Viewer enables participants to track their own cumulative progress without connecting to the Internet. Fast ForWord Reading data can also be reviewed by the supervising professional through the ProgressTracker™ monitoring tool.

FAST FORWORD BASICS™

Fast ForWord Basics was introduced in 1999 and is comprised of seven interactive modules that each focus on key skills needed for success in grades pre-K through 2, such as recognition of colors and shapes, and provides practice in memory, using and manipulating phonemes, letter-name association, word recognition, fine motor control, and hand-eye coordination. Its modular format allows professionals to choose which modules a child will play, providing customized game sessions tailored to a child’s interests or needs.

FAST FORWORD BOOKSHELF™

Fast ForWord Bookshelf, introduced in 1999, is comprised of proprietary stories presented in both an interactive CD ROM format and a four-color printed format. These stories are designed as a companion to the Fast ForWord Basics skill-building software and provide exposure to appropriate spoken and written language content thereby supporting the training related to phonemes, the basic building blocks of language, in Fast ForWord Basics skill-building software games. Some versions contain four different levels of acoustically modified speech as well as natural speech.

PROGRESSTRACKER™

ProgressTracker, a Web browser based, java application, was introduced in 2001 to meet the needs of educators for monitoring student progress. Educators, using our patented Internet and database technology, can view student progress and compliance on our training programs over the Internet in a variety of ways, at the individual, class, school and district level. Teachers can see how students are progressing on specific skills. Reports showing student progress on the skills trained with our programs can be shared with students, parents, fellow teachers and school and district administrators

SLc LESSON™

SLc Lesson employs our patented Internet and database technology to permit the results from each participant’s training program exercises to be conveniently viewed and analyzed by the person overseeing the participant’s training. Training results are uploaded periodically via the Internet to our proprietary database for analysis of the student’s progress to date. SLc Lesson then provides performance charts and templates in various discrete learning areas, which can be downloaded through the Internet, enabling the training administrators to monitor compliance, track performance and provide students and parents with measurable performance results.

AWAY WE GO!™ AND AWAY WE GO! BOOKSHELF

Home versions of Fast ForWord Basics and Fast ForWord Bookshelf are marketed to consumers under the brand name Away We Go!. Away We Go! Bookshelf does not use acoustically modified speech.

READING EDGE™

Reading Edge is a computer-based screening and assessment product designed to evaluate early reading skills. Reading Edge helps identify students who may be at risk for reading problems in grades K-2 and provides later screening of older students who may be experiencing reading difficulties. Reading Edge’s animated games provide fast and reliable measurements for evaluating proficiency in essential skill areas that are strong predictors of future reading success, including phonological memory, phonological awareness, phonemic decoding and letter identification. The educator version of Reading Edge provides a rapid forward assessment tool. The home version incorporates the assessment functionality with engaging games that encourage practice of important reading skills. Reading Edge has been tested with children in grades K-2. We acquired Reading Edge in 1999 from the successor to its developer.

5

CROSSTRAIN™

CrossTrain, launched in November 1999, is a professional development package for educators and speech and language and other professionals that contains all the tools and information necessary to offer our family of language and reading training programs. The package includes videos, CD ROMs, printed materials, and other training materials on the Web. CrossTrain offers the same comprehensive content as our professional development seminars but in a self-paced tutorial that is more convenient.

SERVICES

BRAINCONNECTION.COM

In 1999 we launched BrainConnection, offering an interactive Web site, conferences for educators, and online professional development. BrainConnection provides practical and easily understandable information about how the brain works and how students learn. The BrainConnection.com Web site targets decision-makers in education, policy-makers, front-line educators, clinical professionals and parents with:

Links to information about our products that relate to the topics discussed are present throughout the site.

The BrainConnection to Education forums for educators target educational decision-makers who can influence the policies, curriculum decisions, and funding that impact students. These gatherings feature presentations by well-known scientists and practicing educators and administrators with expertise in the fields of education and learning. In addition, presentations made by our customers offer attendees concrete case studies on how technology and advances in neuroscience can impact student achievement.

In 2000, we introduced BrainConnection Professional Development courses to the Web site. These on-line courses offer practicing educators foundational information with courses such as “The Developing Brain”, “Language and the Brain”, and “The Reading Brain.”

PROFESSIONAL DEVELOPMENT SEMINARS

To assist educators, parents and speech and language and other professionals, we provide educational seminars on brain research, the connection between oral language comprehension and learning to read, and the practical application of the Fast ForWord family of programs. Typically, workshops are one-day intensive training seminars for educators and speech and language professionals. Participants in our professional development seminars are eligible to receive continuing education credit to support the ongoing educational certification requirements of teachers and educators.

SUPPORT SERVICES

SUPPORT FOR EDUCATORS, PARENTS AND PROFESSIONALS. We provide a number of support services for educators, parents and speech and language and other professionals involved in improving reading and language skills. A trained staff is available over a toll-free telephone line and over the Internet to answer questions from and provide support to educators, professional providers and parents.

TECHNICAL SUPPORT. We provide a variety of technical support services to our customer base. An experienced staff of technical service representatives is available to answer technical questions regarding our programs, computer hardware and networks. In addition, for schools that require it, we provide on-site software installation, technical training and technical support.

SCIENTIFICLEARNING.COM. We also maintain our company Web site at ScientificLearning.com. This site provides information about our company and our products and services as well as extensive technical and customer support resources.

6

SALES AND MARKETING

We market and sell our products through two primary channels of distribution: public schools and the private practice channel. We also make some of our programs and products available directly to consumers, through our Web site, but direct-to-consumer sales to date have been minimal.

PUBLIC SCHOOLS. At December 31, 2001, we had 25 sales representatives focused on the public school market. The majority of our public school sales have occurred since the formation in the fall of 1998 of a dedicated sales force focused on that market. Our hiring process has targeted experienced professionals who have established relationships with prospective customers. Our sales force typically targets sales at the school or school district level. We contact school and district officials through direct marketing efforts to encourage them to attend our seminars and learn about how our training programs can improve student results. We also participate in industry conferences and trade shows.

We sell our programs, products and services individually and in various combinations with training and installation on a bundled basis. Depending on the program, our software may be offered for a single student, workstation license, or on a site license basis. Program licenses range from single use, limited term licenses, typically three to twelve months, or on a perpetual basis. Our language and reading training programs generally list for $850 per program per student, while workstation and site license bundles list for $9,995 through $59,900, depending on what is included. Both are typically discounted for volume sales.

PRIVATE PRACTICE CHANNEL. We have two sales representatives focused on the private channel market including speech and language professionals and private schools. Speech and language professionals as well as other professionals in private practice recommend the use of our products in appropriate cases and then administer the program in connection with providing traditional services. In such instances, Fast ForWord Language, Fast ForWord Language to Reading, Fast ForWord Middle and High School, and Fast ForWord Reading are typically sold directly to the student or family for a list price of $850 per student, minimizing the administrative burden on the private practice professional, who charges separately for time spent supervising the student. The fees charged by the speech and language professional generally range from $1,000 to $2,000 per student.

TECHNOLOGY

Our programs are cross-platform, software-based programs available for a variety of hardware and software configurations. They are designed to work with the computer technology widely available in schools and homes, minimizing the need for users to purchase new equipment. The programs can be used in a variety of ways, including an on-site model where educators and speech and language and other professionals supervise students in school or office, an off-site model where students can train from their homes and a client/server-based model for larger scale deployments. Some of our programs link to Scientific Learning via standard Internet connections for data transfer and updates. Using our patented Internet and database technology, program administrators can use any Web browser to upload program results to our database and monitor individuals under their supervision.

Products are typically delivered via a CD ROM. Our training programs can be activated only by receiving a user access code. Some of our programs require periodic uploads of performance data over the Internet. If users of these products do not upload data within a required time period, access to the program is denied.

We use an object-oriented authoring environment for all our software products. New products and product extensions can be built off our core object model, allowing all products to benefit from improvements in the core code and reducing new product development time. The Scientific Learning database maintains a performance history containing all the uploaded data from our language and reading training programs. The database is unique and highly scalable, built on database technology from Oracle Corporation, and capable of dynamic information queries. Using a proprietary set of analytical tools, we automatically generate summaries and reports for use by educators, speech and language professionals, and other professionals. We can also generate custom demographic reports from specific groups of users by defining search characteristics such as school, classroom or common primary language. The resulting reports show exactly how a given user is performing and what challenges remain. The program databases at the client site are tightly integrated with our databases to provide seamless service from professional and technical support to accounting.

7

RESEARCH AND DEVELOPMENT

Our research and development expenses were approximately $3.4 million, $5.7 million, and $4.5 million for the years ended December 31, 2001, 2000, and 1999, respectively. At December 31, 2001, approximately 12% of our employees were engaged in research and development activities, which include both product development and outcomes research. Our research and development efforts are presently focused on the development of improvements to our existing products to enhance the user experience and on additional language and reading programs based on the application of our neuroscience expertise. In 2002, we plan to release new versions of Fast ForWord Language, Language to Reading and Middle and High School. Among other features, these new versions will no longer require customers to regularly connect with our database. We now plan to launch Fast ForWord Advanced Reading, which was originally scheduled for launch in 2001, in late 2002 or 2003.

INTELLECTUAL PROPERTY

We have a broad intellectual property strategy addressing both product technology and product concepts. We aggressively protect our proprietary rights in our products and technology through a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and contractual provisions.

At December 31, 2001, we held 34 issued U.S. patents and 22 pending U.S. applications. We also have 28 pending international patent applications. We were the exclusive licensee under 4 issued U.S. patents, 7 pending U.S. applications and 7 pending international patent applications. The licensed patents and applications are licensed from the Regents of the University of California and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptivity technology developed at those institutions. Fast ForWord Language, Fast ForWord Language to Reading, Fast ForWord Middle and High School, and Fast ForWord Bookshelf incorporate this licensed technology; Fast ForWord Reading, Reading Edge, Fast ForWord Basics and the Away We Go! products do not. To date, approximately 75% of our revenues have been derived from selling products that use the licensed inventions, and loss of this license agreement would cause material harm to our business.

Under the terms of this license, we must pay royalties and milestone payments based upon cumulative net sales of our products, subject to certain minimum royalty amounts. In connection with the license, we issued 114,526 shares of Series A preferred stock, which were converted into 114,526 shares of our common stock upon completion of our July 1999 initial public offering, to Rutgers and made other up-front payments. In 2000 and 2001, we had approximately $870,000 and $635,000, respectively in royalty and milestone expense under the license. In 2002 and each year thereafter during the term of the license, the minimum royalty expense necessary to maintain the license will be $150,000. We expect royalties as a percentage of revenues to decline over time as the royalty rate under the license steps down and we introduce additional programs that are not subject to license fees. However, we cannot predict our future product mix.

Unless otherwise terminated by operation of law or certain acts of the parties, the license remains in effect until the later of the expiration of the last-to-expire patent licensed or the abandonment of the last patent application licensed. The Regents may terminate the license agreement if we fail to perform or violate its terms without curing the violation within 60 days of receiving written notice of the violation.

COMPETITION

The educational market in which we operate is very competitive. We believe that the principal competitive factors in the industry are efficacy, ability to deliver measurable results, cost, efficiency of delivery, ability to provide training to educators, parents and speech and language and other professionals and ability to complement and supplement public school curriculum. We believe that we compete favorably on the basis of these factors. Particularly in the public school market, we compete against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Some of the other companies that provide software and other programs are more established in the school market than we are, offer a broader range of products to schools and have greater technical, marketing and distribution resources than we do. In addition, although the traditional approaches to language and reading are fundamentally different from the approach we take, the traditional methods are more widely known and accepted and, therefore, represent significant competition.

8

EMPLOYEES

As of December 31, 2001, we had 147 full-time and 3 part-time employees. We believe our relations with employees are good. None of our employees is represented by a union or subject to collective bargaining agreements.

RISK FACTORS

The following factors as well as other information contained in this Report on Form 10K should be considered in making any investment decision related to our common stock. If any of the following risks actually occur, our business, financial condition or results of operations could be materially and adversely affected and the trading price of our common stock could decline.

Our business depends on whether we can increase acceptance of our products in the public school market. Any difficulty in increasing sales in the public school market would adversely affect our business.

Our principal target market is public schools. Any difficulty in increasing our sales into this market would be likely to adversely affect our business. We began selling the Fast ForWord Language program to public schools in April 1997 and initiated our public schools sales force in the fall of 1998. At December 31, 2001, we had 25 quota-bearing salespeople focusing on the public school market.

We believe that our success in the public school market will depend largely on the following factors:

9

Our quarterly operating results are susceptible to fluctuations, which could cause our stock price to decline.

Since our formation, our quarterly operating results have fluctuated significantly. For example, our revenues for each fiscal quarter in the last two years have been:

We expect these fluctuations to continue for a number of reasons, including factors described elsewhere in this “Risk Factors” section. One reason we expect quarterly operating results to fluctuate is the long and somewhat unpredictable sales cycle for our products, particularly in the public school market, which is the result of many factors, including the following:

As a result, our sales cycle generally takes several months, and in some cases, can take a year or longer.

An additional reason our quarterly operating results may fluctuate is that demand for our programs and services may be subject to seasonal influences. Historically, in the public school market, our sales in the first quarter have tended to be particularly slow, as have third quarter sales. Demand has tended to pick up in the second and fourth quarters, due in part to school budget cycles. The school calendar can also affect start dates and utilization, and hence affect the timing of when we recognize revenues related to such sales. In our sales to speech and language professionals in private practice, demand for our programs tends to be lower during the school year than in the summer, because the intensive nature of our products may be more conducive to training during school vacation. However, we do not have sufficient operating experience to predict the overall effect of various seasonal factors and their effect on future quarterly sales.

The quarterly revenue recognized from our sales can also be unpredictable. We offer our public school customers a range of software and services, and typically they purchase a mix of our offerings. Different software products and services and different types of software licenses (single use, limited term or perpetual) have different revenue recognition periods ranging from immediately upon shipment or delivery to a period of three years. The beginning of the revenue recognition period may also vary depending on the start date of the contract, the date we ship the software, and the date we perform training . The mix of products and services in a sale frequently varies from customer to customer, and can be unpredictable. See “Management’s Discussion and Analysis – Critical Accounting Policies and Estimates” for a discussion of our revenue recognition policy.

Any significant shortfall of revenues in relation to our or analysts’ expectations could cause significant fluctuations in quarterly operating results, and our stock price could suffer. Prediction of future revenues and expenses is difficult for the reasons set forth above and in the remainder of this Risk Factors section. Our expense levels are based on our expectations of future revenues and are primarily fixed in the short term. We cannot assure you that we will be able to predict our future revenues accurately or that we will be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall.

10

Our common stock may be delisted from the Nasdaq National Market.

Our common stock trades on the Nasdaq National Market, which has certain compliance requirements for continued listing of common stock. Among the requirements applicable to us is the maintenance of either $50 million in market capitalization or $4 million in net tangible assets. In November 2001, we received a notice from Nasdaq that we failed to meet the tangible net asset requirement as of September 30, 2001. On November 30, 2001, we closed a private equity financing in which Warburg, Pincus Ventures, L.P., the Company’s largest stockholder, purchased 4,000,000 shares of Common Stock for an aggregate purchase price of $5,000,000. This financing increased our tangible net assets to a level in excess of the Nasdaq requirement.

As of December 31, 2001, our tangible net assets were approximately $1,411,000, lower than the required level. At March 8, 2002, our stock price was $1.85 per share and our market capitalization was approximately $28.8 million. As a result, Nasdaq may again initiate a review of the Company’s eligibility for continued listing. Delisting of our common stock from the Nasdaq National Market would be likely to reduce the liquidity of any investment in our common stock and to have a material adverse effect on the price of our common stock. Delisting would reduce the ability of holders of our common stock to purchase or sell shares as quickly and as inexpensively as they could have done in the past. This lack of liquidity may make it more difficult for us to raise capital in the future. Although we are working to comply with the continued listing requirements of Nasdaq, there can be no assurance that we will be able to satisfy such continued listing requirements or that, even if we are able to satisfy the requirements, Nasdaq would terminate delisting procedures.

We have incurred a significant amount of debt, and we do not expect to repay that debt in 2002.

In March 2001, we entered into an agreement with Fleet National Bank for a revolving line of credit of $15 million. At December 31, 2001, we had an outstanding obligation of $10 million under the line. The line of credit is guaranteed by WPV, Inc., an affiliate of Warburg, Pincus & Co. and Warburg, Pincus Ventures, in exchange for which we issued WPV, Inc. a warrant to purchase 1,375,000 shares of our Common Stock. The warrant has a seven-year term and an exercise price of $8.00 per share. We have agreed to repay WPV, Inc. for any amounts that it may be required to pay in satisfaction of the loan on account of the guarantee. To secure our reimbursement obligation, we granted WPV, Inc. a security interest in substantially all of our assets. In March 2002, we entered into an agreement with Fleet National Bank and WPV, Inc. to extend the term of the line of credit to June 2004. We do not expect to have sufficient capital resources to repay the line of credit during 2002.

This indebtedness and security interest could have important consequences, including the following:

The loan agreement provides that an event of default under the loan occurs upon certain changes in the composition of the board of directors or the acquisition of more than 40% of our stock by a person or group other than Warburg, Pincus or its affiliates. Such a default could occur at a time when we would be unable to repay the loan.

We have a history of losses, and we expect to incur additional losses this year.

We started operations in February 1996 and began generating revenues in the first quarter of 1997. We have incurred significant operating losses and negative cash flow since inception. Our net losses were approximately $10.7 million for the year ended December 31, 1998, $14.1 million for the year ended December 31, 1999, $20.1 million for the year ended December 31, 2000 and $19.3 million for the year ended December 31, 2001. We have an accumulated deficit of approximately $72 million from inception through December 31, 2001. For 2002, we expect to incur an operating loss, a net loss and negative cash flow for the year as a whole. During 2002, we also expect to continue to incur substantial sales and marketing expenses as we strive to generate increased revenue from our target markets. We cannot assure you that we will meet our targets with respect to revenues or operating results. If we do not meet our targets, we may be forced to further reduce our expenses, which may negatively impact our business.

11

We cannot guarantee that we will ever generate sufficient revenues to achieve or sustain profitability.

We cannot guarantee that we will ever generate sufficient revenues to achieve or sustain profitability or generate positive cash flow. As a result, we may need to obtain additional equity or debt financing in the future, which may not be available on acceptable terms, if at all.

To date we have relied primarily on a single family of products, the Fast ForWord training programs. Within that family of products, the majority of product usage is attributable to a single training program. Any failure to increase our sales of our language and reading training programs could cause our business to suffer.

Since our formation, sales of licenses of our language and reading training programs have accounted for almost 82% of our revenues. Within the family of training programs, the number of participants in one of our training programs, Fast ForWord Language, represented approximately 50% of all participants during 2001. Our remaining revenues are primarily from other educational products and related services, such as professional development courses and technical services relating to implementing our programs. We anticipate that most of our revenues will be related to our language and reading training programs for the foreseeable future. Our business will suffer if we are unable to increase our sales of our language and reading training programs.

Our sales to the private channel have declined over the past two years. Further decreases in sales to this channel could adversely affect our business.

In addition to selling to public schools, we also sell to and through speech and language professionals in private practice (“SLPs”) and, to a lesser extent, to private schools. Selling through and to SLPs was our initial market, but we have shifted our emphasis to the public school market because we believe it has greater growth potential. Our revenues from the private channel fell 26% in 2001 compared to 2000 and 20% in 2000 compared to 1999. Our ability to maintain and grow our sales to this channel are impacted by the following factors:

We expect that sales to the private channel may continue to decline as we continue to focus our limited resources on the public schools channel.

We may not be able to compete effectively in the educational technology market or the education market generally.

The market in which we operate is very competitive. We compete with other companies offering educational software products or non-software-based programs to improve reading or language skills to schools and to speech and language professionals in private practice. Existing competitors may continue to broaden their product lines, and potential competitors, including large software developers and educational publishers, may enter or increase their focus on the school market. Moreover, we expect that we will face additional competition from new entrants into the market. Many competitors have substantially greater technical, marketing and distribution resources than we do. We cannot assure you that we will be able to compete effectively in the educational technology or education markets.

We have significantly reduced our research and development efforts and our business may suffer if we do not introduce new products.

In 2001, because we wanted to focus on the public school market and to reduce expenses, and because we believed our suite of language products was reasonably complete, we significantly reduced our research and development staff. Our development efforts are now focused on increasing ease of use, providing additional student tracking capabilities, and generally increasing flexibility and improving the customer experience. For example, we are currently working to develop versions of our core products that do not require Internet connections. We cannot assure you that we will be successful in developing and marketing any such modified versions of our products or new products. We may not have sufficient resources to make the investments to develop or acquire and market the products necessary to maintain our competitive position. Failure to adapt to evolving technology and educational standards, to enhance our existing products and to develop new products based on our proprietary technology may materially and adversely affect our business and financial condition.

12

Our limited history makes it difficult to evaluate our current business and prospects.

In 1997, we introduced the Fast ForWord Language program. In 1998, we introduced the Fast ForWord Language to Reading program. In 1999, we introduced the Fast ForWord Basics, Fast ForWord Bookshelf, Reading Edge, Cross Train, Fast ForWord Middle & High School, Away We Go! and Away We Go! Bookshelf products. In 2000, we introduced the Fast ForWord Reading program and Brain Connection Professional Development on-line courses. Consequently, we only have a limited history upon which you can gauge the success of our suite of software products in penetrating our target markets.. Companies with limited operating histories, including ours, encounter high risks and uncertainties, particularly in new and rapidly evolving markets such as technology-based educational products and services. These risks include, but are not limited to:

To address these risks, we must, among other things:

We cannot assure you that we will be successful in addressing the risks we face, and our failure to address those risks will materially and adversely affect our business and financial condition.

Our business will suffer if customers delay or forego purchases of our products because of our product enhancements or new products or because of competitors’ superior products.

The demand for our existing products may be reduced or eliminated by our own enhancements or new products and the revenues generated from our enhancements or new products may not adequately offset any resulting loss of revenues from our existing products. Customers may also delay their purchases of our products in anticipation of the release of our product enhancements or new products, if any. Finally, products introduced by our competitors may be superior to the products we offer and reduce the demand for our products.

Economic factors could cause us to reduce our personnel levels, which could negatively impact our revenues or results of operations.

In each of 2000 and 2001, we reduced our personnel levels. We might find it necessary to further reduce our personnel levels if our revenues fail to grow as planned, due to general market or economic factors, or for other reasons. Such a reduction in personnel could adversely affect our revenues or results or operations.

We may be unable to effectively manage any future growth.

We grew rapidly from five employees at April 1, 1996, to approximately 200 employees at December 31, 1999. We ended 2000 with approximately the same number of employees as 1999 due to a mid-year reduction in the sales force and a reduction in research operations at the end of the year. During 2001, our employee count fell, reflecting staff reductions throughout the Company. At December 31, 2001, we had 150 employees. Our historical growth has placed, and any future growth will place, a significant strain on our managerial, operational, financial and other resources. Our future success will depend, in part, upon whether our senior management can manage growth effectively, particularly with limited personnel. Future growth, if any, may require us to implement additional management information systems, to develop additional operating, administrative, financial and accounting systems and controls, and to maintain close coordination among our accounting, finance, marketing, sales, and customer support and service organizations. If we are unsuccessful in managing growth, our business and financial condition will be materially and adversely affected.

13

We rely on our intellectual property rights and may be unable to protect these rights.

Our ability to compete effectively will depend in part on whether we are able to develop and maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and contractual provisions to protect our proprietary rights in our products and technology. We cannot assure you that pending patent applications will result in the issuance of any patents or that issued patents will offer protection against competitors with similar technology. In addition, any patents issued to us or our licensors could be challenged, invalidated or circumvented in the future.

It is possible we may become subject to patent infringement claims and litigation or interference proceedings conducted in the United States Patent and Trademark Office to determine the priority of inventions. Litigation may be necessary to enforce patents issued to us, to protect trade secrets or know-how that we own or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will result in substantial expense and significant diversion of effort by our technical and management personnel. An adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

Failure to maintain our exclusive license would materially harm our business by delaying or preventing new product introductions and necessitating product recalls.

We license certain patents and applications from the Regents of the University of California and Rutgers, the State University New Jersey, which relate to the speech and sound modification and adaptivity technology developed at those institutions. Our primary products, Fast ForWord Language, Fast ForWord Language to Reading and Fast ForWord Middle & High School, incorporate this licensed technology. To date, approximately 75% of our revenues have come from selling programs using the licensed technology. While our professional development seminars and on-line courses, Fast ForWord Reading and other products do not make use of this licensed technology, the vast majority of our product and service revenues relate to the core products, which do use the licensed technology, and its loss would cause material harm to our business. If we lose or are unable to maintain the license agreement during the term of the underlying patents, it would materially harm our business. It could delay or prevent the introduction of new products and would likely require the recall of most of our products from the market. Even if we could identify and license or develop non-infringing equivalent technology, which is far from certain, the cost and delays from such a changeover in our core technology would cause material harm to our business.

The Regents may terminate the license agreement if we fail to perform or violate its terms without curing the violation within 60 days of receiving written notice of the violation. For example, The Regents could terminate the agreement if we fail to perform any of the following obligations:

If we fail to retain our key personnel or attract and retain key employees, our business will suffer.

Our success depends to a significant extent upon the continued active participation of key members of our management, including Sheryle J. Bolton, our Chairman and Chief Executive Officer, Frank M. Mattson, our President and Chief Operating Officer, and Jane A. Freeman, our Chief Financial Officer, as well as others. While we do not believe that any of our employees is irreplaceable, we recognize that we are in an extremely competitive market for executives, and the loss of one or more of these persons could have a material adverse effect on our business, financial condition and results of operations. We recently announced a search for a new Chief Executive Officer. We believe that our future success will depend upon our ability to continue to attract, motivate and retain highly skilled managerial, sales and marketing and product development personnel, including a new Chief Executive Officer. Competition for such personnel is intense. The value of equity incentives provided to our key personnel may vary due to fluctuations in our stock price, which may make it more difficult to retain such personnel or may require us to adopt other types of incentive programs to remain competitive. Our failure to attract or retain the necessary personnel could materially and adversely affect our business.

14

Our executive officers and directors and their affiliates effectively control the voting power of our company.

At December 31, 2001, Warburg, Pincus Ventures, our largest shareholder, owned approximately 50% of the Company’s outstanding stock and, as a whole, our executive officers and directors and their respective affiliates beneficially owned more than 65% of the Company. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also delay, prevent or deter a change in control of our company. In addition, for so long as Warburg, Pincus Ventures continues to hold specified percentages of our company’s stock, we are required, under the terms of our amended and restated registration rights agreement, to nominate up to two individuals affiliated with Warburg, Pincus & Co. for election to the Board of Directors. Warburg, Pincus Ventures has also agreed with LF SL Holding LLC that so long as LF SL continues to hold at least 277,778 shares it originally purchased, Warburg, Pincus Ventures will vote to elect a person nominated by LF SL to the Board.

There is academic debate regarding the scientific basis underlying our products and the efficacy of our products, which could significantly affect the market for our programs and services.

Our training programs are based on particular theories of how the brain functions and learns and theories of language acquisition. Our founders are actively involved in academic debate about their own and opposing scientific theories of neuroscience and language acquisition. As a result, the theories on which our suite of software products is based have been, and are likely to be, subject to public debate and challenges. Although we believe that our suite of software products is based primarily upon non-controversial scientific theories, some of the principles and methodologies underlying and associated with our products are opposed by some academicians and educators, any of whom could influence the market for our products and services. Consequently, academic publications and debate challenging the theories of neuroscience and language acquisition propounded by the founders and others could adversely affect the market for our products and services. In addition, while we believe that we have established the efficacy of our products though appropriate scientific research, some question the efficacy of our products and/or the extent to which the results achieved through the use of those products can be generalized. Issues relating to the efficacy of our products could adversely affect our business.

We could lose revenues as a result of software errors or defects.

Software programs frequently contain errors or defects, especially when first introduced or when new versions are released. We could, in the future, lose revenues as a result of software errors or defects. We cannot assure you that errors will not be found in our current products or new products or releases, if any, even though products are tested prior to release. Any errors could result in loss of revenue or delay in market introduction or acceptance, diversion of development resources, damage to our reputation or increased service and warranty costs.

We could be subject to product liability claims from the sale of our products and services.

Because we market products to the public, we face an inherent business risk of financial exposure to product liability claims. As a publisher of online content, we face potential liability for defamation, negligence, copyright, patent or trademark infringement, or other claims based on the nature and content of materials that we publish or distribute. We currently carry product and general liability insurance that, in general, covers product and general liability claims up to the policy limits. We cannot assure you that we will continue to have access to this insurance at a reasonable cost, if at all, or that the insurance will be adequate to satisfy any liability or litigation expenses. Any claim or claims against us, regardless of their merit or eventual outcome, could materially and adversely affect our business.

15

The market price of our stock may be highly volatile.

The market price of our common stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations for the following reasons, among others: