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SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 0-28977

VARSITY GROUP INC.

1130 Connecticut Avenue, Suite 350

Registrant’s telephone number, including area code:

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

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

      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     þ          No     o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.     o

      The aggregate market value of common stock held by non-affiliates of the registrant was $17,725,858 based on the last reported sale price of $1.10 on March 22, 2002.

      As of March 22, 2002, there were 16,114,416 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

      The registrant intends to file a definitive Proxy Statement for its Annual Meeting of Stockholders pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2001. Portions of such proxy statement are incorporated by reference into Part III of this report.

Forward-Looking Statements

      This Annual Report on Form 10-K (“Form 10-K”) contains certain forward-looking statements within the meaning of Section 27A of the Securities and Exchange Act of 1934, which statements can be identified by the use of forward looking terminology, such as “may”, “will”, “expect”, “anticipate”, “estimate”, or “continue” or the negative thereof or other variations thereon or comparable terminology. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth elsewhere in this Form 10-K. See the “Risk Factors” section of Item 1 “Business” for cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from results referred to in forward-looking statements.

PART I

General

      We are a leading online retailer of new textbooks and educational materials targeting the private middle and high schools, colleges and distance and continuing education markets. Using our website, www.varsitybooks.com, we provide our customers with an opportunity to purchase textbooks online. Through eduPartners, our program serving schools directly, we offer educational institutions an online bookstore solution that allows them to focus their resources on the education process while offering their students the speed and convenience purchasing their textbooks and other learning materials online. Our eduPartners program was the first online bookstore solution focused on meeting the needs of private middle and high schools nationwide. With over 100 schools in our program, we are viewed as the leader and innovator in this market today.

      Throughout 2001, our business priorities, focus and resources have adapted to meet the changing market dynamics and economic realities. We have successfully lowered overall expenses and increased the margins of our retail book business to accelerate our path to profitability. In addition, we made significant reductions in the marketing and sales overhead expenses associated with our business. As a result, we posted the first profitable quarter in the history of our Company during the three months ending September 30, 2001, recorded positive cash flows from operations of $0.4 million for the year ended December 31, 2001 and are positioned to improve our financial performance in 2002.

      We also have historically provided marketing services for other businesses seeking to reach the college and private middle and high school demographics by marketing to students online through our website and on college campuses utilizing College Impact, our nationwide network of student marketing representatives. During 2001, we made a strategic decision to focus our resources on the growth and development of our eduPartners program, having determined that this presented the greatest prospects for long-term growth and value creation. Consequently, we completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs.

      Our overall success and ability to achieve profitability from operations will depend, in part, upon our ability to attract additional schools to our eduPartners program, provide a compelling and satisfying shopping experience to our retail customers and manage our relationship with Baker and Taylor. Marketing services will play a significantly smaller role in the future growth of our company. We anticipate future marketing services revenue will likely represent a small percentage of textbook revenues and will be focused on delivering online solutions compatible with our target eduPartners market. Finally, we must continue to attract and retain experienced personnel to effectively grow our business.

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Retail

      Purchasing new textbooks through traditional retailers tends to be expensive and inconvenient. The new textbook market is presently dominated by on-campus bookstores, with most schools either operating their own bookstore or contracting these services to a third party. Most campus bookstores face little competition, have significant overhead, and are crowded at the beginning of each semester, forcing students to endure high prices, long lines, and frequent out-of-stock inventory problems.

      The challenges associated with operating an efficient, profitable bookstore on campus are exacerbated at smaller schools where operating economies of scale are not present and profitability is more difficult to achieve. This is particularly true at the private middle and high school level, where there is typically only one major textbook buying season (Fall back-to-school) and clothing, school supplies and electronic sales are limited or non-existent.

      Online commerce provides the opportunity to better serve and more efficiently reach the college and private middle and high school student markets. We believe that, for a variety of reasons, few businesses have succeeded in offering students a comprehensive solution tailored to meet their varied needs in a convenient and cost-effective manner.

      The private school market represents approximately 10% of all elementary and secondary students and 25% of all elementary and secondary schools, according to the National Center of Education Statistics (NCES). More than 5.2 million students are enrolled in private schools, with approximately 2.84 million students in elementary level schools, 830,000 students in secondary level schools and 1.55 million students in combined elementary and secondary level schools. Almost half of all private school students attend schools that are located in urban areas. According to the Council on American Private Education, secondary school enrollment is expected to increase as much as 8% between 2000 and 2006.

      Students are powerful retail consumers. Although the college market is large and diverse, students still have common needs. For instance, students typically must buy expensive school related goods and services such as textbooks and school supplies. In fact, textbooks are most students’ single largest school related expenditure after tuition, room and board. The Almanac 2000-2001 reports that the average expense per college student for books and supplies is $625 to $700, and does not vary significantly between two and four year colleges, or private and public institutions. According to Student Monitor, during a one-year period ending Spring 2000, students purchased more than $59 million in textbooks online, with an average student purchase of $228. In addition, the number of students purchasing textbooks online has increased to 13%, up from 8% over the prior year. Overall, new textbook sales were approximately $4.3 billion in the academic year 1998-1999, based on statistics published by the National Association of College Stores.

      The college student market is large and growing. The U.S. Census Bureau reports that there are 15.5 million undergraduate and graduate students at more than 4,000 colleges and universities in the United States. According to the National Center for Educational Statistics, college enrollment will increase to approximately 16 million students by 2008. College students are actively using the Internet and are increasingly purchasing goods and services online. According to Student Monitor, during the spring 2000 semester, 97% of college students used the Internet. Approximately 70% of these students accessed the Internet one or more times daily, up from 57% in spring 1999. During a one-year period ending in the spring of 2000, approximately 37% of these students made online purchases, up from 26% last year.

      We continue to take the steps necessary to create an online book business with significant growth potential and the ability to deliver contribution dollars sufficient to reach annual operating profitability. We have successfully lowered the expenses and increased the margins of our retail book business through various means, including the transition from a discounted textbook pricing model to one more closely aligned with

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      We intend to invest in the development of eduPartners and expand our reach into private middle and high schools, traditional two and four year colleges, distance learning and other continuing education programs. Our eduPartners program was the first online bookstore solution focused on meeting the needs of private middle and high schools nationwide. We have eduPartner schools located in many key markets nationwide and are aggressively targeting remaining areas to establish a comprehensive nationwide network of member schools. We have been successful extending our presence in new markets by leveraging the positive experience and word-of-mouth generated once our initial partner in that market has completed a successful back-to-school selling season.

      We provide students with a reliable, convenient alternative to the traditional campus textbook shopping experience. We are able to reduce the overhead associated with textbook sales because we do not maintain individual stores and we outsource our ordering, inventory, warehousing and fulfillment needs to Baker & Taylor, a leading distributor of books, videos and music products. In addition to providing new textbooks at competitive prices, we are committed to providing best-in-class customer service, dedicated account management, customized websites for each partner school and same-day shipment of orders.

      Through eduPartners, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience to their students by outsourcing new textbook sales to us. We believe that for many schools the expense and inconvenience of maintaining a bookstore exceed the schools’ financial return. We provide an innovative solution for schools and enable them to offer increased convenience and value to students, their parents, and the entire school community. Through these relationships, we are endorsed as the exclusive textbook retailer at our eduPartners schools and gain direct access to their students. As a result, eduPartners is an attractive way for us to acquire customers.

      As of March 2002, we were the exclusive new textbook supplier for approximately 100 educational institutions. In addition, through eduPartners, we reach students early, enabling us to extend our brand and establish a customer relationship with students prior to their attending college. Our exclusive relationships generally are for a period of two to four years and automatically renew on a year-to-year basis. As of March 2002, approximately 35 agreements expire during 2002 based upon their original term. As per the terms of these agreements, each of these 35 agreements automatically renew for one year if neither party serves notice of intent to terminate 90 days prior to the date of expiration.

      With eduPartners, we create a personalized virtual bookstore for each school on our website. Students are able to search by region and state on our homepage to locate the link to their co-branded bookstore. Parents and students can be linked directly to their school bookstore page from the own school’s homepage. Once they reach the entry page to their customized online bookstore, the student or parent can navigate the site by clicking on the appropriate grade, discipline and class to select required and optional books. The school benefits from the decreased costs, inconveniences and inefficiencies inherent in the seasonal business of purchasing, inventory management and selling learning materials directly to students on campus. In addition, schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features.

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      Our website, www.varsitybooks.com, offers several benefits to students including convenience, ease of use and depth of product selection. When logging on to our website, visitors are presented with several shopping options, including:

	•	Searching by School. Students at eduPartners schools can use our customized map to locate their school. Once they find their school they can link through a list of departments to a list of classes and to the specific booklists for the courses they are taking. Our customers have the option of placing all the textbooks for a particular class in their shopping cart with a single click or selecting only those titles that interest them.
	•	Searching for Books. If we have not posted a specific school’s booklist, our customers can search for the books they need by author, title, keyword, publisher or ISBN. Our website offers additional book verification for many selections, including pictures of jacket art, editor’s name, volume number, table of contents and other identifying characteristics.

      When our customers are ready to place an order, they can proceed through our shopping cart function directly to our checkout page. We presently accept Visa, Discover, MasterCard, money order and personal check as payment for our products. At our eduPartners schools, we also offer school and student credit accounts. During the ordering process, we ask our customers for basic information about themselves, which we maintain in our customer database. Once a customer places an order, he or she immediately receives an e-mail that includes a unique order number and confirms that the order has been received and processed. If a book is not in stock at the time an order is processed, that title is automatically placed on backorder and shipped to the customer as soon as it returns to stock. Customers are not charged for any book until it has been shipped. After an order is shipped, the customer receives a second e-mail that includes a UPS tracking number, a description of titles shipped and placed on backorder, the amount charged to their credit card for this shipment and a link to a page on our website where they can follow their order through the delivery process. We use a variety of UPS services to ensure our customers will receive their orders timely.

      We are committed to delivering superior customer service to all of our customers, including partner schools, parents and students. We currently manage customer service in-house, leveraging the experience and commitment of our own employees to provide a best-in-class level of service. We believe this allows us to more directly control the quality and content of each customer interaction with our company and provides important real-time insight into the performance of our eduPartner program. Our customers can access our customer service representatives at any time during their visits to our website. The customer service page of our website offers answers to frequently asked questions and enables our customers to ask their own questions through e-mail. We also have a toll-free customer service telephone number. Our customer service agents are available to telephone orders from customers that do not have access to the Internet or are uncomfortable placing an order online. We increase our customer service staffing during our peak periods to ensure a fast response to customer queries.

      We fulfill all of our textbook orders through Baker & Taylor, a leading distributor of books, videos and music products with whom we have a series of written agreements, each of which is scheduled to expire on October 1, 2002 with automatic renewal for one year unless either party elects in writing not to renew. The agreements are terminable upon up to 30 days’ notice by either party in the event of a default. Under these agreements with Baker & Taylor, we agree to provide Baker & Taylor with our written demand forecasts for each upcoming semester and we agree to use Baker & Taylor as our principal supplier of textbooks and drop-ship and fulfillment services. We pay fees and expenses related to the services Baker & Taylor provides and we purchase products from Baker & Taylor at a discount to the suggested price. In return, Baker & Taylor agrees

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      As a result of the data access our agreements provide, information on availability of book titles is automatically updated on our website on an hourly basis from 8:00 a.m. to 10:00 p.m. eastern standard time based on a direct feed from Baker & Taylor, ensuring our customers receive accurate in-stock inventory information. Orders placed on our website are automatically transmitted to Baker & Taylor within twenty minutes of their receipt. At the Baker & Taylor warehouse currently used for fulfillment, the order is processed, packaged in a VarsityBooks.com branded box and shipped directly to our customers via UPS. We extend a convenient return policy to our customers under which returns are shipped directly to Baker & Taylor to expedite processing. Finally, providing Baker & Taylor with our demand forecasts for each semester helps to ensure they maintain an adequate and relevant inventory to meet the demands of our customers.

      We use an array of site management, search, customer interaction, transaction-processing and fulfillment services and systems using a combination of proprietary technologies and commercially available, licensed technologies. Our strategy is to license commercially available technology whenever possible rather than seek internally developed solutions.

      Our technology environment is designed to provide:

	•	a satisfying customer experience;
	•	consistent system availability and good performance;
	•	high security for all transactions, particularly, our customers’ commerce transactions;
	•	scalability for continued growth; and
	•	the collection, maintenance and security of valuable information.

      We currently use a Microsoft Windows NT operating system platform and multiple Compaq application servers that house our web server and search engine applications. These servers are able to handle applications including accepting and validating customer orders, handling multiple shipment methods and accepting, authorizing and charging customer credit cards. In addition, our system maintains ongoing automated e-mail communications with customers throughout the ordering process. These systems entirely automate many routine communications, facilitate management of customer e-mail inquiries and allow customers to, on a self-service basis, check order status and order history, change their personal information and check subscriptions to personal notification services.

      We manage user requests and other traffic-using load balancing devices that work across the entire complement of our hardware. This strategy of balancing traffic allows all customers and site users to enjoy favorable response times and other performance measures, regardless of traffic fluctuations. Although we own and maintain our hardware and software systems, Qwest Communications located in Sterling, Virginia, hosts our server environment and acts as our Internet service provider and we lease the space in which our hardware system resides from Qwest. A group of in-house systems administrators and network engineers and Qwest personnel monitor and operate our website, network operations and transaction-processing systems.

      Our agreement with Qwest currently provides for service to be provided on an annual basis, subject to renewal. We pay for the space in which our hardware system resides and our Internet access based on our usage, on a monthly basis. We may terminate this agreement on any annual renewal date without penalty.

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      We use the Microsoft suite of tools for our development environment, including Site Server Commerce, InterDev and SQL SVR for the database engine. Additionally, we have separate database servers that capture and retain transaction “logs” of all activity that occurs on the site. These log databases can, among other things, trace a transaction from its inception to its completion. Our separate recording database generates and delivers reports and interfaces for our marketing, operations and financial systems.

      We employ SSL data encryption technology to protect credit card data while it is passed from the customer through the site during a purchase transaction. This prevents outside parties from intercepting the customer’s credit card data during transaction processing.

      E-commerce, in general, and online textbooks, more specifically, are highly competitive markets. The number of e-commerce websites competing for customers’ attention has increased rapidly, and the market for online textbook sales is relatively new, intensely competitive and rapidly changing. We currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:

	•	traditional new and used textbook retailers, such as campus bookstores;
	•	traditional used textbook retailers, some of which have or are expected to begin online selling;
	•	textbook retailers and distributors such the Follett Corporation, MBS Textbook Exchange and Adams Book Company; and
	•	Internet-based booksellers such as Amazon.com, and barnesandnoble.com.

      We believe that the principal competitive factors in attracting and retaining retail customers are:

	•	entering relationships with educational institutions;
	•	convenience;
	•	competitive pricing;
	•	selection of available products;
	•	customer service;
	•	quality of content and navigability tools;
	•	brand recognition; and
	•	reliability and speed of fulfillment.

      The Company has also provided marketing services for other businesses seeking to reach the college and private middle and high school demographics by marketing to students online through its website and on college campuses utilizing a nationwide network of student marketing representatives. In 2000, for example, we executed marketing campaigns for companies such as AT&T Wireless, Inc., Papa John’s, Inc, Polaroid, Inc., Palm, Inc. and Ben & Jerry’s Homemade, Inc. These campaigns were developed to meet the goals of each client. Marketing activities included online marketing, traditional flyering and postering, peer-to-peer marketing, on-campus events, product trial and demonstrations, and sponsorship opportunities.

      However, during 2001, the Company made a strategic decision to focus resources on the growth and development of the eduPartners program. The Company determined that the eduPartners model presented the greatest prospects for long-term growth and value creation and elected to concentrate the resources and energy of the entire organization on maximizing this opportunity. The Company completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. The Company anticipates future marketing services revenue will likely represent a

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Intellectual Property

      We regard our trademarks, service marks, trade dress, copyrights, trade secrets, proprietary technology and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality and license agreements with our employees, customers, independent contractors, sponsors and others to protect our proprietary rights. We have applied to register VarsityBooks.com as a service mark with the United States Patent and Trademark Office. The Trademark Office approved this application for publication on January 6, 2000. If no oppositions are filed against our application, it will be “allowed” and we will file evidence of use and be issued a registration.

      We may be required to obtain licenses from others to refine, develop, market and deliver new products and services. There can be no assurance that we will be able to obtain any such license on commercially reasonable terms or at all, or that rights granted pursuant to any licenses will be valid and enforceable.

      Domain names are the user’s Internet “address.” Domain names have been the subject of significant trademark litigation in the United States. Domain names derive value from the individual’s ability to remember such names, therefore there can be no assurance that our domain name will not lose its value if, for example, users begin to rely on mechanisms other than domain names to access online resources.

Government Regulation

      There are an increasing number of laws and regulations pertaining to the Internet. In addition, a number of legislative and regulatory proposals are under consideration by federal, state, local and foreign governments and agencies. Laws or regulations may be adopted relating to issues such as to liability for information retrieved from or transmitted over the Internet, online content regulation, user privacy, taxation and quality of products and services. Moreover, it may take years to determine whether and how existing laws such as those governing intellectual property ownership and infringement, privacy, libel, copyright, trade mark, trade secret, obscenity, personal privacy, taxation and the regulation of the sale of other specified goods and services apply to the Internet. The requirement that we comply with any new legislation or regulation, or any unanticipated application or interpretation of existing laws, may decrease the growth in the use of the Internet, which could in turn decrease the demand for our Internet-based services, increase our cost of doing business or otherwise materially harm our business.

      Federal, state and foreign governments have enacted or may enact laws or consider regulations regarding the collection and use of personal identifying information obtained from individuals when accessing websites, with particular emphasis on access by minors. Such regulations may include requirements that companies establish procedures to:

	•	give adequate notice to consumers regarding information collection and disclosure practices;
	•	provide consumers with the ability to have personal identifying information deleted from a company’s data;
	•	provide consumers with access to their personal information and with the ability to rectify inaccurate information;
	•	clearly identify affiliations or a lack thereof with third parties that may collect information or sponsor activities on a company’s website;
	•	obtain express parental consent prior to collecting and using personal identifying information obtained from children; and

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	•	the Federal Children’s Online Privacy Act.

      Such regulation may also include enforcement and redress provisions. While we have implemented programs designed to enhance the protection of the privacy of our users, including children, there can be no assurance that such programs will conform to applicable laws or regulations. Moreover, even in the absence of such regulations, the Federal Trade Commission has begun investigations into the privacy practices of companies that collect information on the Internet. One such investigation has resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the privacy safeguards described above.

      It is also possible that “cookies” may become subject to laws limiting or prohibiting their use. The term “cookies” refers to information keyed to a specific server, file pathway or directory location that is stored on a user’s hard drive, possibly without the user’s knowledge, and which is used to track demographic information and to target advertising. Some of the currently available Internet browsers allow users to modify their browser settings to remove cookies or prevent cookies from being stored on their hard drives.

      We currently obtain and retain personal information about our website users with their consent. We have a stringent privacy policy covering this information. However, if third persons were able to penetrate our network security and gain access to, or otherwise misappropriate, our users’ personal information, we could be subject to liability. Such liability could include claims for misuses of personal information, such as for unauthorized marketing purposes or unauthorized use of credit cards. These claims could result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant financial resources.

      Legislation pending in Congress, if passed, would afford broader rights to owners of databases of information, such as stock quotes and sports scores. Such protection already exists in the European Union. If enacted, this legislation could result in an increase in the price of services that provide data to websites. In addition, such legislation could create potential liability for unauthorized use of such data.

      A number of legislative proposals have been made at the federal, state and local level, and by foreign governments, that would impose additional taxes on the sale of goods and services over the Internet and some states have taken measures to tax Internet-related activities. Although Congress has placed moratorium on state and local taxes on Internet access or on discriminatory taxes on e-commerce, existing state or local laws have been expressly excepted from this moratorium. Further, once this moratorium is lifted, some type of federal or state taxes may be imposed upon Internet commerce. Such legislation or other attempts at regulating commerce over the Internet may substantially impair the growth of commerce on the Internet and, as a result, adversely affect our opportunity to derive financial benefit from such activities.

      Due to the global reach of the Internet, it is possible that, although our transmissions over the Internet originate primarily in the Commonwealth of Virginia, the governments of other states and foreign countries might attempt to regulate Internet activity and our transmissions or take action against us for violations of their laws.

Risk Factors

      We were founded in December 1997 and began selling textbooks on our website in August 1998. Due to the seasonality of textbook sales, our peak selling periods are currently in July, August, and September, when the new academic year begins and students purchase the majority of their textbooks. During 2001, approximately 81% of our textbook revenues were recognized in this period. We expect this trend to increase as the concentration of private middle and high schools in our eduPartners program increases. As a new

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      We have incurred substantial losses in every fiscal year since inception. For the year ended December 31, 2001, we incurred a loss from operations of approximately $2.8 million and positive cash flows from operations of $0.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.8 million and negative cash flows from operations of $27.5 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and negative cash flows from operations of $29.4 million. As of December 31, 2000 and 2001 we had accumulated deficits of approximately $68.2 million and $70.5 million, respectively.

      During the three months ending September 30, 2001, the Company recorded the first profitable fiscal period in its history with a net profit of approximately $1.0 million in the critical back-to-school textbook buying season. Positive cash flows from operations of $0.4 million were recorded for the year ended December 31, 2001. The operating profits from the three months ended September 30, 2001 were not sufficient to reverse the losses recorded in the other three fiscal quarters of 2001. This resulted in a net loss of approximately $2.2 million for the year ended December 31, 2001.

      We expect that operating losses and negative cash flows from operations will likely continue until our seasonally critical back-to-school buying season in the third quarter of 2002. As part of the increased emphasis on eduPartners and lower overhead cost structure, we expect the costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our previous levels, we believe, in the aggregate, that this will reduce the historical losses and negative cash flows from our sales of textbooks. We intend to increase spending on the development of eduPartners and relationships with other businesses. Failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

      We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures until such time as we achieve operating profitability. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed our current expectations. Any required additional financing may be unavailable on terms favorable to us, or at all.

      We intend to continue to grow our business. We currently anticipate that our available funds will be sufficient to meet our anticipated needs until such time as annual operating profitability is achieved. We may continue to lose money and generate negative cash flows from operations for the foreseeable future. We may need to raise additional funds in the future to fund more aggressive marketing programs, to acquire or develop new technology, to increase our staff to meet operational demands, to introduce new products or services or to acquire complementary businesses or services or intellectual property rights. Any required additional financing may be unavailable on terms favorable to us or at all. If we raise additional funds by issuing equity securities, you may experience significant dilution of your ownership interest and such securities may have rights senior to those of the holders of our common stock. Obtaining additional financing will be subject to a number of factors, including:

	•	market and economic conditions;
	•	our financial condition and operating performance; and

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	•	investor sentiment.

      These factors may make the timing, amount, terms and conditions of additional financing unattractive for us. Currently, companies that are considered primarily on-line retailers are not perceived well by the market. If additional financing is not available when required or is not available on acceptable terms, we may be unable to:

	•	fund our expansion;
	•	successfully promote our brand name;
	•	develop or enhance our products and services;
	•	develop or purchase new servers, software and other technology to enable us to process increased transactions and service increased traffic on our website;
	•	attract and retain the appropriate talent and a sufficient number of employees to handle our increasing operations; and
	•	take advantage of business opportunities or respond to competitive pressures.

      Our ability to generate significant revenues and profits from the sale of textbooks and other products and services we may offer in the future is uncertain. To be successful, we must attract and retain a significant number of schools to our eduPartner program. Ultimately, we must attract the students and parents from each eduPartner school to our website at a reasonable cost. Any significant shortfall in the expected number of purchases occurring through our website will negatively affect our financial results by increasing or prolonging operating losses and negative cash flows. Conversion of schools from traditional on campus bookstore operations to eduPartners’ online bookstore solution may not occur as rapidly as we expect, if at all. Therefore, we may not achieve the customer traffic we believe is necessary to become successful. Specific factors that could prevent widespread customer acceptance of our business and our ability to increase retail revenues include:

	•	lack of consumer awareness of our eduPartner program;
	•	pricing that does not meet consumer expectations;
	•	consumer concerns about the security of online transactions;
	•	shipping charges, which do not apply to shopping at traditional retail stores and are not always charged by some of our online competitors;
	•	delivery time associated with online orders, as compared to the immediate receipt of products at traditional retail stores;
	•	product damage from shipping or shipments of the wrong products, which may result in a failure to establish trust in purchasing our products online;
	•	delays in responses to consumer inquiries or in deliveries to consumers; and
	•	difficulty in returning or exchanging orders.

      We may not be able to retain existing eduPartners member schools or sign-up new eduPartners member schools.

      Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. We expect to experience seasonality in our business related to the academic calendar and the corresponding demand for textbooks and educational

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	•	seasonal trends in the textbook industry and in the buying habits of students;
	•	concentration of private middle and high schools in our eduPartners program;
	•	our ability to manage or influence inventory and fulfillment operations;
	•	the level of merchandise returns we experience;
	•	our ability to attract new customers, retain existing customers and maintain customer satisfaction;
	•	introduction of enhancements or a change in pricing policies, by us or our competitors, or a change in pricing policy by our sole fulfillment source;
	•	changes in the amount and timing of expenditures related to marketing, information technology and other operating expenses to support future growth;
	•	technical difficulties or system downtime affecting the Internet generally or the operation of our website specifically;
	•	increasing consumer acceptance and use of the Internet for the purchase of consumer products;
	•	potential acquisitions or strategic alliances either by us or our competitors; and
	•	general economic conditions and economic conditions specific to the Internet, online commerce and the book industry.

      As a result of the seasonal fluctuations and because the online sale of textbooks and online selling in general is new and it is difficult to predict consumer demand, it is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. In that event, it is likely that the price of our stock would decline.

      We depend on Baker & Taylor, Inc. as our current sole supplier of the textbooks we offer. Our relationship with Baker & Taylor is critical to our success. If we were unable to rely on them for inventory maintenance and shipping services, our business would be materially harmed.

      We do not warehouse any of our own inventory, so we rely on Baker & Taylor to maintain an adequate inventory and rapidly fill our customers’ orders. Prices we pay for promotional, customer service and database management services and credits that we receive from Baker & Taylor are currently based on volume and average cost requirements. Failure to meet these benchmarks could increase our costs. If they do not maintain sufficient inventory, or if they are unable to deliver the specific books our customers order or deliver these books in a timely fashion, we would not be able to meet our obligations to our customers, our revenues would decrease and we would likely experience a reduction in the value of our brand. Baker & Taylor fills orders for a number of textbook retailers. Baker & Taylor has advised us that it fills all the orders it receives on a first-come, first-served basis without providing preferential treatment for us or any of our competitors. If other Baker & Taylor customer orders depleted Baker & Taylor’s inventory, and Baker & Taylor was unable to quickly replenish its inventory, our orders would not be processed or filled in a timely manner. If our relationship with Baker & Taylor is disrupted or does not continue for any reason and we are unable to establish a comparable vendor relationship or open our own warehouse before the Baker & Taylor relationship

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      We benefit from the shipping discounts offered to Baker & Taylor by United Parcel Service and we rely on UPS and other third party carriers for all shipments to and from Baker & Taylor. If Baker & Taylor’s relationship with UPS is discontinued or disrupted for any reason, we cannot be certain we would be able to affordably obtain comparable delivery services and might not be able to deliver textbooks to our customers in a timely manner. In addition, because we rely on third party carriers to ship products to and from the single Baker & Taylor warehouse that our fulfillment is currently conducted from, we are subject to the risks, including employee strikes and inclement weather, that may prevent such third parties from meeting our fulfillment and delivery needs. Failure to deliver products to our customers in a timely and accurate manner would harm our reputation, our brand and our business.

      The e-commerce, online textbook and marketing services markets are new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new websites at a relatively low cost. We currently compete with a variety of other companies in the sale of textbooks, and if we are able to add other product or service offerings we will have additional competition in those markets. Our current and potential competition includes the following categories of companies:

	•	traditional new and used textbook retailers, such as campus bookstores;
	•	traditional used textbook retailers, some of which have or are expected to begin online selling;
	•	textbook retailers and distributors such the Follett Corporation, MBS Textbook Exchange and Adams Book Company; and
	•	Internet-based booksellers such as Amazon.com, efollett.com (affiliated with The Follett Corporation) and barnesandnoble.com.

      We are not able to reliably estimate the number of our direct competitors. Many of our current and potential competitors have longer general retail operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing, technological, operational and other resources than we do. Some of our competitors may be able to secure textbooks from vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing, shipping policies or inventory availability policies and devote substantially more resources to website and systems development than we can. As competition increases, we may experience reduced operating margins, loss of market share and a diminished brand franchise. To remain competitive, we may from time to time make pricing, service or marketing decisions or acquisitions that could affect our financial condition and results of operations. It is possible that our supply channel (distributors and, indirectly, publishers) may enter the market and match our pricing through direct retail centers or that either or both our supply channel and traditional college bookstores may enter the online commerce market as our competitors. It is also possible that companies that control access to transactions through network access or web browsers could promote our competitors or charge us a substantial fee for inclusion. As Internet use becomes increasingly prevalent, it is possible that the full text of books we offer for sale will be available for viewing on the web or on other electronic devices such as virtual textbooks. If virtual textbooks become a reality and students rely on them in lieu of purchasing hard copies of textbooks, our business may decline.

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      Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder, Chief Executive Officer, President and Chairman of the Board. We have entered into an agreement with Mr. Kuhn that provides, among other things, that he be compensated in the event he is terminated without cause. We have not entered into similar agreements with any other personnel. Nonetheless, the loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team. In addition, a number of members of our management team have joined us within the last year. These individuals have not previously worked together and are becoming integrated into our management team. They may not be able to work together effectively or successfully manage our growth, resulting in adverse consequences to our business.

      The satisfactory performance, reliability and availability of our website, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and maintain adequate customer service levels. An unanticipated dramatic increase in the volume of traffic on our website or the number of orders placed by our customers may force us to expand and upgrade our technology, transaction-processing systems and network infrastructure. There can be no assurance that we will be able to accurately project the rate or timing of increases, if any, in the use of our website or timely expand and upgrade our systems and infrastructure to accommodate such increases. To be successful, we must adapt to our rapidly changing market by continually enhancing the technologies used in our Internet products and services and introducing new technology to address the changing needs of our business and customers. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing market conditions or business and customer requirements, our business could be harmed.

      Our operations are dependent on our ability to maintain our computer and communications software and equipment in effective working order and to protect our systems against damage from fire, natural disaster, power loss, communications failure or similar events. In addition, the growth of our customer base may strain or exceed the capacity of our computer and communications systems and lead to degradations in performance or systems failure. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We use an internally developed system for our website, search engine and substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping.

      Substantially all of our computer and communications hardware and software systems are located at a single facility in Sterling, Virginia. That facility is owned, maintained and serviced by Qwest Communications. Although we own and maintain our hardware and software systems, including the software which is central to the sales, ordering and shipping processes, we rely on Qwest to ensure our computer and communications hardware and software operate efficiently and continuously. We do not presently have fully redundant systems or a formal disaster recovery plan and do not carry sufficient business interruption insurance to compensate for losses that may occur. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins, fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. Any damage, failure or delay that causes interruptions in our system operations could have a material adverse effect on our business.

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      In addition to our offsite software and hardware related to our website, at our headquarters we maintain a local area network, or LAN, which we use for our financial reporting systems, customer service operations, monitoring of our customer orders, e-mails and other internal processes. Any loss of service or other failure of this LAN, regardless of the availability of our website, would significantly impair our ability to service our customers and monitor and fulfill customer orders, which could have a material adverse effect on our business.

      The failure of either our website or our LAN or any other systems interruptions that results in unavailability of our website or reduced order fulfillment performance, especially during our peak sales period of July/ August/ September, could result in negative publicity or could reduce the volume of goods sold and attractiveness of our website and would seriously impair our ability to service our customers’ orders, all of which could negatively affect our revenues. Because our servers are located at a third-party’s facility and because some of the reasons for a systems interruption may be outside of our control, we also may not be able to exercise sufficient control to remedy the problem quickly or at all. Regardless of whether we or a third-party controls or creates system failure, the occurrence of system failure could adversely affect our reputation, seriously harm our business and cause us to lose a significant and disproportionate amount of revenues.

      A significant barrier to confidential communications over the Internet has been the need for security. We rely on SSL encryption technology to prevent the misappropriation of customer credit card data during the transaction process. Under current credit card practices, a merchant is liable for fraudulent credit card transactions where, as is the case with the transactions we process, that merchant does not obtain a cardholder’s signature. A failure to adequately control fraudulent credit card transactions could reduce our collections and harm our business. Internet usage could decline if any well-publicized compromise of security occurred. Our site could be particularly affected by any such breach because our online commerce model requires the entry of confidential customer ordering, purchasing and delivery data over the Internet, and we maintain a database of this historical customer information. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential customers may inhibit the growth of the Internet as a medium for commerce. We cannot be certain that advances in computer capabilities, new discoveries in the field of cryptography or other developments will not result in the compromise or breach of the algorithms we use to protect content and transactions on our website or proprietary information in our databases. Anyone who is able to circumvent our security measures could misappropriate proprietary, confidential customer or company information or cause interruptions in our operations. We may incur significant costs to protect against the threat of such security breaches or to alleviate problems caused by these breaches.

      To date, governmental regulations have not materially restricted use of the Internet in our markets. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. Uncertainty and new regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our online services and limit the growth of our revenues. In addition to new laws and regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues, which include:

	•	sales and other taxes;
	•	user privacy;
	•	pricing controls;
	•	characteristics and quality of products and services;
	•	consumer protection;

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	•	libel and defamation;
	•	copyright, trademark and patent infringement; and
	•	other claims based on the nature and content of Internet materials.

      We currently hold various Internet domain names relating to our brand, including the “VarsityBooks.com” domain name. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the generic category of domain names (i.e., .com, .net and .org) is now controlled by a non-profit corporation, which may create additional top-level domains. Requirements for holding domain names have also been affected. As a result, there can be no assurance that we will be able to acquire or maintain relevant domain names. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. Any such inability could harm our business.

      A 1992 Supreme Court decision held that the Commerce Clause of the United States Constitution limits a state’s ability to impose a sales or use tax collection responsibility on an out-of-state vendor unless such vendor maintains a physical presence, i.e., substantial nexus, in the taxing state. Based on this Supreme Court decision, we have determined that we do not have a substantial nexus in several jurisdictions where our products are received by customers, and, therefore, do not collect or remit sales or use tax in such jurisdictions. Because the scope of the 1992 Supreme Court decision is unclear, states may challenge our determination of substantial nexus. If successful, such challenges could result in significant liabilities for sales and use taxes with a material and adverse effect on our business. We currently collect and remit sales or use tax on all shipments to Illinois, North Carolina, California, Colorado and the District of Columbia. In one of these jurisdictions, we are currently appealing an assessment of sales and use taxes related to audit periods before we began collecting and remitting sales and use taxes in such jurisdiction. There is a risk that our appeal of this assessment will not be successful and may result in additional liabilities for sales and use taxes that could have an adverse effect on our business. An additional state, unrelated to the jurisdictions where we currently collect and remit sales and use taxes, has contacted the Company to inquire about possible exposure for sales and use taxes. As of the date of this form, this state has determined that the Company has no sales tax liability for the audit period in question. The 1992 Supreme Court decision also established that Congress has the power to enact legislation that would permit states to require collection of sales and use taxes by mail-order companies. Congress has from time to time considered proposals for such legislation. We anticipate that any legislative change, if adopted, would be applied on a prospective basis. While there is no case law on the issue, we believe that this analysis could also apply to our online business. Recently, several states and local jurisdictions have expressed an interest in taxing e-commerce companies who do not have any contacts with their jurisdictions other than selling products online to customers in such jurisdictions. The Internet Tax Freedom Act imposed a moratorium on new taxes or levies on e-commerce for a three-year period and originally was due to expire in October 2001. However, Congress has extended the Internet Tax Freedom Act through October 2003. There is no guarantee that Congress will subsequently extend this Act. If the Act is not extended new taxes could result that could have an adverse effect on online commerce, including our business.

      Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially own approximately 53.0% of our outstanding common stock. These stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors, the approval of

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      Presently, our common stock is eligible to be traded on the OTC Bulletin Board and we believe that certain broker/dealers are making a market in our common stock. These broker/dealers are under no obligation to make a market and there can be no assurance that they will continue to make such a market or that they will not decide to discontinue making a market without notice to us or our stockholders. Effective with the open of business on March 21, 2001, our common stock was delisted from The Nasdaq National Market. Since we have been delisted from Nasdaq, we cannot assure you that an active trading market for our common stock will continue. If an active trading market for our common stock is not sustained, you may not be able to sell your common stock when you need to do so, or at a price acceptable to you, or even at all.

      The stock market, in general, and the trading prices of shares in public technology companies, particularly those such as ours that offer Internet-based products and services, have been extremely volatile and have experienced a substantial drop in market price. Indeed, the trading price of our common stock dropped significantly, thereby precipitating our delisting from Nasdaq. We believe that this drop has resulted from many factors, some of which are beyond our control, such as:

	•	investor perception of us and online retailing services in general;
	•	general economic conditions both in the United States and in foreign countries;
	•	our results in operations;
	•	adverse business developments;
	•	changes in financial estimates by securities analysts; and
	•	announcements by our competitors of new products and services.

      As a result of these factors, and due to the risks related to the absence of an active trading market for our common stock (which are described above) we cannot assure you that the trading price of our common stock will not continue to drop or stay at its currently low price. The significant decreases in the trading price of our common stock and the currently low trading price that we are experiencing is likely to affect our visibility and credibility in our market and will likely limit our ability to raise capital in the future. Additionally, as a result of our low stock trading price and our delisting for Nasdaq, you may not be able to resell your shares of common stock when you need to or at prices higher than what you paid to purchase such shares.

      Securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against the lawsuit and a diversion of management’s attention that could cause our business to be harmed.

      The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

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      Delaware corporate law and our amended and restated certificate of incorporation and our by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of Varsity Group or a change of our management that stockholders may consider favorable or beneficial. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include those which:

	•	authorize the issuance of “blank check” preferred stock, which is preferred stock that can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of common stock;
	•	provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors;
	•	prohibit stockholder action by written consent; and
	•	establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting.

Employees

      As of March 2002, we had approximately 20 employees. We hire temporary employees, particularly at the beginning of the Fall school semester to support our customer service efforts, and contract service providers as necessary. None of our employees is represented by a labor union or is the subject of a collective bargaining agreement. We believe that relations with our employees are good.

      Our headquarters is located at 1130 Connecticut Avenue, Suite 350, Washington, DC. We currently lease approximately 3,200 square feet pursuant to a lease that is scheduled to expire on November 30, 2002. The Company was previously headquartered at 2020 K Street, N.W. in Washington, D.C. At this previous site, we leased an aggregate of approximately 34,000 square feet pursuant to a lease that was scheduled to expire in February 2003. On March 8, 2001 we terminated the operating lease for this office space located at 2020 K Street, NW, Washington, DC. Under the terms of this settlement, we effectively agreed to pay all rents through March 2001 in addition to a buyout amount for the remaining lease term.

      The Company is a party to various legal proceedings and claims incidental to its business. Management does not believe that these matters will have a material adverse effect on the results of operations or financial condition of the Company.

      None.

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PART II

      Our common stock traded on the Nasdaq National Market under the symbol VSTY from February 15, 2000 until March 20, 2001. Beginning on March 21, 2001 our common stock traded on the OTC Bulletin Board under the symbol VSTY.OB. Prior to February 15, 2000, our common stock was not publicly traded. For the period from January 1, 2001 to December 31, 2001, the high and low closing prices per share of our common stock were as follows:

      On March 5, 2002, the closing price per share of our common stock was $0.87 and we had approximately 239 stockholders of record and approximately 3,771 beneficial holders of our common stock.

      On March 8, 2001 we appeared before a Nasdaq Listing Qualifications Panel (the “Panel”) to present our case for continued inclusion on The Nasdaq National Market pursuant to an exception to the bid price and market value of public float requirements, as set forth in Nasdaq Marketplace Rules 4450(a)(5) and 4450(a)(2). However, in a letter dated March 20, 2001 the Panel informed us of their decision to delist our securities from The Nasdaq National Market, effective with the open of business on March 21, 2001. The letter also informed us we did not satisfy all the requirements for continued listing on The Nasdaq SmallCap Market. Effective with the Panel decision, our securities immediately became eligible to trade on the OTC Bulletin Board.

      We have never declared or paid any cash dividends on our common stock. Any decision regarding the declaration of future cash dividends will be made by the Company’s Board of Directors.

      On October 19, 2001 the Company purchased 957,063 previously issued and outstanding shares of Varsity Group, Inc. Common Stock in a privately negotiated transaction.

RECENT SALES OF UNREGISTERED SECURITIES

      None.

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      The selected financial data presented below as of and for the fiscal years ended December 31, 1999, 2000 and 2001 have been derived from the Company’s audited consolidated financial statements. This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company’s Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K.

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(1)	Adjusted net loss per share is computed using:

	a.	The weighted average number of common shares outstanding, including the pro-forma effects of the conversion of the Company’s Series A, Series B and Series C convertible preferred stock into shares of the Company’s common stock on a one-to-one basis effective upon the closing of the Company’s initial public offering as if such conversion occurred on January 1, 1998 or at the date of original issuance, if later, as well as the impact of the Company’s one-for-two stock split in December 1999.

	b.	Adjustments for certain non-cash expenses, including non-cash charges and interest expense.

 Overview

      We are a leading online retailer of new textbooks and educational materials targeting private middle and high schools, colleges and distance and continuing education markets. Through eduPartners, our program serving schools and organizations directly, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience and value to their students by outsourcing to us the sale of new textbooks and other learning materials.

      We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. For the period from inception through August 9, 1998, our primary activities consisted of:

	•	developing our business model;
	•	establishing, negotiating and consummating a relationship with our supplier, Baker & Taylor;
	•	initial planning and development of our website;
	•	developing our information systems infrastructure;
	•	developing our marketing plans; and
	•	establishing finance and administrative functions.

      Since the launch of our website, we have continued these activities and have also focused on increasing sales, expanding our product and service offerings, improving the efficiency of our order and fulfillment process, recruiting and training employees, enhancing finance and administrative functions and increasing customer service operations and the depth of our management team to help implement our growth strategy.

      We began to generate sales when we launched our website in August 1998. To date, our revenues have consisted primarily of sales of new textbooks. Our original sales model focused on building a broad consumer brand offering promotions and deeply discounted textbook prices to entice college students visit our website and purchase their textbooks from us.

      In January 1999 we created eduPartners, whereby we became the exclusive provider of new books and learning materials to a variety of learning institutions. This program is a cost-effective model that enables us to increase the number of customers to our website and generate book sales that does not require the significant marketing and brand building expenses associated with our earlier model. During 2000, we began to focus resources on the growth and development of our eduPartner program and we extended that focus throughout 2001. In quarter ending September 30, 2001, revenues from eduPartners accounted for approximately 97% of

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      The Company has also provided marketing services for other businesses seeking to reach the college and private middle and high school demographics by marketing to students online through its website and on college campuses utilizing a nationwide network of student marketing representatives. During the fourth quarter of fiscal 1999, we began generating revenues from marketing programs. In 2000, for example, we executed marketing campaigns for companies such as AT&T Wireless, Inc., Papa John’s, Inc, Polariod, Inc., Palm, Inc. and Ben & Jerry’s Homemade, Inc. These campaigns were developed to meet the goals of each client. Marketing activities included online marketing, traditional flyering and postering, peer-to-peer marketing, on-campus events, product trial and demonstrations, and sponsorship opportunities.

      During 2001, we made a strategic decision to focus resources on the growth and development of the eduPartners program. We determined that the eduPartners model presented the greatest prospects for long-term growth and shareholder value creation and elected to concentrate the resources and energy of the entire organization on maximizing this opportunity. We completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. We anticipate future marketing services revenue will likely represent a relatively small percentage of textbook revenues and will be focused on delivering online solutions compatible with our target eduPartners market.

      Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable. Costs associated with our marketing programs are recognized as incurred.

      Throughout 2001, our business priorities, focus and resources have adapted to meet the changing market dynamics and economic realities. We have successfully lowered overall expenses and increased the margins of our retail book business to accelerate our path to profitability. In addition, we made significant reductions in the marketing and sales overhead expenses associated with our business. As a result, during the three months ending September 30, 2001, we recorded the first profitable fiscal period in our history, posting over $1 million in net operating profits. We also recognized positive cash flows from operations of $0.4 million for the year ended December 31, 2001.

      Although our margins have increased and our overall expenses have been lowered significantly, our ability to reach annual operating profitability depends on our ability to generate and sustain higher net revenues. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as an indication of future performance. If we cannot achieve and sustain profitability or positive cash flow from operations, we may be unable to meet our working capital requirements or to obtain additional financing, which would adversely affect our business and my cause us to discontinue operations.

      We have incurred substantial losses in every fiscal year since inception. For the year ended December 31, 2001, we incurred a loss from operations of approximately $2.8 million and positive cash flows from operations of $0.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.8 million and negative cash flows from operations of $27.5 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and negative cash flows from operations of $29.4 million. As of December 31, 2000 and 2001 we had accumulated deficits of approximately $68.2 million and $70.5 million, respectively.

      However, during the three months ending September 30, 2001, the Company recorded the first profitable fiscal period in its history with a net profit of approximately $1.0 million in the critical back-to-school textbook buying season. We were also able to record positive cash flows from operations of $0.4 million for the year

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      We expect that operating losses and negative cash flows from operations will likely continue until our seasonally critical back-to-school buying season in the third quarter of 2002. Based upon our current cost structure and recent growth levels within the eduPartners program, we believe we are positioned to improve upon the financial performance of 2001. As part of the increased emphasis on eduPartners and lower overhead cost structure, we expect the costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our previous levels, we believe, in the aggregate, that this will reduce the historical losses and negative cash flows from our sales of textbooks. We intend to increase spending on the development of eduPartners and relationships with other related businesses. Failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

      We granted options to purchase 2.1 million shares for the year ended December 31, 1999, 0.6 million shares for the year ended December 31, 2000 that have been deemed to be compensatory. There were no options granted during the year ended December 31, 2001 that have been deemed to be compensatory. As a result, we recorded deferred compensation of $5.1 million and $1.8 million during the year ended December 31, 1999 and 2000, respectively.

      Additionally, effective August 1, 1999, we sold 207,077 shares of our common stock at a price of $0.30 per share to each of our founders, Mr. Kuhn and Mr. Levy. The shares vest at a rate of 40% upon the completion of one year of service and the remaining 60% vest at the end of the second year. Mr. Levy’s shares accelerated upon his separation, which was effective March 15, 2000. We have deemed that the fair value of the underlying stock for the sale of common stock is in excess of the related sales or exercise price. As a result, we recorded deferred compensation of $2.6 million during August 1999 for these transactions.

      Furthermore, effective August 24, 1999, Mr. Kuhn was granted an option to purchase 138,052 shares of our common stock at an exercise price of approximately $0.30 per share. The option vests in equal monthly installments over each of the next 48 months assuming Mr. Kuhn remains employed by the Company. Further, on December 17, 1999, we granted to Mr. Kuhn an option to purchase 345,470 of the Company’s fully diluted common stock at an exercise price of $10 per share. We have deemed that the fair value of the underlying stock for the option grants is in excess of the related sales or exercise price. As a result, we recorded deferred compensation of $0.9 million and $1.1 million during August 1999 and December 1999, respectively, for these transactions.

      Effective December 21, 2000, we sold 350,000 shares of our common stock at a price of $0.001 per share to Mr. Kuhn. These shares were issued with certain restrictions limiting or preventing their sale or transfer. We have deemed that the fair value of the underlying stock for the sale of common stock is in excess of the related sales or exercise price. As a result, we recorded non-cash compensation expense of $21,840 in December 2000. There was no deferred compensation expense associated with this transaction.

      During the year ending December 31, 2001, we sold 666,667 shares of our common stock at a price of $0.001 to members of senior management and our Board of Directors. The shares initially carry a restricted legend which limits their ability to be sold or transferred and is removed in equal increments over a 24 month period, based upon their continued service to the Company. We have deemed that the fair value of the underlying stock for the sale of common stock is in excess of the related sales or exercise price. As a result, we recorded deferred compensation expense of $215,033 associated with this transaction.

      Amortization of deferred compensation is included in non-cash compensation in the accompanying consolidated statements of operations. Non-cash compensation is being charged to operations over the vesting period of the underlying shares and options. Due to staffing reductions during the year ended December 31, 2000, a significant percentage of granted options and the associated deferred compensation outstanding as of

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 Critical Accounting Policies

      Varsity Group’s consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. For a comprehensive discussion of our accounting policies, see note 2 in the accompanying consolidated financial statements included in this Annual Report on Form 10-K. Varsity Group does not have any ownership interest in any special purposes entities and does not have any significant related party transactions. Pursuant to recent guidance published by the SEC regarding disclosure about critical accounting policies, we have identified the following accounting policies as critical to the understanding of our results of operations.

Reliance On A Single Supplier

      The Company relies on a single supplier as its current sole provider of textbooks, fulfillment and shipping services. While the Company believes it could obtain these services from other qualified suppliers on similar terms and conditions, a disruption in the supply of these services by the current supplier could materially harm the business. The controlling shareholder of this supplier was a 13% owner of the Company’s common stock at December 31, 2001.

      Substantially all of the Company’s computer and communications hardware and software systems are located at a single facility that is owned, maintained and serviced by a third party. Any damage, failure or delay that causes interruptions in the Company’s systems operations could materially harm the Company’s business.

Revenue Recognition

      The Company recognizes revenue from textbook sales, including sales under the Company’s partnership program, net of any discounts and coupons, when the textbooks are received by its customers. The Company takes title to the textbooks sold upon transfer to the shipper and assumes the risks and rewards of ownership including the risk of loss for collection. The Company does not function as an agent or broker for its supplier. Outbound shipping charges are included in net sales. The Company provides allowances for sales returns, promotional discounts and coupons based on historical experience in the period of the sale. To date, the Company’s revenues have consisted primarily of sales of new textbooks. The Company has also generated revenues through the sale of general interest books, banner advertisements and marketing service agreements. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable. Costs associated with our marketing programs are recognized as incurred.

  Years Ended December 31, 2001 Compared to Year Ended December 31, 2000

Net Sales

      Net sales decreased to $12.5 million for the year ended December 31, 2001 from $28.5 million for year ended December 31, 2000, from lower textbook and marketing services revenues as a result of our focus on the growth and development of our eduPartners program. Book revenues in our eduPartners program increased to approximately $9.3 million for the year ended December 31, 2001 from approximately $7.3 million for the year ended December 31, 2000. The decrease in overall revenues is attributed largely to a sharp reduction in revenues from our original mass-market college targeted textbook sales model. This reduction was largely attributed to our focused growth from our eduPartners program and the elimination of significant national marketing expenditures and promotions historically expended to drive college students to our website.

      Marketing services revenues decreased to $0.9 million for the year ended December 31, 2001 from $2.6 million for the year ended December 31, 2000. The majority of revenues recognized in 2001 were associated with contracts signed during 2000. No new marketing services contracts with an aggregate contact

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      Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable.

Operating Expenses

  Cost of Product — Related Party (Baker & Taylor)

      Cost of product — related party consists of the cost of products sold to customers. Cost of product — related party decreased to $7.9 million for the year ended December 31, 2001 from $21.3 million for year ended December 31, 2000. This decrease was primarily attributable to our decreased sales volume. We expect that cost of product — related party will increase in absolute dollars as eduPartners and our customer base expands.

  Cost of Shipping — Related Party (Baker & Taylor)

      Cost of shipping — related party consists of outbound shipping. Cost of shipping decreased to $0.7 million for the year ended December 31, 2001 from $2.2 million for year ended December 31, 2000. This decrease was primarily attributable to our decreased sales volume. Also, for the year ended December 31, 2001, shipping revenue exceeded cost of shipping — related party by $0.2 million or 36%. For the year ended December 31, 2000, cost of shipping — related party actually exceeded shipping revenue by $0.4 million or 24%. In the fourth quarter of 2000, we increased our shipping rates to ensure that shipping revenue exceeded cost of shipping on most orders and have continued that policy in 2001. While we will continue to offer competitive, value-based shipping prices to our customers, we expect that shipping revenue will continue to exceed cost of shipping in 2002. We recognize this action may negatively impact our ability to aggressively expand eduPartners and our customer base.

      Effective October 1, 1999 we amended the documents governing our relationship with Baker & Taylor. The amendment provides for assignment of separate values to the separate services provided by Baker & Taylor: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by Baker & Taylor. Effective with the amendment of our agreement with Baker & Taylor on October 1, 1999, we have included in “cost of product — related party” in our statement of operations the cost of purchased books from Baker & Taylor, we included in “shipping — related party” the cost of shipping charges from Baker & Taylor and we included in marketing and sales the cost of other services including website content and customer database management charged from Baker & Taylor.

      Since the effective date of these amendments, these agreements have served to reduce cost of product — related party (Baker & Taylor) as a percentage of revenue and increase marketing and sales expense as a percentage of revenue.

  Cost of Marketing Services

      Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. Cost of marketing services for the year ended December 31, 2001 decreased to approximately $45,000 from $0.4 million for the year ended December 31, 2000. This decrease was primarily attributable to our decreased marketing services revenue.

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  Marketing and Sales

      Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses for personnel engaged in marketing, including the expenses previously associated with the maintenance and development of our nationwide network of student representatives. Marketing and sales expense decreased to $1.7 million for the year ended December 31, 2001 from $23.3 million for the year ended December 31, 2000. This decrease was primarily attributable to the elimination of marketing and brand building expenses associated with the promotion of our original mass-market collegiate textbook sales model, lower sales and marketing expenses associated with our agreement with Baker & Taylor and the elimination of our network of student representatives.

      Advertising expense decreased from $7.0 million for the year ended December 31, 2000 to approximately $30,000 for the year ended December 31, 2001. This decrease was primarily attributable to the elimination of marketing and brand building expenses associated with the promotion of our original mass-market collegiate textbook sales model in 2001. We made similar reductions in the headquarter staffing associated with our consumer marketing effort and management of our student representative network.

      Certain marketing and sales expenses associated with our agreement with Baker & Taylor are the product of the classification of services such as website content and customer database management as marketing and sales expense and we expect these costs will increase in absolute dollars as we expand grow our business.

      During 2001 we continued to reduce the marketing and sales overhead associated with our business. We focused resources on the growth and development of our eduPartners program. During the first quarter of 2001 we scaled back our network of student representatives to focus more closely on markets and campuses most frequently targeted by our marketing services clients. In the second half of 2001 we evaluated the prospects for continued growth, broader economic factors and the costs associated with maintaining a best-in-class on-campus network of student representatives. Based upon this analysis, we determined the most effective utilization of our resources was to focus on the growth and development of our eduPartners program. Consistent with that decision, we ceased operating and maintaining our student representative network and focused our marketing services efforts on developing opportunities consistent with our on-line eduPartner model. We anticipate future marketing services revenue will focus on online solutions compatible with our eduPartners focus that leverage our website and opt-in customer email database and can be managed internally with existing resources. As a result of these actions and the considerably lower costs associated with marketing and promoting eduPartners, we expect that marketing and sales expense will continue to be lower in absolute dollars than historical levels associated with our original mass-market collegiate textbook sales model and on-campus collegiate marketing services network.

  Product Development

      Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense decreased to $0.3 million for the year ended December 31, 2001 from $4.2 million for year ended December 31, 2000. This decrease was primarily attributable to overall reductions in technology staffing levels, the streamlining and simplification of our website consistent with our eduPartner model and the elimination of booklist development for non-eduPartner schools. We believe that the majority of site features and functionality necessary to support and expand our businesses have been successfully implemented. Based upon our decision to focus resources on the growth and development of our eduPartner program, we made a strategic decision to eliminate the development of detailed “booklists” for non-eduPartners institutions on our site. We anticipate our product development expenses will continue to be lower in absolute dollars than historical levels associated with our original mass-market collegiate textbook sales model and on-campus collegiate marketing services network.

  General and Administrative

      General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense decreased to $3.9 million for the year ended December 31, 2001 from

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  Non-Cash Compensation

      Non-cash compensation expense consists of expenses related to the granting of employee options measured based on the intrinsic value of the stock option. Non-cash compensation expense decreased to $0.8 million for the year ended December 31, 2001 from $4.6 million for year ended December 31, 2000. This decrease was primarily attributable to reduction in staffing levels and the cancellation of non-vested employee options for employees who left the Company during 2000 and 2001.

  Other Expense

      During the year ended December 31, 2001 we sold or disposed of certain fixed assets that were no longer critical to the successful execution of our business plan. The disposal of these assets resulted in a loss or expense of approximately $38,000 during the year ended December 31, 2001 compared to a loss of approximately $0.3 million for the year ended December 31, 2000.

  Interest Income, net

      Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $0.6 million for the year ended December 31, 2001 compared to $1.0 million for the year ended December 31, 2000. This decrease was primarily attributable to lower interest rates and lower average cash and cash equivalent and short-term investment balances during the year ended December 31, 2001.

  Income Taxes

      As of December 31, 2000 and December 31, 2001, we had net operating loss carryforwards for federal income tax purposes of $54.8 million and $59.2 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See note 10 to our consolidated financial statements.

  Years Ended December 31, 2000 Compared to Year Ended December 31, 1999

Net Sales

      Net sales increased to $28.5 million for the year ended December 31, 2000 from $10.6 million for year ended December 31, 1999, as a result of a much stronger selling season in January/ February of 2000 compared to the similar period in 1999, the expansion of eduPartners and the commencement of our marketing services business. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable.

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Operating Expenses

  Cost of Product — Related Party (Baker & Taylor)

      Cost of product — related party consists of the cost of products sold to customers. Cost of product — related party increased to $21.3 million for the year ended December 31, 2000 from $9.1 million for year ended December 31, 1999. This increase was primarily attributable to our increased sales volume.

  Cost of Shipping — Related Party (Baker & Taylor)

      Cost of shipping — related party consists of outbound shipping. Cost of shipping increased to $2.2 million for the year ended December 31, 2000 from approximately $0.9 million for year ended December 31, 1999. This increase was primarily attributable to our increased sales volume. Also, for the year ended December 31, 2000, cost of shipping — related party exceeded shipping revenue by $0.4 million or 24.2%. As part of our business strategy, we have historically charged a flat rate for shipping, which in many cases was less than our actual costs. In the fourth quarter of 2000, we increased our shipping rates to ensure that shipping revenue exceeded cost of shipping on most orders.

      Effective October 1, 1999 we amended the documents governing our relationship with Baker & Taylor. The amendment provides for assignment of separate values to the separate services provided by Baker & Taylor: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by Baker & Taylor. Effective with the amendment of our agreement with Baker & Taylor on October 1, 1999, we have included in “cost of product — related party” in our statement of operations the cost of purchased books from Baker & Taylor, we included in “shipping — related party” the cost of shipping charges from Baker & Taylor and we included in marketing and sales the cost of other services including website content and customer database management charged from Baker & Taylor.

      Since the effective date of these amendments, these agreements have served to reduce cost of product — related party (Baker & Taylor) as a percentage of revenue and increase marketing and sales expense as a percentage of revenue.

  Equity Transactions — Related Party (Baker & Taylor)

      Equity transactions — related party consists of the fair value of warrants and the amortization of the excess of the fair value over the cost of common stock issued to Baker & Taylor. During 1998, we issued a warrant to purchase 107,143 shares of our common stock at an exercise price of $2.33 per share in July; a warrant to purchase up to 50,000 shares of our common stock at an exercise price of $0.20 per share in October; and a warrant to purchase up to 53,571 shares of our common stock at an exercise price of $2.33 per share in December. Additional warrants to purchase up to 5,950 and 62,500 shares of our common stock at an exercise price of $2.33 and $0.22 per share, respectively, were issued to Baker & Taylor in 1999. We estimated the fair value of the warrants on the date of grant using an established option pricing model (see note 3 to the accompanying consolidated financial statements). On July 10, 1998, we sold 535,714 shares of our common stock to Baker & Taylor at par value. We subsequently determined that the fair value of the common stock was in excess of the exercise price and sales price. Fair value per share was derived by reference to the preferred stock value since inception — see note 3 to the accompanying consolidated financial statements. We expensed the excess of the fair value of the common stock over its cost, which was approximately $643,000, in July 1998. In connection with all of the Baker & Taylor equity transactions, we recorded an aggregate expense of $169,000 for the year ended December 31, 1999, a decrease from the $798,000 we recorded for such transactions for the year ended December 31, 1998. There we no similar expenses incurred during the year ended December 31, 2000.

  Cost of Marketing Services

      Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus

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  Marketing and Sales

      Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses for personnel engaged in marketing, including the expenses associated with the continued development of our nationwide network of student representatives. Marketing and sales expense increased to $23.3 million for the year ended December 31, 2000 from $20.0 million for year ended December 31, 1999. This increase was primarily attributable to increases in sales and marketing expenses associated with our agreement with Baker & Taylor and increased sales and marketing staffing levels in the first half of the year. Advertising expense decreased to $7.0 million for the year ended December 31, 2000 from $11.4 million for year ended December 31, 1999. This decrease was primarily attributable to the contraction of our online and offline advertising in the second half of 2000. Certain marketing and sales expenses associated with our agreement with Baker & Taylor are the product of the classification of services such as website content and customer database management as marketing and sales expense and we expect these costs will continue to increase in absolute dollars as we expand grow our business. However, during the fourth quarter of 2000, we made reductions in other marketing and sales overhead associated with our business. We scaled back our network of student representatives to focus more closely on markets and campuses most frequently targeted by our marketing services clients. We reduced or eliminated consumer advertising and marketing budgets targeting the national college market and refocused resources on the continued growth of eduPartners. We made similar reductions in the headquarter staffing associated with our consumer marketing effort and management of our student representative network.

  Product Development

      Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense decreased to $4.2 million for the year ended December 31, 2000 from $4.5 million for year ended December 31, 1999. This decrease was primarily attributable to the capitalization of certain technology development costs associated with feature and functionality enhancements made to our website during 2000, overall reductions in technology staffing levels in the second half of 2000 and the reduction or elimination of booklist development for non-eduPartner schools. We believe that the majority of site features and functionality necessary to support and expand our businesses have been successfully implemented. Based upon observing customer navigation patterns on our site and the related cost-benefit analysis, we made a strategic decision to reduce or eliminate the development of detailed “booklists” for non-eduPartners institutions on our site.

  General and Administrative

      General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense increased to $7.4 million for the year ended December 31, 2000 from $5.1 million for year ended December 31, 1999. This increase was primarily attributable to the hiring of additional personnel and increased professional services expenses during 2000. Consistent with efforts taken in other areas of our business, we have taken steps to reduce the overhead associated with managing and growing our enterprise. During the second half of 2000 we have reduced headcount, renegotiated vendor agreements and reduced ongoing administrative expenses.

  Non-Cash Compensation

      Non-cash compensation expense consists of expenses related to the granting of employee options measured based on the intrinsic value of the stock option. Non-cash compensation expense increased to $4.6 million for the year ended December 31, 2000 from $2.6 million for year ended December 31, 1999. This increase was primarily attributable to increases in staffing levels during the second half of 1999 and 2000.

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  Other Expense

      During the year ended December 31, 2000 we sold or disposed of certain fixed assets that were no longer critical to the successful execution of our business plan. The disposal of these assets resulted in a loss or expense of approximately $0.3 million during the year ended December 31, 2000.

  Interest Income, net

      Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $1.0 million for the year ended December 31, 2000 compared to $0.4 million for the year ended December 31, 1999. This increase was primarily attributable to interest income on higher average cash and cash equivalent and short-term investment balances during the year ended December 31, 2000.

  Income Taxes

      As of December 31, 1999 and December 31, 2000, we had net operating loss carryforwards for federal income tax purposes of $29.9 million and $54.8 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See note 10 to our consolidated financial statements.

 Seasonality

      We have experienced significant seasonality in our results of operations. Due to the academic calendar and the seasonal nature of the textbook industry, our peak selling periods have historically been August/ September and January/ February, when college students return to school and new semesters begin. However, consistent with our focus on the expansion of eduPartners and its current concentration of private middle and high school institutions, our peak selling period during the year ended December 31, 2001 was the July/ August/ September back-to-school season. During 2001, approximately 81% of our textbook revenues were recognized in this period. We expect this trend to continue as we extend eduPartners’ leadership position in the private middle and high school market. While many private middle and high school institutions have an active book buying season in December/ January, the volume of purchases are typically significantly lower than the initial back-to-school season. Part of our strategy is to expand eduPartners more deeply into the college and distance learning markets. This would result in more balanced selling seasons between fall and winter. However, based upon our current eduPartners school mix, we may continue to experience fluctuations in quarterly operating results.

 Liquidity and Capital Resources

      As of December 31, 2001, we had $16.8 million of cash and cash equivalents. As of that date, our principal commitments consisted of obligations outstanding under operating leases, accounts payable and accrued liabilities. Although we have no material commitments for capital expenditures, we may experience increases in our capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel.

      During the year ended December 31, 2001, we generated $0.4 million in cash from operating activities. Net cash used in operating activities was $27.5 million for the year ended December 31, 2000, and $29.4 million the year ended December 31, 1999, consisting primarily of net losses adjusted for changes in accounts receivable, accounts payable and accrued expenses.

      During the year ended December 31, 2001, net cash generated from investing activities was $0.8 million. Net cash used in investing activities was $1.4 million for the year ended December 31, 2000, and $2.7 million the year ended December 31, 1999, consisting primarily of purchases of computer equipment, fixtures and furniture, as well as the purchase of a six month certificate of deposit of $0.5 million in 1999.

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      Net cash provided by financing activities was $0.2 million, $36.5 million and $38.5 million the years ended December 31, 2001, 2000 and 1999, respectively. Net cash provided by financing activities during the year ended December 31, 2001 consisted primarily of net proceeds of $0.7 million from an outstanding warrant receivable and $0.6 million cash used to purchase treasury shares. Net cash provided by financing activities during the year ended December 31, 2000 consisted primarily of net proceeds of $35.8 million from the issuance of common stock.

      On January 19, 2000 we entered into a revolving credit facility with Imperial Bank in an aggregate amount of $7.5 million with sublimits of $3.0 million for purchases of property, equipment and software and $750,000 for letters of credit. The maturity date for working capital advances was December 31, 2000 and the maturity date for property, equipment and software advance is October 18, 2002. Interest on outstanding balances accrued at Imperial’s prime rate plus 1.0% until the closing of our initial public offering, and afterwards at Imperial’s prime rate. All amounts outstanding, which could be up to $7.5 million, would be collateralized by a pledge of all of our assets. Under the terms of the credit facility, as amended, we must maintain a tangible net worth of $15 million and we must maintain a ratio of our current assets to our current liabilities of 1.5 to 1. We also issued a warrant to Imperial to purchase 37,500 shares of our common stock at an exercise price of $10.00 per share. We borrowed $2.5 million under the revolving credit facility during February 2000 and repaid such borrowings with a portion of the proceeds of our initial public offering on February 22, 2000. This credit facility matured on December 31, 2000 and was not renewed in 2001. At the time of the maturity, the outstanding balance under the facility totaled $264,073, comprised entirely from an issued and irrevocable Letter of Credit. The outstanding Letter of Credit was subsequently secured by cash deposits, and as a result, the outstanding balance under the matured revolving credit facility is $0.

      We expect that operating losses and negative cash flows from operations will likely continue until our seasonally critical back-to-school buying season in the third quarter of 2002. Based upon our current cost structure and recent growth levels within the eduPartners program, we believe we are positioned to improve upon our financial performance of 2001. As part of our increased emphasis on eduPartners and lower overhead cost structure, we expect the costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our previous levels, we believe, in the aggregate, that this will reduce the historical losses and negative cash flows from sales of textbooks. We intend to increase spending on the development of eduPartners and relationships with other businesses. Failure to generate sufficient revenues, raise additional capital or reduce discretionary spending could harm our results of operations and financial condition.

      We currently anticipate that available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures until such time as annual operating profitability is achieved. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed current expectations. Any required additional financing may be unavailable on favorable terms, or at all.

 Recent Accounting Standards

      In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, “Business Combinations,” which addresses the financial accounting and reporting for business combinations and supersedes Accounting Principles Board Opinion No. 16, “Business Combinations,” and SFAS No. 38, “Accounting for Preacquisition Contingencies of Purchased Enterprises,” and is applicable to all business combinations initiated after June 30, 2001. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against the new criteria and may result in certain intangibles being reclassified to goodwill, or alternatively, amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill. The Company does not expect that the adoption of SFAS No. 141 will have a material impact on our consolidated financial statements.

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      In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets,” which is effective beginning in fiscal year 2002. This statement addresses financial accounting and reporting for intangible assets acquired individually or with a group of other assets at acquisition. This statement also addresses financial accounting and reporting for goodwill and other intangible assets subsequent to their acquisition. Under SFAS No. 142, goodwill will not be amortized. Instead, the statement requires that entities perform an initial impairment assessment upon adoption and then again on at least an annual basis or upon the occurrence of triggering events, if earlier, to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized, if any. An impairment loss is recognized when the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of the goodwill shall be its new accounting basis. The Company does not expect that the adoption of SFAS No. 141 will have a material impact on our consolidated financial statements.

      In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective beginning in fiscal year 2002. SFAS No. 144 supersedes previous guidance for financial accounting and reporting for the impairment or disposal of long-lived assets and for segments of a business to be disposed of. SFAS No. 144 retains the fundamental provisions of existing generally accepted accounting principles with respect to recognition and measurement of long-lived asset impairment contained in SFAS No. 121, “ Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to be Disposed Of.” However, SFAS No. 144 provides new guidance intended to address certain significant implementation issues associated with SFAS No. 121, including expanded guidance with respect to appropriate cash flows to be used, whether recognition of any long-lived asset impairment is required, and if required, how to measure the amount of impairment. SFAS No. 144 also requires that any net assets to be disposed of by sale be reported at the lower of carrying value or fair market value less costs to sell, and expands the reporting of discontinued operations to include any component of an entity with operations and cash flows that can be clearly distinguished from the rest of the company. The Company does not expect that the adoption of SFAS No. 141 will have a material impact on our consolidated financial statements.

      Substantially all of our cash equivalents are at fixed interest rates, and, therefore, the fair value of these instruments is affected by changes in market interest rates. However, as of December 31, 2001, all of our cash equivalents mature within three months. As of December 31, 2001, we believe the reported amounts of cash equivalents and short-term investments to be reasonable approximations of their fair values. As a result, we believe that the market risk arising from our holdings of financial instruments is minimal. As of December 31, 2001 we were not subject to any material variable rate indebtedness.

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Item 8.      Consolidated Financial Statements and Supplementary Data

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
Varsity Group Inc.

      In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Varsity Group Inc. and its subsidiaries at December 31, 2001 and December 31, 2000, and the results of their operations and their cash flows for the three years ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

McLean, Virginia

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VARSITY GROUP INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

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VARSITY GROUP INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

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VARSITY GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY