SCANSOFT INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
------------------------
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 COMMISSION FILE NUMBER 0-27038

SCANSOFT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 94-3156479
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)

9 CENTENNIAL DRIVE
PEABODY, MASSACHUSETTS 01960
(ADDRESS OF REGISTRANT'S PRINCIPAL EXECUTIVE (ZIP CODE)
OFFICES)

REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA (978) 977-2000
CODE

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE.

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $0.001 PAR VALUE PER SHARE.
PREFERRED SHARE PURCHASE RIGHTS.

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

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

The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $151,923,025.23 as of March 22, 2002, based on
$4.91 per share, the last reported sales price on the Nasdaq National Market for
such date. Shares of Common Stock held by each executive officer and director
and by each person who owns 5% or more of the outstanding Common Stock have been
excluded in that such persons may be deemed to be affiliates. This determination
of affiliate status is not necessarily a conclusive determination for other
purposes.

The number of shares of the registrant's Common Stock, $0.001 par value,
outstanding as of March 22, 2002 was 63,440,143.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement dated April 30, 2002, to be
delivered to shareholders in connection with the Annual Meeting of Shareholders
to be held on June 14, 2002 are incorporated by reference into Part III.
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SCANSOFT, INC.

TABLE OF CONTENTS

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FORWARD LOOKING STATEMENTS

THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WITHIN
THE MEANING OF THE FEDERAL SECURITIES LAWS. THESE FORWARD-LOOKING STATEMENTS
INCLUDE, WITHOUT LIMITATION, STATEMENTS REGARDING: OUR STRATEGIC OBJECTIVES AND
PLANS RELATED TO STRATEGIC INVESTMENTS; OUR INTENTIONS REGARDING GROWTH STRATEGY
RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES; OUR BELIEFS AND EXPECTATIONS
REGARDING THE ABILITY OF CERTAIN NEWLY RELEASED SOFTWARE TO PENETRATE MARKETS
AND THE FUNCTIONALITY, PERFORMANCE, AND ROBUSTNESS OF SOFTWARE CURRENTLY IN
DEVELOPMENT; OUR INTENTIONS AND EXPECTATIONS REGARDING OUR MARKET LEADERSHIP IN
TEXT-TO-SPEECH TECHNOLOGY AND OUR RELEASE AND THE PERFORMANCE OF A NEW
GENERATION OF ENGINES IN THE TEXT-TO-SPEECH TECHNOLOGY SPACE; OUR INTENTIONS,
BELIEFS AND EXPECTATIONS REGARDING THE AUTOMOTIVE AND MOBILE COMMUNICATIONS
MARKETS AND OUR EXPANSION WITHIN THESE MARKETS; OUR INTENTION TO LEVERAGE OUR
STRENGTH IN PARTICULAR MARKET SEGMENTS; OUR PLANS AND EXPECTATIONS REGARDING OUR
SALES CAPACITY AND VALUE-ADDED RESELLERS, SYSTEM INTEGRATORS, AND STRATEGIC
PARTNERS; OUR BELIEFS AND EXPECTATIONS REGARDING INTERNATIONAL MARKETS, GROWTH
OF OUR INTERNATIONAL BUSINESS, EXPANSION OF OUR OPERATIONS, INTERNATIONAL SALES
AND OUR REVENUE; OUR PLANS REGARDING THE SPECIFICATION AND TESTING OF TIFF-FX;
OUR BELIEFS AND EXPECTATIONS REGARDING BUNDLING SOFTWARE PRODUCTS; OUR BELIEFS
AND INTENTIONS REGARDING SOFTWARE UPGRADES, NEW SOFTWARE FEATURES, AND EXPANDING
SOFTWARE PRODUCT LINE, THE INTRODUCTION OF MAJOR NEW SOFTWARE PRODUCTS AND OUR
REVENUES; OUR BELIEFS AND EXPECTATIONS REGARDING SALES THROUGH INDEPENDENT
DISTRIBUTORS AND RESELLERS; OUR BELIEFS AND EXPECTATIONS REGARDING ALTERNATIVE
SOURCES OF SUPPLY FOR OUR PRODUCT COMPONENTS; OUR BELIEFS AND EXPECTATIONS
REGARDING FACTORS UPON WHICH OUR SUCCESS DEPENDS; OUR BELIEFS AND EXPECTATIONS
REGARDING THE MARKET FOR SPEECH RECOGNITION APPLICATIONS; OUR BELIEFS AND
EXPECTATIONS REGARDING DISCLOSURE OF OUR TRADE SECRETS AND PROPRIETARY KNOW-HOW
TO EMPLOYEES, LICENSING TECHNOLOGY FROM THIRD PARTIES AND SOFTWARE PIRACY; OUR
BELIEFS AND EXPECTATIONS REGARDING ATTRACTING, HIRING AND RETAINING QUALIFIED
EMPLOYEES AND THE CONTINUED SERVICE OF KEY TECHNICAL AND SENIOR MANAGEMENT
PERSONNEL; OUR BELIEFS AND EXPECTATIONS REGARDING PAST AND FUTURE ACQUISITIONS
AND PAYMENT TREATMENT AND ACCOUNTING RELATED TO SUCH ACQUISITIONS; OUR BELIEFS
AND EXPECTATIONS REGARDING COMPETITION, OUR ABILITY TO COMPETE AND THE PRODUCT
DEVELOPMENT OF AND POTENTIAL ALLIANCES AMONG COMPETITORS; OUR BELIEFS AND
EXPECTATIONS REGARDING OUR REVENUES, REVENUE MIX, OPERATING RESULTS, EXPENSE
LEVELS, PRODUCT RETURNS, OTHER ALLOWANCES, ACCOUNTS RECEIVABLE AND REVENUE
RECOGNITION; OUR BELIEFS AND EXPECTATIONS REGARDING THE MARKET FOR AND
COMMERCIAL ACCEPTANCE OF OUR SPEECH TECHNOLOGY PRODUCTS; OUR BELIEFS AND
EXPECTATIONS REGARDING THE SIGNIFICANCE OF CONTINUING PRODUCT RELEASES AND OUR
ABILITY TO ENHANCE AND IMPROVE EXISTING PRODUCTS AND TECHNOLOGIES AND TO DEVELOP
AND INTRODUCE NEW PRODUCTS AND FEATURES AND THE NEED TO IMPLEMENT EMERGING
STANDARDS AND ADAPT PRODUCTS; OUR BELIEFS AND EXPECTATIONS REGARDING
INTERNATIONAL SPEECH PRODUCT SALES AND INVESTMENTS RELATED THERETO; OUR BELIEFS
AND EXPECTATIONS REGARDING OUR EXISTING FACILITIES; OUR INTENTIONS REGARDING
FUTURE EARNINGS AND CASH DIVIDENDS; OUR BELIEFS AND EXPECTATIONS REGARDING
SOFTWARE GROSS MARGINS AND SALES OF SOFTWARE PRODUCTS; OUR BELIEFS AND
EXPECTATIONS REGARDING SFAS 142 AND OUR EXPECTATIONS REGARDING SFAS 144; OUR
BELIEFS AND EXPECTATIONS REGARD-

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ING AMORTIZATION EXPENSE; OUR BELIEFS AND EXPECTATIONS REGARDING OUR ADOPTION
AND IMPLEMENTATION OF EITF ISSUE 01-9; OUR BELIEFS AND EXPECTATIONS REGARDING
OUR POLICY FOR DETERMINING FUNCTIONAL CURRENCY, FOREIGN CURRENCY EXCHANGE RATE
RISK; OUR BELIEFS AND EXPECTATIONS REGARDING SALES AND SALES VOLUMES; OUR
BELIEFS AND EXPECTATIONS REGARDING COST OF REVENUE, REVENUE GROWTH AND A PAY FOR
SUPPORT PROGRAM; OUR BELIEFS AND EXPECTATIONS REGARDING RESEARCH AND DEVELOPMENT
EXPENSES AND OUR POLICY REGARDING CAPITALIZATION OF DEVELOPMENT COSTS; OUR
BELIEFS AND EXPECTATIONS REGARDING SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
AND RELATED ASSUMPTIONS AND INFLUENTIAL FACTORS; OUR BELIEFS AND EXPECTATIONS
REGARDING RESTRUCTURING RESERVES AND SEVERANCE PAYMENTS; OUR BELIEFS AND
EXPECTATIONS REGARDING FEDERAL AND STATE NET OPERATING LOSS AND RESEARCH AND
DEVELOPMENT CREDIT CARRYFORWARDS; OUR BELIEFS AND EXPECTATIONS REGARDING CASH
FLOWS; AND OUR BELIEFS AND EXPECTATIONS REGARDING LEGAL PROCEEDINGS AND
LITIGATION MATTERS. THESE FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND
UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY. FOR A
DETAILED DISCUSSION OF THESE RISKS AND UNCERTAINTIES, SEE THE SECTION ENTITLED
"RISK FACTORS" IN THIS ANNUAL REPORT ON FORM 10-K. WE UNDERTAKE NO OBLIGATION TO
UPDATE FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES OCCURRING
AFTER THE DATE OF THIS ANNUAL REPORT ON FORM 10-K.

PART I

ITEM 1. BUSINESS

BUSINESS OVERVIEW

ScanSoft is a leading supplier of imaging, speech and language solutions
that make businesses more productive. Our portfolio of solutions and
technologies automate a range of manual processes to help consumers,
professionals and enterprises save time, increase productivity and improve
customer service.

Historically, ScanSoft has been a leader in paper-to-digital solutions and
document imaging applications and technologies. Our optical character
recognition, digital paper management and eForms applications are used by
leading corporations, government organizations and technology vendors to
instantly convert paper documents into digital information.

With the acquisition of certain Lernout & Hauspie ("L&H") assets in
December 2001, ScanSoft added speech and language solutions to its portfolio of
productivity-enhancing applications and technologies. The group of assets
acquired includes the RealSpeak text-to-speech technology, Dragon speech
recognition software and other speech and voice-related technologies aimed at
the rapidly growing telecommunications, automotive and mobile device markets.
ScanSoft believes that its speech-based technology and intellectual property is
widely considered the finest in the industry.

ScanSoft, Inc. was incorporated as Visioneer, Inc. in March 1992 and
through December 1998, developed and sold scanner hardware and software
products. On January 6, 1999, Visioneer sold the hardware business and the
Visioneer brand name to Primax Electronics, Ltd., and on March 2, 1999,
Visioneer acquired ScanSoft, in a cash election merger, from Xerox Corporation.
The corporate entity "Visioneer" survived the merger, but changed its name to
"ScanSoft, Inc." In addition, Visioneer changed the ticker symbol for its common
stock that trades on the NASDAQ, to "SSFT."

On December 7, 2001, the Company entered into a definitive asset purchase
agreement (the "Purchase Agreement") to acquire certain assets and intellectual
property relating to the former L&H entities that were in bankruptcy under the
jurisdiction of both the U.S. Bankruptcy Courts for the District of Delaware and
the Belgium Court of Ieper. We purchased these assets in a closed auction
proceeding administered by the

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creditor committee of the former entities and approved by both the U.S. and
Belgium courts on December 11, 2001. The transaction was completed on December
12, 2001. See Management Discussion and Analysis Recent Events for further
discussion.

ScanSoft maintains executive offices and principal facilities at 9
Centennial Drive, Peabody, MA 01960. Our telephone number is (978) 977-2000. We
maintain a World Wide Web site at www.scansoft.com. When we refer to "we" or
"ScanSoft" or "the Company" in this Annual Report on Form 10-K, we mean the
current Delaware corporation ScanSoft, Inc., including all of its consolidated
subsidiaries.

SCANSOFT'S STRATEGY

Our objective is to continue to be a leading provider of digital imaging
and speech-based productivity solutions. Key elements of our strategy to achieve
this objective include:

EXPAND MARKET SHARE FOR IMAGING PRODUCT LINES

ScanSoft is the leading developer of document automation applications and
imaging technologies. ScanSoft's OCR, eForms and digital paper management
applications have been selected by leading corporate and government
organizations to instantly convert paper into digital information. ScanSoft's
information capture, OCR and imaging toolkits are the enabling document
automation technologies within commercial products delivered by leading
technology vendors, including Autodesk, Captiva, Cardiff, FileNET, Lexmark,
Microsoft, and Xerox. Our ability to achieve broader market acceptance of our
products will depend on several factors such as ease-of-use, OCR accuracy,
speed, overall functionality and the continued acceptance of digital copies and
similar hardware devices.

Our strategy is to maintain and enhance our technological position by
investing in OCR and image processing technology and strategic business and
technology partnerships with other leading companies. We will continue to invest
in our digital imaging applications as well as target the growing demand for
information capture products. We are enhancing our offerings to serve the needs
for PDF functionality in the corporate market. We are also investing to take
advantage of the growing demand for network-enabled scanning, to provide our
first digital imaging offerings for the mobile market, and to pursue Asian
markets with new software development kits (SDKs).

PURSUE GROWTH OPPORTUNITIES IN SPEECH AND LANGUAGE

ScanSoft maintains one of the broadest portfolios of speech and language
technologies, including several automatic speech recognition (ASR),
text-to-speech (TTS) and other engines. We believe the combination of our speech
and language technologies enable us to compete more effectively than our
competitors in many situations, particularly those requiring the integration of
multiple speech and language technologies. In addition, we believe that we are
one of few providers capable of offering speech and language products for all
environments, spanning server, desktop and device. We maintain a variety of
engines with capabilities ranging from small footprint recognition of discrete
words to speaker independent, large vocabulary recognition of continuous,
spontaneous speech. We believe that, by offering this range of capabilities, we
are better able to access more segments of the speech and language technology
market.

Our growth strategy in speech and language will focus on three areas:

Document Creation / Dictation -- We are a leading provider of
speech-enabled document creation or dictation solutions with our Dragon
NaturallySpeaking product family. We believe the strength of our newly
released Dragon NaturallySpeaking version 6 will enable us to penetrate
more deeply into corporate markets, as well as the healthcare and legal
vertical segments. Dragon NaturallySpeaking version 7 is currently in
development and is expected to provide additional functionality,
performance and robustness that will further expand our language coverage.

Broad Licensing of Text-to-Speech -- Our RealSpeak text-to-speech
(TTS) technology is the most widely accepted TTS engine in the world,
capable of delivering high-quality, human-sounding speech in

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19 languages and across a number of platforms. We believe the strength and
breadth of our technology in the TTS market positions us well for broad,
horizontal licensing opportunities. We intend to extend our current market
leadership in text-to-speech, by continuing to provide the broadest
language coverage available in the market and through the release of a new
generation of engines. We expect these engines will set new benchmarks in
quality, flexibility, and performance.

Automotive/Mobile Solutions -- ScanSoft offers the most complete,
integrated suite of technologies and services that provide speech
capabilities for the automotive and mobile industry. We believe that the
automotive and mobile communications markets are dedicated to adopting
speech technology, a logical interface for a range of services and
capabilities. Our automotive solutions are renowned for broad language
support, speech recognition, noise management and synthesized speech. We
intend to work closely with automotive OEMs, tier-one integrators,
aftermarket device manufacturers and telematic service providers to expand
our influence in these markets. To capitalize on growth opportunities
within these markets, we intend to leverage a number of trends, including
legislative pressures for hands-free operation of mobile devices, emergence
of telematic and navigational services, and in-vehicle command and control.

EXPAND OUR CHANNELS AND PARTNERSHIPS

We have nearly 10 million registered users for our products, distributed
across the home office, small-medium business (SMB) and corporate segments. We
believe we have particular strength within certain verticals, including legal,
medical and government, and we intend to leverage our strength in these areas.

To enable a broader presence for our products and technologies, we will
continue to increase our sales capacity. ScanSoft entered 2002 with more than 70
sales personnel and robust software channels worldwide. We plan to strengthen
our base of value-added resellers and system integrators. In addition, we intend
to work closely with strategic partners, including Alcatel, AOL/Time Warner,
Canon, Cisco, HP, Microsoft, Oracle and Xerox, to enable the broadest reach for
our solutions.

EXPAND INTERNATIONAL PRESENCE

We believe that international markets present a large market for imaging
and speech and language products. We have established a number of customer and
partner relationships throughout North America, Europe and Asia, maintain
offices and affiliates in more than 40 countries, and offer the majority of our
products and technologies in multiple languages. We expect the international
market for our applications to grow and intend to continue expanding our
operations to address international opportunities. In particular, we intend to
significantly expand our presence in Asia through local sales personnel,
strategic technology and channel partners and new products designed specifically
for Asian markets.

INVEST IN INTERNET AND WIRELESS SOLUTIONS

ScanSoft also provides Internet imaging software, which includes products
that make it easier to publish and share paper documents and photos via the
Internet. Currently, our products allow users to capture and convert paper-based
documents to Joint Photographic Experts Group ("JPEG"), Hypertext Mark-up
Language ("HTML") and Portable Document Format ("PDF") files and share photos
and documents via e-mail or as part of an Internet site.

PRODUCTS

Our solutions portfolio comprises a variety of digital imaging and speech
and language applications and technologies. Digital imaging solutions include
optical character recognition, digital paper management and

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eForms software. Speech and language solutions include speech recognition,
text-to-speech or speech synthesis, and technologies for telematic applications.
Our core product categories include:

OPTICAL CHARACTER RECOGNITION PRODUCTS

OmniPage Pro(R) -- OmniPage Pro 11 software is widely used as a tool to
increase productivity as it saves time and expense by reducing the tedious
efforts of recreating documents that are in paper form or read-only image files.
The software converts all types of paper-based documents into the users'
preferred office applications which enables them to edit, archive and share
information without retyping. OmniPage Pro 11 supports the recognition of 114
languages and converts PDF documents that contain text, tables and graphics into
fully formatted documents users can edit.

TextBridge(R) Pro -- TextBridge Pro is our value priced OCR offering
maintaining excellent accuracy (over 99%) with fewer advanced features than
OmniPage Pro. TextBridge Pro combines OCR with page layout comprehension to
recreate electronic files that are similar to the paper originals in terms of
page layout, font characteristics and graphics.

DIGITAL PAPER MANAGEMENT PRODUCTS

PaperPort Deluxe(R) -- PaperPort Deluxe brings static paper documents into
a digital environment enabling users to scan, store, organize, retrieve and use
paper documents on a computer along with existing PC files. Documents can be
stored locally and shared with others without requiring the IT overhead
structures and high costs of larger, more expensive image and document
management systems implementations. The newest version, PaperPort Deluxe 8.0,
includes highly secure, Web-based document storage and collaboration service
called PaperPortOnline(TM) that allows users to store, share and collaborate
with colleagues via the Web.

eFORMS DESIGN AND PUBLISHING PRODUCTS

OmniForm(R) -- OmniForm software is a leading solution for instantly
converting paper forms into automated fill-able electronic forms. Corporate,
government and academic organizations rely on OmniForm to automate a wide range
of internal and Web-based forms processes, from expense reports and timecards to
surveys and order forms. OmniForm Premium 5.0 saves money and increases worker
productivity by allowing organizations to distribute, fill, collect and process
forms completely electronically.

INTEGRATED IMAGING TOOLKITS

ScanSoft's integrated imaging offerings are provided through our software
development toolkits (SDKs) that are targeted to the developer, systems
integrator and corporate IT manager. The SDKs complement the desktop application
product lines. Our toolkits include:

Developers' Kit 2000 -- Comprehensive toolkit includes the industry's
leading implementations of multiple recognition technologies -- including
Optical Character Recognition (OCR), Intelligent Character Recognition
(ICR), remittance processing and bar code recognition.

ScanSoft(R) SDK -- Provides application developers, system integrators
and OEM customers full access to the functionality of our award-winning OCR
engine, the same technology licensed to Microsoft. The technology is
designed for applications such as fax software, document imaging and
content management.

OmniForm(R) Developer's Edition -- Provides tools for developing
fillable electronic forms that can be incorporated directly into
proprietary applications or turnkey software solutions, or integrated into
a Web page through the use of an OmniForm ActiveX Control.

IMAGING PRODUCTS FOR OEM PARTNERS

We bundle various versions of OmniPage, TextBridge, PaperPort and OmniForm
with leading scanner, multi-function device and storage device manufacturers and
leading independent software vendors. OEM

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customers often require us to integrate products with other applications or
customize existing products to meet specific requirements. Therefore, we offer
OEM customers both packaged products to bundle and a software developer's
toolkit to facilitate the integration of OCR functionality with other
applications. Our objective in bundling software products with multi-function
devices is to expand the overall market for OCR and document management software
by providing a larger number of purchasers with experience in the advantages of
the software. "Light" versions with limited capabilities, -- or superseded
versions, are now bundled with most multi-function devices being sold. This
seeding of the rapidly growing base of multi-function device owners has greatly
expanded our number of registered product users, providing a growing revenue
opportunity for future product releases.

DICTATION/DOCUMENT CREATION APPLICATIONS

Dragon NaturallySpeaking(R) -- Our Dragon NaturallySpeaking software helps
a range of customers -- from consumers and small businesses to government
agencies and Fortune 1000 companies -- use the power of voice to create and edit
documents, reports, spreadsheets and email. Our dictation products offer
extended vocabularies of more than 300,000 words and support dictation speeds of
up to 160 words per minute. By comparison, the average vocabulary of an average
English speaker with a college degree is approximately 12,000 words. The same
college graduate is only able to type about 35 words per minute with any
significant degree of accuracy. Dragon NaturallySpeaking can enhance the
productivity of professionals at degrees of accuracy in excess of 94 percent.
Recognizing the opportunity in specialized professions, we offer customized
products for the medical, legal and public safety markets, as well as a several
versions with varying functionality that are sold through corporate resellers,
VARs and retail outlets.

TEXT-TO-SPEECH (TTS) TECHNOLOGIES

Our portfolio of TTS engines spans a range of techniques, capabilities and
requirements matched to specific applications and the available processing power
in each. The RealSpeak(TM) family of TTS engines are state-of-the-art and
capable of generating high-quality, human-sounding speech in 19 languages,
including regional variants. These engines are able to read, understand, and
convert any text into natural-sounding male and female voices. The high quality
and intelligibility of the RealSpeak TTS engine helps businesses deploy highly
interactive and user-friendly applications, enhancing the user experience and
improving customer relationships. Customers are using our TTS technology in a
wide variety of advanced applications, from unified messaging systems to
speech-enabled video games and virtual newscasters.

RealSpeak(TM) -- RealSpeak is a high-quality, human-sounding TTS engine
with a large inventory of speech segments available for synthesis. The RealSpeak
engine is targeted toward server-based telephony systems and PC/multimedia
platforms and is available in 19 languages.

RealSpeak(TM) Compact -- RealSpeak Compact is a high-quality,
human-sounding TTS engine with a large inventory of speech segments available
for synthesis, but it is engineered to operate within a smaller footprint than
our flagship RealSpeak product. It uses a fully concatenative synthesis engine
and is targeted toward high-end mobile and embedded applications.

RealSpeak(TM) UltraCompact -- RealSpeak UltraCompact is a high-quality,
human-sounding TTS engine that uses a reduced database of speech segments,
automatically derived from the RealSpeak database, and is targeted toward mobile
and embedded applications.

TTS3000 -- TTS3000 is a low footprint, highly intelligible TTS system with
a small inventory of speech segments and available in 13 languages.

TTS2500 -- TTS2500 is a very low footprint talking dictionary system with
dedicated linguistic analysis and available in five languages.

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AUTOMATIC SPEECH RECOGNITION (ASR) TECHNOLOGIES

Our speech recognition engines span a range of techniques, capabilities and
requirements matched to specific applications and the available processing power
in each. These engines are available in many languages, application domains and
platforms. Specific engines include:

ASR 1600 and ASR 1500 -- These high-performance engines are
grammar-based, speaker-independent speech recognizers that support word
recognition with a small memory footprint and limited computational
resources. The ASR 1600 is used for multi-media, embedded and automotive
applications, while the ASR 1500 is used in the high-density telephony
market.

ASR 300 and ASR 100 -- These low-end engines are designed for embedded
applications that require word-based, isolated word recognition
capabilities. ASR 300 is used for building small-footprint, menu-driven
voice interfaces for automotive, consumer and mobile devices. ASR 100
provides voice-enabled dialing on relatively small platforms, such as
mobile phones, using vocabulary entries created by the user.

MREC -- The MREC (Modular Recognizer) engine is a general-purpose,
large-vocabulary continuous speech recognition engine that serves as a
foundation for Dragon NaturallySpeaking and other applications including
AudioMining and transcription products.

NEW PRODUCTS AND TECHNOLOGIES

We intend to design and develop improvements and feature enhancements to
extend the life and usability of our products for our installed base through the
development of software upgrades and add-on accessory products. We also plan to
incorporate new software features into our software, and to expand our software
product lines in 2002 through the development of alternative form factors
comprising enhanced capabilities and other features and functionality. We
believe that the development of these and other products and features is
essential to our success. Accordingly, we will continue to make significant
investments in the research and development of new products. Such expenses may
fluctuate from quarter to quarter depending on a wide range of factors,
including the status of various development projects.

SALES AND DISTRIBUTION

Our products and services are available to customers through channels that
include: our direct sales force, distributors, retail, mail order, corporate
resellers, value added resellers (VARs), original equipment manufacturers
(OEMs), partnerships, education and consulting. We also sell certain of our
products and product upgrades over the Internet and through the use of direct
mail. We sell corporate site licenses directly as well as through our
distribution and corporate reseller channels.

We maintain distribution relationships with major independent distributors,
including Ingram Micro, Tech Data, 1450 and Digital River. These distributors in
turn sell to computer superstores, such as CompUSA and Fry's Electronics;
consumer electronic stores, such as Best Buy and Circuit City; mail order
houses, such as CDW, PC Connection and MicroWarehouse; office superstores, such
as Office Max, Office Depot and Staples, and VARs. We also maintain
relationships with these major retailers. Our sales force works closely with our
major distributor and reseller accounts to manage the flow of orders, inventory
levels and sell-through to customers. We also work closely with them to manage
promotions and other demand creation activities.

In 2001, we derived a significant portion of our revenue from sales through
our independent distributors, direct fulfillment partners, retailers and
resellers. Although we have established strategic software OEM partnerships and
have increased our direct sales force, we expect that sales through our
independent distributors, direct fulfillment partners and resellers will
continue to account for a significant portion of our revenues for the
foreseeable future. Digital River acts as a direct fulfillment partner for
direct marketing campaigns of our products. For the year ended December 31, 2001
and 2000, our top distributor Ingram Micro accounted for 28% and 27% of revenue
respectively, and Digital River accounted for 15% and 11% of our

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revenue, respectively. Our agreements with distributors are generally
nonexclusive and may be terminated by either party without cause.

Our return policy allows distributors, subject to various limitations, to
return purchased products in exchange for new products or for credit towards
future purchases. End users may return products through dealers and distributors
for a full refund, within a reasonable period from the date of purchase.
Retailers may return older versions of products. Product returns occur when we
introduce upgrades and new versions of products or when distributors order too
much product. In addition, competitive factors often require us to offer rights
of return for products that distributors or retail stores are unable to sell. In
addition, we offer various end-user rebate programs for our products. We reserve
for expected returns, and anticipated rebate redemption in amounts that the
Company believes are reasonable. However, there can be no assurance that these
reserves will be sufficient or that any future returns, or rebate redemption
will not have a material adverse effect on our business and operating results,
especially in light of the rapid product obsolescence that often occurs during
product transitions.

We also enter into a number of marketing programs with our retailers and
distributors. These programs normally include a variety of marketing and product
placement services in exchange for a flat fee based on revenues generated by the
retailers. In November 2001, the Emerging Issues Task Force ("EITF"), a
committee of the FASB, reached a consensus on EITF Issue 01-9, "Accounting for
Consideration Given by a Vendor to a Customer or Reseller of the Vendor's
Products" ("EITF 01-9"). EITF 01-9 presumes that consideration from a vendor to
a customer or reseller of the vendor's products is a reduction of the selling
prices of the vendor's products and, therefore, should be characterized as a
reduction of revenue when recognized in the vendor's income statement and could
lead to negative revenue under certain circumstances. Revenue reduction is
required unless consideration relates to a separate identifiable benefit and the
benefit's fair value can be established, in which case such amounts may be
recorded as operating expenses. In accordance with its provisions, we will adopt
EITF 01-9 on January 1, 2002. Certain of our co-operative marketing and
marketing development fund programs do not meet the criteria to be recorded as
operating expenses, which is our current policy. Unless we are able to
renegotiate or otherwise change these marketing programs with our retailers,
amounts earned by the retailers under such programs will be recorded as revenue
reductions in the future. Upon adoption, we will reclassify all prior period
results of operations to conform to the presentation required by EITF 01-9.

We have software OEM agreements with a large number of manufacturers who
bundle digital imaging software with the scanning, capture, and multi-function
devices or software they sell including: Apple, Brother, Canon, Compaq, Epson,
Hewlett-Packard, IBM, Mattel, Xerox and Visioneer. The Company also has key
technology partnerships with several software companies, including arrangements
with Microsoft and Oracle.

As of December 31, 2001, we employed 118 full-time sales and marketing
employees worldwide. This includes 62 employees hired in connection with the L&H
acquisition in December 2001.

INTERNATIONAL OPERATIONS

We currently have offices in a number of international locations including:
Amsterdam, the Netherlands, Budapest, Hungary, Ghent, Belgium, Tokyo, Japan,
Hong Kong, Taiwan, Reading, England; Munich, Germany; Milan Italy, and Paris,
France. The scope of our international operations includes research and
development, customer support and sales and marketing. Our research and
development is conducted in Budapest Hungary and Ghent Belgium. Additionally
sales and support offices are located throughout the world to support our
current international customers and to expand or international revenue
opportunities.

Revenue from resellers and distributors outside North America represented
approximately 21% of revenue in 2001 as compared to 18% in 2000, and 13% in
1999. We expect our revenue from international sales channels to account for
approximately 25% to 30% of revenues in 2002. Revenue outside of the United
States is determined based on the billing address of our customers. A number of
our North American OEM partners

8

distribute our products throughout the world but because our partners do not
provide the geographic dispersion of our products we have recognized the revenue
in the United States.

TECHNICAL SUPPORT

Customers who purchase full-featured software products and who register
with us currently receive limited hotline technical support and product
information limited to installation. Additional technical support services are
available on a "fee for support" basis. We currently offer several technical
support options to customers of packaged products. These include telephone, fax
or email support by a customer support representative or self-help by accessing
our technical information bulletins or frequently asked questions on the
Internet. Full-featured software product customers receive technical support
from a third party company on both a fee and non-fee basis.

OEM RELATIONSHIPS

We have software OEM agreements with a large number of manufacturers who
bundle digital imaging software with scanning, capture, and multi-function
devices or software they sell including: Apple, Brother, Canon, Compaq, Epson,
Hewlett-Packard, IBM, Mattel, Microtek, Mustek, Olivetti-Lexikon, Primax, Smith
Micro, and Visioneer. Additionally, the Company has entered into multiple
non-exclusive agreements with Xerox Corporation (a significant stockholder) in
which ScanSoft has agreed to license, to Xerox a royalty-bearing right to copy
and distribute certain versions of Pagis, PaperPort and TextBridge software
programs with Xerox's multifunction peripherals. The Company also has key
technology partnerships with several companies, including a recent arrangement
with Microsoft.

RESEARCH AND DEVELOPMENT

Our research and development teams are located in Peabody, Massachusetts;
Waltham, Massachusetts; Ghent, Belgium; and Budapest, Hungary. As of December
31, 2001, we employed 256 full-time and 9 contract software design and quality
assurance engineers, technicians and support staff. These include 138 employees
hired in connection with the L&H acquisition in December 2001.

Our growth and future financial performance will depend in part upon our
ability to enhance existing applications and to develop and introduce new
applications that keep pace with technological advances, meet changing customer
requirements, respond to competitive products and achieve market acceptance. As
a result, we expect that we will continue to commit substantial resources to
product research and development in the future.

MANUFACTURING

We outsource a majority of the duplication and production of our software
products on a worldwide basis to a third party that procures all required
components, including compact disks, floppy disks, product manuals, boxes, and
other product literature, and manufacture completed software products. A
significant portion of our manufacturing and fulfillment services is currently
provided by one manufacturing supplier. An interruption or failure by our
principal manufacturing supplier which has facilities in Massachusetts and the
Netherlands could result in a delay in the shipment of our products.
Additionally, we are required to purchase any excess finished goods inventory
that was manufactured at our request that is older than 80 days. If demand for
our products decreases it may result in increased inventory levels.

Most of the components used in the manufacture of our products are
available from multiple sources of supply. Certain components used in the
manufacture of our speech and language and OCR products are currently available
only from a single source. Although our manufacturing supplier generally
maintains a several-month inventory level of these components, failure of a
single-source supplier to deliver required quantities of such materials to our
manufacturing service provider could materially and adversely affect our
operating results. We believe that, if necessary, we could develop alternative
sources of supply for these

9

components and parts, or re-engineer the products. However, any delays in
developing such alternative sources of supply or in the re-engineering of the
products could have a material adverse effect on our results of operations.

COMPETITION

The markets for ScanSoft products are characterized by intense competition,
evolving industry standards, rapid technology developments, aggressive pricing,
and frequent new product introductions. Our future success will depend on our
ability to enhance our existing products, introduce new products on a timely and
cost-effective basis, meet changing customer needs, extend our core technology
into new applications, and anticipate or respond to emerging standards and other
technological changes.

Optical Character Recognition

OCR users are requiring increased accuracy, better performance and higher
reliability. ScanSoft's products in this market, including OmniPage Pro and
TextBridge Pro, face competition from companies offering similar products and
will continue to face competition from emerging products and technologies. These
competitors include Adobe, ABBYY, I.R.I.S., and NewSoft. With the exception of
Adobe, the competitors are surfacing from foreign countries.

Paper Management

In the desktop imaging market, we offer products and suites including
PaperPort Deluxe, Pagis Pro Scanning Suite and OmniPage Scan Suite. We believe
these individual products compete favorably on the basis of features and
functionality, ease of use, product reliability, and price and performance
characteristics. Competitors in this segment of the market who offer comparable
products are NewSoft, Zydeco, J2, and other smaller players.

The toughest challenge in this segment is the Windows operating system
filing and finding functionality. We believe the capabilities and visual
structure of our products add significant benefit and, with increased awareness
building, we believe our paper to digital desktop solution will continue to be
adopted. There is a risk of Microsoft implementing similar features and
functions in the future.

eForms Solutions

In the forms conversion and design market segments, our OmniForm software
has faced competition from both large and smaller competitors including many
Internet start-ups. The forms industry is broken into 2 distinct segments -- the
first being paper forms conversion and data collection, and the second, forms
processing from paper based forms. ScanSoft's products vie in the former with
competitors such as OCR for Forms, G-7 Productivity Systems, PureEdge, Shana,
Cardiff and JetForm (renamed Accelio and, in 2002, acquired by Adobe). This
segment of the market is changing rapidly to extend the forms conversion to new
devices such as PDA's in addition to standardization of HTML based forms for
easier deployment. To continue to compete, we have to continue with rapid
product releases that meet the needs of the market, ensure cross platform
support, and adopt the standards within the industry as they evolve.

Dictation/Document Creation Solutions

Speech recognition application users are requiring increased accuracy,
better performance and higher reliability. ScanSoft's products in this market,
including the family of Dragon NaturallySpeaking solutions, face competition
from IBM, Dictaphone and general transcription services.

Embedded Speech and Language Solutions

For embedded speech and language solutions, our RealSpeak text-to-speech
and ASR speech engines face competition from (i) specialized companies,
including Fonix Corp., Nuance Communications and SpeechWorks International and
(ii) larger, more diversified software developers such as IBM, Lucent

10

Technologies and Philips Electronics that offer voice-enabled interface
capabilities developed along with their systems and software applications. We
differentiate our products from competitors in terms of quality of technology,
number of speech and language technologies offered, and the number of
environments in which our technologies operate.

PROPRIETARY TECHNOLOGY

We exploit our proprietary technology, trade secrets, know-how, continuing
technological innovations and licensing opportunities to maintain our
competitive position. We rely on patent law, copyright law, trade secret laws,
secrecy, technical measures, licensee agreements and non-disclosure agreements
to protect our technology, trade secrets, and other proprietary rights. Our
policy is to file patent applications to protect technology, inventions and
improvements that are important to the development of our business, to maintain
a technological advantage over our competitors, and to generate licensing
revenue. In this regard, we have obtained patents that directly relate to our
products. Furthermore, we have obtained through acquisition 132 patents and 136
pending patent applications in the speech and language field. These patents
expire on various dates between 2005 and 2016. We cannot assure you that any of
our patents issued to the Company will not be challenged, invalidated or
circumvented or that the rights granted by the patents will provide us with
competitive advantages.

In order to protect our ownership rights in our software products, we
license our products to OEMs and resellers on a non-exclusive basis with
contractual restrictions on reproduction, distribution and transferability. In
addition, we generally license our software in object code form only. We license
our software products to end-users by use of a "shrink-wrap" or "click wrap"
customer license that restricts the end user to personal use of the product.
Despite these contractual restrictions, it may be possible for competitors or
users to illegally copy our software products or obtain information that we
regard as proprietary.

We require our employees to execute confidentiality and invention
assignment agreements in order to protect our proprietary technology and other
proprietary rights.

We also rely on trade secrets and proprietary know-how. We have been, and
will continue to be, required to disclose our trade secrets and proprietary
know-how to employees and consultants. Although we seek to protect our trade
secrets and proprietary know-how by entering into confidentiality agreements
with such persons, there can be no assurance that these agreements will not be
breached, that we will have an adequate remedy for any breach, or that our trade
secrets will not otherwise become known or be independently discovered by
competitors.

Because of technological developments in our industry segment, it is
possible that certain of our products may infringe third party proprietary
rights. From time to time we have received, and in the future may receive,
notices of claims of infringement. In response to these claims, we may have to
obtain licenses and pay royalties to continue to sell an allegedly infringing
product or stop selling such product and pay damages for past infringement.

In addition, ScanSoft has developed products in the past that incorporate
technology licensed from third parties. Our ability to continue to develop and
commercialize our products will be affected by our ability to renew existing
technology licenses and to obtain technology licenses from third parties in the
future. There can be no assurance that we will be able to renew our current
licenses or obtain any necessary licenses in the future. The failure to renew
existing licenses or to obtain any licenses that may be required in the future
could have a material adverse effect on our business.

Policing unauthorized use of technology is difficult, especially in the
software industry. Software piracy can be expected to be a persistent problem
for the software industry for the foreseeable future. Such piracy can be
particularly egregious in some international markets in which we distribute our
products. We believe that, due to the rapid pace of technological change in the
industry, factors such as knowledge, ability, frequent product enhancements,
timeliness and quality of product support and the experience of our employees
are more significant as a means to protect our competitiveness than patent,
copyright and trade secret protection.

11

EMPLOYEES

As of December 31, 2001, ScanSoft employed 472 people on a full-time basis,
269 in the United States and 203 internationally. Of the total, 256 were in
product research and development, 118 in sales and marketing and, 59 in
operations and support, and 39 in finance and administration. Of these employees
223 were hired in connection with the L&H acquisition completed in December
2001. ScanSoft's success is highly dependent on its ability to attract and
retain qualified employees. Competition for employees is intense in the software
industry. To date, we believe that we have been successful in our efforts to
recruit and retain qualified employees, but there is no assurance that it will
continue to be as successful in the future. Our future performance depends in
significant part on the continued service of our key technical and senior
management personnel. None of our employees are subject to collective bargaining
agreements. We have experienced no work stoppages and believe that our employee
relations are good. We have utilized the services of consultants, third-party
developers, and other vendors in its sales, development, and manufacturing
activities.

RISK FACTORS

OUR BUSINESS COULD BE HARMED IF WE DO NOT SUCCESSFULLY MANAGE THE
INTEGRATION OF THE BUSINESSES THAT WE ACQUIRE, INCLUDING THE L&H ACQUISITION.
As part of our business strategy, we have in the past and expect to continue to
acquire other businesses and technologies. Our recent acquisition of the speech
and language technology assets of L&H will require substantial integration and
management efforts. Acquisitions, including the L&H acquisition, involve a
number of risks, including:

- THE DIFFICULTY OF INTEGRATING THE OPERATIONS AND PERSONNEL OF THE
ACQUIRED BUSINESSES;

- THE POTENTIAL DISRUPTION OF OUR ONGOING BUSINESS AND DISTRACTION OF
MANAGEMENT;

- THE DIFFICULTY IN INCORPORATING ACQUIRED TECHNOLOGY AND RIGHTS INTO OUR
PRODUCTS AND TECHNOLOGY;

- UNANTICIPATED EXPENSES AND DELAYS RELATING TO COMPLETING ACQUIRED
DEVELOPMENT PROJECTS AND TECHNOLOGY INTEGRATION;

- THE MANAGEMENT OF GEOGRAPHICALLY REMOTE UNITS;

- THE MAINTENANCE OF UNIFORM STANDARDS, CONTROLS, PROCEDURES AND POLICIES;

- THE IMPAIRMENT OF RELATIONSHIPS WITH EMPLOYEES AND CUSTOMERS AS A RESULT
OF ANY INTEGRATION OF NEW MANAGEMENT PERSONNEL;

- RISKS OF ENTERING MARKETS OR TYPES OF BUSINESSES IN WHICH WE HAVE LIMITED
EXPERIENCE;

- THE POTENTIAL LOSS OF KEY EMPLOYEES OF THE ACQUIRED COMPANY; AND

- POTENTIAL UNKNOWN LIABILITIES OR OTHER DIFFICULTIES ASSOCIATED WITH
ACQUIRED BUSINESSES.

As a result of these and other risks, we may not realize anticipated
benefits from our acquisitions, including the L&H acquisition. Failure to
achieve these benefits or failure to successfully integrate these acquired
businesses and technologies could materially harm our business.

THE PRICE OF OUR SECURITIES MAY BE AFFECTED BY A WIDE RANGE OF
FACTORS. Some of the factors that may cause volatility in the price of our
securities include:

- QUARTERLY VARIATIONS IN OUR FINANCIAL RESULTS;

- CHANGES IN REVENUE OR EARNINGS ESTIMATES OR PUBLICATION OF RESEARCH
REPORTS BY ANALYSTS;

- FAILURE TO MEET ANALYSTS REVENUE OR EARNINGS ESTIMATES;

- SPECULATION IN THE PRESS OR INVESTMENT COMMUNITY;

- STRATEGIC ACTIONS BY US OR OUR COMPETITORS, SUCH AS ACQUISITIONS OR
RESTRUCTURINGS;

- ACTIONS BY INSTITUTIONAL SHAREHOLDERS;

12

- BUSINESS AND PRODUCT MARKET CYCLES;

- THE TIMING OF NEW PRODUCT INTRODUCTIONS

- OUR ABILITY TO DEVELOP, IMPLEMENT AND SUCCESSFULLY MARKET NEW PRODUCTS
AND TECHNOLOGIES, INCLUDING THE SPEECH PRODUCTS AND TECHNOLOGIES ACQUIRED
FROM L&H; AND

- DOMESTIC AND INTERNATIONAL ECONOMIC FACTORS UNRELATED TO OUR PERFORMANCE,
SUCH AS THE EFFECTS OF THE SEPTEMBER 11, 2001 TERRORIST ATTACKS ON THE
UNITED STATES AND THE RELATED POLITICAL AND MILITARY ACTIONS.

The price of our securities may also be affected by the estimates and
projections of the investment community, general economic and market conditions,
and the cost of operations in one or more of our product markets. While we
cannot predict the individual effect that these factors may have on the price of
our securities, these factors, either individually or in the aggregate, could
result in significant variations in price during any given period of time.

THE IMAGING AND SPEECH AND LANGUAGE TECHNOLOGY SOFTWARE MARKETS ARE HIGHLY
COMPETITIVE. Competitors in the speech and language technology market,
resulting from the L&H acquisition, include: Apple Computer, Inc.; IBM; Locus
Dialogue; Lucent Technologies; Microsoft Corporation; Motorola; NEC Corp.;
Nuance Communications; Philips Electronics N.V.; and SpeechWorks International,
Inc.

IBM and Philips have introduced dictation products which compete directly
with our dictation products. We also compete with other smaller companies which
have developed advanced speech and language technology products. Current and
potential competitors have established, or may establish, cooperative
relationships among themselves or with third parties to increase the abilities
of their advanced speech and language technology products to address the needs
of our prospective customers. Accordingly, new competitors or alliances among
competitors may emerge.

The imaging market is also highly competitive and our competitors in this
area include Adobe, ABBYY, I.R.I.S., and Microsoft.

The competition in these markets could adversely affect our operating
results by reducing the volume of imaging and speech and language products we
sell or the prices we can charge. Some of our competitors or potential
competitors in this market have significantly greater financial, technical and
marketing resources than we do. These competitors may be able to respond more
rapidly than we can to new or emerging technologies or changes in customer
requirements. They may also devote greater resources to the development,
promotion and sale of their products than we do. There is no assurance that the
price and performance of our products and technologies will be superior relative
to the products of our competitors. As a result, we may experience a loss of
competitive position that could result in lower prices, fewer customer orders,
reduced revenues, reduced gross margins, and loss of market share. We may not
meet our design, development, and introduction schedules for new products or
enhancements to our existing and future products. In addition, our products and
technologies may not achieve market acceptance or sell at favorable prices which
could hurt our revenues, results of operations and the price of our common
stock.

Our future competitive performance depends on a number of factors,
including our ability to:

- PENETRATE TARGET MARKETS;

- IDENTIFY EMERGING TECHNOLOGICAL TRENDS AND DEMAND FOR PRODUCT FEATURES
AND PERFORMANCE CHARACTERISTICS;

- ENHANCE OUR PRODUCTS BY ADDING INNOVATIVE FEATURES THAT DIFFERENTIATE OUR
PRODUCTS FROM THOSE OF OUR COMPETITORS;

- BRING PRODUCTS TO MARKET ON A TIMELY BASIS AT COMPETITIVE PRICES;

- RESPOND EFFECTIVELY TO TECHNOLOGICAL CHANGES OR NEW PRODUCT ANNOUNCEMENTS
BY OTHERS; AND

- ADOPT AND/OR SET EMERGING INDUSTRY STANDARDS.

13

SPEECH AND LANGUAGE TECHNOLOGY PRODUCTS MAY NOT ACHIEVE WIDESPREAD
ACCEPTANCE BY BUSINESSES, WHICH COULD LIMIT OUR ABILITY TO GROW OUR SPEECH AND
LANGUAGE TECHNOLOGY BUSINESS. The market for speech and language technology
products is relatively new and rapidly evolving. Sales of our speech and
language technology products would be harmed if the use of speech-activated and
voice interactive software does not continue to develop, or develops more slowly
than we expect. Our ability to increase revenue in the future for our speech and
language technology products depends on the acceptance by both our customers and
their end users of speech technology. In order to achieve commercial acceptance,
we may have to educate prospective customers about the uses and benefits of
speech technology and our products in particular. If these efforts fail, or if
speech technology platforms do not achieve commercial acceptance, our business
could be harmed.

The continued development of the market for our speech and language
technology products will also depend on the following factors:

- WIDESPREAD DEPLOYMENT OF VOICE INTERFACE APPLICATIONS BY THIRD PARTIES,
WHICH IS DRIVEN BY CONSUMER DEMAND FOR SERVICES HAVING A VOICE USER
INTERFACE;

- DEMAND FOR NEW USES AND APPLICATIONS OF VOICE INTERACTIVE TECHNOLOGY,
INCLUDING ADOPTION OF VOICE USER INTERFACES BY COMPANIES THAT OPERATE WEB
SITES;

- ADOPTION OF INDUSTRY STANDARDS FOR VOICE INTERFACE AND RELATED
TECHNOLOGIES; AND

- CONTINUING IMPROVEMENTS IN HARDWARE TECHNOLOGY THAT REDUCE THE COST OF
VOICE INTERFACE SOFTWARE SOLUTIONS.

IF THE STANDARDS WE ACQUIRED FOR SPEECH TECHNOLOGY FROM L&H ARE NOT ADOPTED
AS THE STANDARDS FOR VOICE INTERFACE SOFTWARE AND SPEECH-ACTIVATED SYSTEM
SOLUTIONS, BUSINESSES MIGHT NOT USE OUR SOFTWARE PLATFORM FOR DELIVERY OF
APPLICATIONS AND SERVICES. The market for voice interface software and
speech-activated system solutions is new and emerging and industry standards
have not been established. We may not be competitive unless our products support
changing industry standards. The emergence of industry standards, whether
through adoption by official standards committees or widespread usage, could
require costly and time-consuming redesign of the technology and products
acquired from L&H. If these standards become widespread and our products do not
support them, our customers and potential customers may not purchase our
products. Multiple standards in the marketplace could also make it difficult for
us to ensure that our products will support all applicable standards, which
could in turn result in decreased sales of our products.

OUR FAILURE TO RESPOND TO RAPID CHANGE IN THE MARKET FOR SPEECH TECHNOLOGY
PRODUCTS COULD CAUSE US TO LOSE REVENUE AND HARM OUR BUSINESS. The speech
technology industry is new and rapidly evolving. We are new to this market as a
result of the L&H acquisition. Our success will depend substantially upon our
ability to enhance existing products and technologies acquired from L&H and to
develop and introduce, on a timely and cost-effective basis, new products and
features that meet changing customer requirements and incorporate technological
advancements. If we are unable to develop new products and enhance
functionalities or technologies to adopt to these changes, our business will
suffer.

IF WE ARE UNABLE TO HIRE AND RETAIN TECHNICAL, SALES AND MARKETING AND
OPERATIONAL PERSONNEL, OUR BUSINESS COULD BE HARMED. We intend to continue to
hire additional personnel, including software engineers, sales and marketing
personnel and operational personnel. We may not be able to attract, assimilate,
or retain additional highly qualified personnel in the future. The failure to
attract, integrate, motivate and retain these employees could harm our business.

MATURE MARKETS FOR IMAGING PRODUCTS. The market for our imaging products
is relatively mature and may not experience significant growth or expansion in
the future.

OUR SPEECH TECHNOLOGY PRODUCTS ARE NOT 100% ACCURATE WHICH COULD RESULT IN
DELAYED OR LOST REVENUE, EXPENSIVE CORRECTION, LIABILITY TO OUR CLIENTS AND
CLAIMS AGAINST US. Complex software products such as our speech technology
products may contain errors, defects and bugs. Defects in the solutions or
products that we develop and sell to our customers could result in delayed or
lost revenue, adverse client reaction and negative publicity about us or our
products and services or require expensive corrections. Also, due to the
developing nature of speech recognition technology and text-to-speech
technology, our products are not currently, and

14

may never be accurate, in every instance. Clients who are not satisfied with our
products or services could bring claims against us for damages, which, even if
unsuccessful, would likely be time consuming and could result in costly
litigation and payment of damages. Such claims could have an adverse effect on
our financial results and competitive position.

WE DEPEND ON SALES THROUGH DISTRIBUTION CHANNELS FOR A MAJORITY OF OUR
REVENUE, AND A SIGNIFICANT PORTION OF OUR REVENUE COMES FROM A SMALL NUMBER OF
CUSTOMERS IN THESE DISTRIBUTION CHANNELS. ANY DECREASE IN REVENUES FROM THESE
CUSTOMERS COULD HARM OUR RESULTS OF OPERATIONS. A substantial portion of our
revenue is derived from the sale of our software products through a variety of
distribution channels, including traditional software distributors, direct
fulfillment partners, VARs, OEMs, hardware and software superstores, retail
dealers, and direct sales. Our products are sold primarily through distributors,
direct fulfillment partners, VARs, and OEMs. In particular, one U.S. based
distributor, Ingram Micro, Inc., accounted for 28% of consolidated revenues, and
Digital River, our direct fulfillment partner, accounted for 15% of our
consolidated revenues, respectively, during the year ended December 31, 2001. In
addition, one of our OEM customers, Xerox Corporation, which is also one of our
significant stockholders and a related party, accounted for 11% of our
consolidated revenues during the year ended December 31, 2001. Our resellers
generally offer products of several different companies, including in some
cases, products that are competitive with our products. There can be no
assurance that our software resellers will continue to purchase our products or
provide them with adequate levels of support. The loss of, or a significant
reduction in sales volume to, a significant reseller could have a material
adverse effect on our results of operations.

OUR DISTRIBUTORS ARE SUBJECT TO ECONOMIC AND COMPETITIVE RISK. Our
distributors in the retail channel are experiencing competition both among
themselves and from the shift to electronic commerce. A failure by any one of
our distributors could result in a material adverse effect on our results of
operations including:

- RECOGNITION OF MATERIAL BAD DEBTS;

- LOSS OF ASSOCIATED SALES; AND

- SIGNIFICANT COSTS INCURRED IN CONNECTION WITH ESTABLISHING NEW PRODUCT
DISTRIBUTION CHANNELS.

WE RELY ON OUR CUSTOMERS, SOME OF WHOM ARE OUR COMPETITORS, TO DEVELOP
APPLICATIONS FOR OUR PRODUCTS, MARKET PRODUCTS INCORPORATING OUR TECHNOLOGY AND
GENERATE LICENSE REVENUES FOR US. Many of our software development kits are
licensed primarily to applications developers, original equipment manufacturers,
component manufacturers and software vendors who incorporate our technology into
applications developed by them and sold to end-users. The success of these
licensed products depends to a substantial degree on the efforts of others in
developing and marketing products incorporating our technology. Our customers
often require several months to integrate our technologies into their products.
Products incorporating our technology may not necessarily be successfully
implemented or marketed by our customers.

Our customers, such as Microsoft, have also developed or acquired products
or technologies that compete with our technology. These customers may give
higher priority to the sale of these competitive products or technologies.

OUR QUARTERLY OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS AND
SEASONALITY, AND IF WE FAIL TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS OR
INVESTORS, OUR SHARE PRICE MAY DECREASE SIGNIFICANTLY. Our revenue and
operating results have fluctuated in the past. Our future quarterly operating
results may fluctuate significantly and may not meet the expectations of
securities analysts or investors. If this occurs, the price of our stock would
likely decline. Factors that may cause fluctuations in our operating results
include the following:

- VOLUME, TIMING AND FULFILLMENT OF CUSTOMER ORDERS;

- REDUCTION IN THE PRICES OF OUR PRODUCTS IN RESPONSE TO COMPETITION OR
MARKET CONDITIONS;

- INCREASED EXPENDITURES INCURRED IN CONNECTION WITH THE PURSUIT OF NEW
PRODUCT OR MARKET OPPORTUNITIES;

- INABILITY TO ADJUST OUR OPERATING EXPENSES TO COMPENSATE FOR SHORTFALLS
IN REVENUE AGAINST FORECAST;

15

- RETURNS AND ALLOWANCE CHARGES IN EXCESS OF RECORDED AMOUNTS;

- DEMAND FOR PRODUCTS;

- SEASONALITY;

- GENERAL ECONOMIC TRENDS AS THEY AFFECT RETAIL AND CORPORATE SALES;

- CUSTOMERS DELAYING THEIR PURCHASE DECISIONS IN ANTICIPATION OF NEW
VERSIONS OF PRODUCTS INCLUDING NEW OPERATING SYSTEMS;

- INTRODUCTION OF NEW PRODUCTS BY US OR OUR COMPETITORS; AND

- TIMING OF SIGNIFICANT MARKETING AND SALES PROMOTIONS.

Due to the foregoing factors, among others, our revenue and operating
results are difficult to forecast. We intend to base our expense levels in
significant part on our expectations of future revenue. Our failure to meet
revenue expectations would have a material adverse effect on our business,
operating results and financial condition. Further, an unanticipated decline in
revenue for a particular quarter may disproportionately affect our net income
because a relatively small amount of our expenses are intended to vary with our
revenue in the short term. We experienced net losses during the years ended
December 31, 1999 and 2000 and 2001, and may never become profitable or sustain
profitability.

OUR REVENUE HAS BEEN DEPENDENT ON DEMAND FOR A FEW PRODUCTS. Historically,
a substantial portion of our revenue has been generated by a few products. For
the fiscal year ended December 31, 2001, ScanSoft's OCR product family
represented approximately 63% of revenue, Paper management represented
approximately 16% of revenue, eForms represented 9% of revenue. Although we
anticipate the our future revenues will be derived from a wider array of
products as a result of the L&H acquisition, we believe that a reduction in
revenue contribution from any of these product families could have a material
adverse impact upon our business, results of operations, financial condition and
our stock price.

WE HAVE GROWN, AND MAY CONTINUE TO GROW THROUGH ACQUISITIONS, WHICH MAY
RESULT IN SIGNIFICANT INTANGIBLE ASSETS, DILUTION OF OUR STOCKHOLDERS, USE OF
CASH AND OTHER RISKS. We made significant acquisitions within the last two
years and may complete material acquisitions in the future. Our past
acquisitions have given rise to, and future acquisitions may result in,
substantial levels of intangible assets that will be amortized in future years
and our future results will be adversely affected if we do not achieve benefits
from these acquisitions commensurate with these charges. In addition, our
acquisition of Caere Corporation included a substantial write-off of acquired
in-process research and development costs and this also may occur as a result of
future acquisitions. In connection with our acquisition of Caere Corporation and
the L&H assets, we issued 19.0 million and 7.4 million shares of ScanSoft common
stock, respectively. We may continue to issue equity securities for future
acquisitions and working capital purposes that could be dilutive to our existing
stockholders. In connection with the L&H asset acquisition, we paid $10 million
of cash and issued a promissory note for $3.5 million. Future acquisitions may
also require us to expend significant funds or incur debt. If we expend funds or
incur additional debt, our ability to obtain financing for working capital or
other purposes could decrease.

WE DEPEND ON CONTINUED DEMAND FOR OUR IMAGING PRODUCTS FROM ORIGINAL
EQUIPMENT MANUFACTURERS AND ON THE CONTINUED GROWTH OF SCANNER SALES. ScanSoft
has OEM relationships with a number of companies that provide scanners and other
imaging hardware. OEM revenue has historically represented approximately 15-30%
of our consolidated revenue and represented 30% of our consolidated revenues for
the fiscal year ended December 31, 2001. Our agreements with OEMs do not
obligate them to bundle our software and they may choose to bundle software
products of our competitors. A significant reduction in scanner sales or other
digital imaging hardware sales may adversely impact our revenues. A decline in
OEM revenue could have a material adverse impact upon our business, results of
operations, financial condition and our stock price.

THIRD PARTIES HAVE CLAIMED AND MAY CLAIM IN THE FUTURE THAT WE ARE
INFRINGING THEIR INTELLECTUAL PROPERTY, AND WE COULD BE EXPOSED TO SIGNIFICANT
LITIGATION OR LICENSING EXPENSES OR BE PREVENTED FROM SELLING OUR PRODUCTS IF
SUCH CLAIMS ARE SUCCESSFUL. We have from time to time been notified and we may
in the future be notified

16

or otherwise become aware of claims that we or our customers may be infringing
or contributing to the infringement of certain intellectual property rights of
others. We may be unaware of intellectual property rights of others that may
cover some of our technology and products. If it appears necessary or desirable,
we may seek licenses for these intellectual property rights. However, we can
give no assurance that licenses will be offered by any or all claimants, that
the terms of any offered licenses will be acceptable to us or that in all cases
the dispute will be resolved without litigation. Any litigation regarding
intellectual property could be costly and time consuming and could divert the
attention of our management and key personnel from our business operations. In
the event of a claim of intellectual property infringement, we may be required
to enter into costly royalty or license agreements. However, we may not be able
to obtain such royalty or license agreements on terms acceptable to us or at
all. Third parties claiming intellectual property infringement may be able to
obtain injunctive or other equitable relief that could effectively block our
ability to develop and sell our products. We may also be subject to significant
damages. If any third parties are successful in their intellectual property
infringement claims against us, our operating results and financial position
could be adversely impacted.

In January 2002, ScanSoft received notice that Massachusetts Institute of
Technology and Electronics For Imaging, Inc. had filed a patent infringement
claim against 94 defendants, including ScanSoft. Damages are sought in an
unspecified amount. To date, we have not yet been served with the court
documents. We cannot predict the outcome of the claim, nor can we make any
estimate of the amount of damages, if any, for which we will be held responsible
in the event of a negative conclusion of the claim.

On August 16, 2001, ScanSoft was sued by Horst Froessl for patent
infringement. Damages are sought in an unspecified amount. We filed an Answer
and Counterclaim on September 19, 2001. We believe this claim has no merit and
we intend to defend the action vigorously.

We believe that the final outcome of the current litigation matters
described above will not have a significant adverse effect on our financial
position and results of operations, including the expenditure of a significant
amount of resources defending such claims. However, should we not prevail in
these litigation matters, our operating results and financial position could be
adversely impacted.

OUR FUTURE RESULTS COULD BE HARMED BY ECONOMIC, POLITICAL, REGULATORY AND
OTHER RISKS ASSOCIATED WITH INTERNATIONAL SALES AND OPERATIONS. Since we sell
our products worldwide, our business is subject to risks associated with doing
business internationally. We anticipate that revenue from international
operations will represent an increasing portion of our total revenue.
International revenue for the fiscal year ended December 31, 2001 represented
21% of our consolidated revenue for that period. In addition, some of our
products are developed and manufactured outside the United States. The
development and manufacturing of the acquired L&H automated speech recognition
products and text-to-speech products are completed in Belgium and our imaging
research and development is conducted in Budapest, Hungary. Accordingly, our
future results could be harmed by a variety of factors, including:

- CHANGES IN A SPECIFIC COUNTRY'S OR REGION'S POLITICAL OR ECONOMIC
CONDITIONS;

- TRADE PROTECTION MEASURES AND IMPORT OR EXPORT LICENSING REQUIREMENTS;

- NEGATIVE CONSEQUENCES FROM CHANGES IN TAX LAWS;

- DIFFICULTIES IN STAFFING AND MANAGING OPERATIONS IN MULTIPLE LOCATIONS IN
MANY COUNTRIES;

- DIFFICULTIES IN TRADE ACCOUNTS RECEIVABLE COLLECTION; AND

- LESS EFFECTIVE PROTECTION OF INTELLECTUAL PROPERTY.

IN ORDER TO INCREASE OUR SPEECH PRODUCTS' INTERNATIONAL SALES, WE MUST
DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO, WE MAY BE
UNABLE TO GROW THE RELATED REVENUE. We intend to expand our international
speech product sales, which require us to invest significant resources to create
and refine different language models for each particular language or dialect.
These language models are required to create versions of our products that allow
end users to speak the local language or dialect and be understood. If we fail
to

17

develop localized versions of our speech products, our ability to address
international market opportunities and to grow our speech business will be
limited.

OUR PRODUCTS INCORPORATE TECHNOLOGY WE LICENSE FROM OTHERS. OUR INABILITY
TO MAINTAIN THESE LICENSES COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR
BUSINESS. Some of the technology included in, or operating in conjunction with,
our products is licensed by us from others. Certain of these license agreements
are for limited terms. If for any reason these license agreements terminate, we
may be required to seek alternative vendors and may be unable to obtain similar
technology on favorable terms or at all. If we are unable to obtain alternative
license agreements, we may be required to modify some features of our speech
products, which could adversely affect sales of our products.

WE ARE EXPOSED TO FLUCTUATIONS IN FOREIGN CURRENCY EXCHANGE RATES. Because
we have international subsidiaries and distributors that operate and sell our
products outside the U.S., we are exposed to the risk of changes in foreign
currency exchange rates or declining economic conditions in these countries. We
generally do not engage in hedging transactions to manage our exposure to
currency fluctuations. Our exposure to currency rate fluctuations could affect
our operations and/or cash flows.

THE PROTECTION OF OUR PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY IS
KEY TO OUR SUCCESS. ScanSoft relies heavily on our proprietary software
technology, trade secrets and other intellectual property. Unauthorized parties
may attempt to copy aspects of our products or to obtain and use information
that we regard as proprietary. Policing unauthorized use of our products is
difficult and we may not be able to protect our technology from unauthorized
use. Additionally, our competitors may independently develop technologies that
are substantially the same or superior to ours. In addition, the laws of some
foreign countries do not protect our proprietary rights to the same extent as
the laws of the United States. Although the source code for our proprietary
software is protected both as a trade secret and as a copyrighted work,
litigation may be necessary to enforce our intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity. Litigation, regardless of the outcome, can be very expensive and can
divert management efforts.

Other may assert that our technology and products infringe their patents or
other intellectual property rights. Any such assertion, if resolved adversely to
us, may require us to enter into licensing arrangements and may harm our
business.

XEROX'S AND THE STATE OF WISCONSIN INVESTMENT BOARD'S STOCKHOLDINGS MAY
ENABLE THEM TO INFLUENCE MATTERS REQUIRING STOCKHOLDER APPROVAL. Xerox
currently owns approximately 19% of ScanSoft's outstanding common stock and all
of ScanSoft's outstanding nonvoting, convertible Series B Preferred Stock. In
addition, as of December 31, 2001, Xerox had the opportunity to acquire up to a
maximum of 520,413 additional shares of ScanSoft common stock pursuant to a
warrant, as calculated in accordance with a formula defined in the warrant
agreement. Xerox is currently ScanSoft's largest stockholder followed by the
State of Wisconsin Investment Board ("SWIB"), which currently owns approximately
19% of our common stock. Because of their large holdings of our capital stock
relative to other shareholders, either Xerox, SWIB, or both entities acting
together, could have a strong influence over matters requiring approval by
ScanSoft's stockholders.

OUR EARNINGS AND STOCK PRICE HAVE HISTORICALLY BEEN AND MAY CONTINUE TO BE
VOLATILE. Due to the factors noted throughout this section, our earnings and
stock price have been and may continue to be subject to significant volatility.
There have been previous quarters in which we have experienced shortfalls in
revenue and earnings from levels expected by securities analysts and investors,
which have had an immediate and significant adverse effect on the trading price
of our common stock. This may occur again in the future.

ITEM 2. PROPERTIES

Our principal administrative, sales, marketing and support functions along
with our North American imaging research and development functions occupy 45,860
square feet of space that we lease in Peabody, Massachusetts. We also lease
26,568 square feet of space in Waltham, Massachusetts where our North American
speech and language research and development is performed. These leases expire
in July 2006 and September 2006, respectively. Additionally, we lease
approximately 21,180 square feet of research and

18

development space located in Budapest, Hungary and 20,085 square feet in Ghent,
Belgium, which houses our international headquarters and research and
development space. These leases expire in December 2006 and April 2008,
respectively. We also lease a number of small sales and marketing offices in
Asia and Europe, including offices located in Tokyo, Japan, Hong Kong, Taiwan,
Reading, England; Amsterdam, Holland; Munich, Germany; Milan Italy, and Paris,
France.

We believe that our existing facilities are adequate for our needs for at
least the next twelve months.

ITEM 3. LEGAL PROCEEDINGS

Like many companies in the software industry, we have from time to time
been notified of claims that we may be infringing certain intellectual property
rights of others. These claims have been referred to legal counsel, and they are
in various stages of evaluation and negotiation. If it appears necessary or
desirable, we may seek licenses for these intellectual property rights. We can
give no assurance that licenses will be offered by any or all claimants, that
the terms of any offered licenses will be acceptable to us or that in all cases
the dispute will be resolved without litigation, which may be time consuming and
expensive, and may result in injunctive relief or the payment of damages by us.

In January 2002, ScanSoft received notice that Massachusetts Institute of
Technology and Electronics For Imaging, Inc. had filed a patent infringement
claim against 94 defendants, including ScanSoft. Damages are sought in an
unspecified amount. To date, we have not yet been served with the court
documents. We cannot predict the outcome of the claim, nor can we make any
estimate of the amount of damages, if any, for which we will be held responsible
in the event of a negative conclusion of the claim.

On August 16, 2001, ScanSoft was sued by Horst Froessl for patent
infringement. Damages are sought in an unspecified amount. We filed an Answer
and Counterclaim on September 19, 2001. We believe this claim has no merit and
we intend to defend the action vigorously.

We believe that the final outcome of such matters will not have a
significant adverse effect on our financial position and results of operations,
including the expenditure of a significant amount of resources defending such
claims. However, should we not prevail in any such litigation, our operating
results and financial position could be adversely impacted.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

MARKET FOR COMMON STOCK

Our common stock commenced trading on the Nasdaq National Market on
December 11, 1995 under the symbol "VSNR," and traded under that symbol until
March 3, 1999. Our common stock is now traded under the symbol "SSFT." The
following table sets forth for the periods indicated the high and low sale
prices for our common stock as reported on the Nasdaq National Market.

HOLDERS OF RECORD

As of March 22, 2002, there were approximately 565 holders of record of our
common stock.

DIVIDENDS

To date, we have not paid any cash dividends on shares of our common stock.
We presently intend to retain all future earnings for our business and do not
anticipate paying cash dividends on our common stock in the foreseeable future.

RECENT SALES OF UNREGISTERED SECURITIES

During the past three years, we have issued unregistered securities to a
limited number of persons, as described below. None of these transactions
involved any underwriters, underwriting discounts or commissions, or any public
offering, and the ScanSoft believes that each transaction was exempt from the
registration requirements of the Securities Act of 1933, as amended (the
"Securities Act") by virtue of Section 4(2) thereof. The recipients of
securities in each such transaction represented their intention to acquire the
securities for investment purposes only and not with a view to or for sale in
connection with any distribution thereof, and appropriate legends were affixed
to the share certificates and instruments issued in such transactions. All
recipients had adequate access, through their relationships with us, to
information about us.

(a) On March 2, 1999, in connection with the acquisition of ScanSoft (then
a wholly owned subsidiary of Xerox Imaging Systems) by Visioneer, Inc., Xerox
Corporation was issued 11,853,602 shares of our Common Stock and 3,562,238
shares of non-voting Series B Preferred Stock. In addition, Xerox has the
opportunity to acquire additional shares of common stock pursuant to a ten-year
warrant (see Note 5 to the Notes to Consolidated Financial Statements). We
relied upon Section 4(2) of the Securities Act in connection with the issuance
of these shares.

(b) On November 12, 2001, we issued 262,200 shares of our Common Stock at a
price per share of $2.67 to Bear, Stearns & Co., Inc. ("Bear Stearns"). The
shares were issued pursuant to a Settlement and Release Agreement. ScanSoft, as
successor-in-interest to Caere Corporation, and Bear Stearns are parties to an
engagement letter dated September 9, 1999 (the "Bear Engagement Letter").
Pursuant to the terms of the

20

Bear Engagement Letter, Bear Stearns was to receive certain payments from us as
compensation for its role as financial advisor with respect to certain
transactions (the "Original Bear Payment"). Bear Stearns agreed to accept
payment other than the Original Bear Payment as payment in full to satisfy fees
and expenses due from us to Bear Stearns, including 262,200 shares of Common
Stock. We relied upon Section 4(2) of the Securities Act in connection with the
issuance of these shares.

(c) On December 12, 2001, in connection with the acquisition of the speech
and language assets of Lernout & Hauspie N.V. and related entities, Lernout &
Hauspie N.V. was issued 7,400,000 shares of our Common Stock. We relied upon
Section 4(2) of the Securities Act in connection with the issuance of these
shares.

(d) On December 13, 2001, we sold the State of Wisconsin Investment Board
("SWIB") 3,500,000 shares of our Common Stock, at a price of $3.10 per share. We
relied upon Section 4(2) of the Securities Act in connection with the issuance
of these shares.

(e) On December 28, 2001, we agreed to issue Merrill Lynch, Pierce, Fenner
& Smith Incorporated ("Merrill Lynch") 65,100 shares of our Common Stock at a
price per share of $5.16. The shares were issued pursuant to a Settlement and
Termination Agreement. ScanSoft and Merrill Lynch are parties to an engagement
letter dated December 13, 1999 (the "Merrill Engagement Letter"). Pursuant to
the terms of the Merrill Engagement Letter, Merrill Lynch was to receive certain
payments from us as compensation for its role as financial advisor with respect
to certain transactions (the "Original ML Payment"). Merrill Lynch agreed to
accept payment other than the Original ML Payment as payment in full to satisfy
fees and expenses due by us to Merrill Lynch, including the 65,100 shares being
registered herewith. We relied upon Section 4(2) of the Securities Act in
connection with the issuance of these shares.

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data is not necessarily
indicative of the results of future operations and should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our consolidated financial statements and related notes included
elsewhere in this Annual Report on Form 10-K.

On December 12, 2001, we acquired certain of the speech and language
technology assets of L&H. On March 13, 2000 and March 2, 1999, we completed
acquisitions of Caere Corporation and ScanSoft, Inc., an indirectly wholly-owned
subsidiary of Xerox Corporation, respectively. On June 30, 1999, we acquired
certain assets and liabilities of MetaCreations Corporation. These acquisitions
were accounted for under the purchase method of accounting. Accordingly, the
results of operations of L&H, Caere Corporation, ScanSoft and MetaCreations are
included in our results from operations from the applicable acquisition dates.

Through December 1998, we developed and sold scanner hardware and software
products. On January 6, 1999, we sold our hardware business. Accordingly, the
results of the hardware business are included in our results of operations
through the date of disposal.

21

SCANSOFT, INC.

SELECTED FINANCIAL DATA

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE
CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO CONTAINED IN ITEM 8 OF
THIS REPORT.

RECENT DEVELOPMENTS

On December 7, 2001, we entered into a definitive asset purchase agreement
(the "Purchase Agreement") to acquire certain assets and intellectual property
relating to the former L&H entities that were in bankruptcy under the
jurisdiction of both the U.S. Bankruptcy Courts for the District of Delaware and
the Belgium court of Ieper. We purchased these assets in a closed auction
proceeding administered by the creditor committee of the former entities and
approved by both the U.S. and Belgium courts on December 11, 2001. The
transaction was completed on December 12, 2001.

22

Pursuant to the Purchase Agreement, we acquired certain of the speech and
language technology assets of L&H including patent and trade mark portfolios,
core technology, and completed technology as well as certain accounts receivable
and fixed assets. We paid $41.3 million in total consideration to the creditors
as follows: $10.0 million in cash, we issued 7.4 million shares of stock valued
at $27.8 million (based on the average of the closing share price of our stock 3
days before and after the deal was announced) and issued a 9% promissory note in
the principal amount of $3.5 million, to be repaid in installments of $0.1
million of principal and interest due and payable on the fifteenth (15th) of
each March, June, September and December commencing on March 15, 2002, for a
total of eleven (11) payments. All remaining principal and interest shall become
due on December 15, 2004.

In connection with the acquisition, we assumed certain liabilities
including liabilities for products which were sold prior to the acquisition date
and which are expected to be upgraded with newer versions in 2002 and
liabilities for development contracts with customers. The actual amount of the
liabilities may differ from the estimated amounts. Differences between the
actual and estimated amounts will be recorded as an adjustment to the liability.

On December 27, 2001, we filed a Current Report on Form 8-K with the SEC to
report our acquisition of certain assets of the Speech and Language Technologies
of Lernout & Hauspie. We accounted for the transaction as an acquisition of
assets.

In connection with the 8-K filing, we sought the concurrence of the SEC
staff with respect to our accounting for this transaction as an acquisition of
assets. We have had ongoing discussions with the SEC staff since that time. The
most recent communication with the SEC staff indicated that they would
ordinarily conclude that an acquisition of this type would be considered an
acquisition of a business rather than as an acquisition of assets, but the SEC
staff said they would consider the matter further upon us furnishing additional
information on the transaction. We are actively preparing a response to this
request.

If we were required to change the method of accounting for this
transaction, the change would not have a material effect on our results of
operations or financial condition. The impact on 2001, as reported, would be as
follows: (i) a reduction of amortization expense of approximately $0.1 million,
(ii) a reduction in identifiable tangible and intangible assets of approximately
$21.3 million, (iii) increase in goodwill in the amount of approximately $21.3
million, (iv) no change to net revenues or net loss per share, and (v) a
decrease in our net loss of approximately $0.1 million. Additionally, the impact
to 2002 would be a benefit of approximately $0.5 million of reduced amortization
expense per quarter.

CRITICAL ACCOUNTING POLICIES

Financial Reporting Release No. 60, which was released by the Securities
and Exchange Commission, or SEC, requires all companies to include a discussion
of critical accounting policies or methods used in the preparation of financial
statements. Note 2 of the Notes to the Consolidated Financial Statements
included in this report contains a summary of the significant accounting
policies and methods used in the preparation of our Consolidated Financial
Statements. The following is a discussion of the more significant accounting
policies and methods used by us. In addition, Financial Reporting Release No. 61
was recently released by the SEC to require all companies to include a
discussion to address, among other things, liquidity, off-balance sheet
arrangements, contractual obligations and commercial commitments.

GENERAL

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the dates of the financial
statements and the reported amounts of revenue and expenses during the reporting
periods. The most significant estimates and assumptions included in the
financial statements are revenue recognition, estimating valuation allowances
(specifically sales returns and other allowances), the recoverability of
intangible assets including goodwill and valuation allowances for deferred tax
assets. Actual amounts could differ significantly from these estimates.

23

We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of the consolidated
financial statements.

REVENUE RECOGNITION

We derive our revenues from sales of our software products to end-users
through distribution partners and value added resellers (VAR's), royalty
revenues from OEM partners, license fees from sales of our products to end-users
and from services, primarily maintenance associated with software license
transactions.

We apply the provisions of Statement of Position 97-2 "Software Revenue
Recognition," as amended by Statement of Position 98-9 "Modification of SOP
97-2, Software Revenue Recognition, With Respect to Certain "Transactions" to
all transactions involving the sale of software products. In addition, we apply
the provisions of Staff Accounting Bulletin 101, "Revenue Recognition."

Sales of our software products through distribution partners and VAR's
provide certain rights of return. As a result, we make estimates of potential
future product returns related to products sold to distributors. Our estimates
of sales returns and allowance reserves are based on inventory levels at
distributors and VAR's as well as historical returns, current economic trends,
and obsolescence based on new product introductions. Additionally, from time to
time we offer price protection or rebates to certain of our customers. We
estimate the amount of the price protection and rebate offers at the later of
the sale or time the offer is made. The judgments made and estimates used in
connection with establishing the sales returns and other allowances may be
material in any accounting period. If actual returns or acceptance of other
offers differ significantly from those estimates, such differences may have a
material impact on the results of operations for the period in which the actual
returns or acceptance of other offers become known. The provision for sales
returns and other allowances amounted to $5.5 million at December 31, 2001.
Similarly, we must make estimates of the uncollectibility of our accounts
receivables. We specifically analyze accounts receivables and analyze historical
bad debts, customer concentrations, customer credit-worthiness, current economic
trends and changes in our customer payment terms when evaluating the adequacy of
the allowance for doubtful accounts risk. Our accounts receivable balance was
$14.3 million, net of sales return and other allowances of $5.5 million and
allowance for doubtful accounts of $0.8 million as of December 31, 2001.

Royalty revenues derived from sales to certain OEM partners are based on
estimates of additional deployments of the licenses by the customer in the most
recent reporting period. If actual additional licenses differ significantly from
estimates made based on historical experience, such differences may have a
material impact on the results of operations for the period in which the actual
licenses deployed become known.

If our experience changes dramatically due to changes in the market,
changes in our customer base, seasonality or other economic factors, our ability
to make such estimates may be impacted and therefore we may be unable to
recognize revenue until these rights lapse or until we receive royalty payments.

VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL:

We have significant long-lived tangible and intangible assets, which are
susceptible to valuation adjustments as a result of changes in various factors
or conditions. The most significant long-lived and intangible assets are
patents, core technology, developed technology, and goodwill. The values of
these assets were determined by a risk adjusted, discounted cash flow approach.
We assess the potential impairment of identifiable intangibles, long-lived
assets and related goodwill whenever events or changes in circumstances indicate
that the carrying value may not be recoverable. Factors we consider important
which could trigger an impairment include the following:

- Significant underperformance relative to expected historical or projected
future operating results;

- Significant changes in the manner of or use of the acquired assets or the
strategy for our overall business;

- Significant negative industry or economic trends;

- Significant decline in our stock price for a sustained period; and

24

- Our market capitalization relative to net book value.

Future adverse changes in these or other unforeseeable factors could result
in an impairment charge that would impact future results of operations and
financial position.

DETERMINING DEFERRED TAX VALUATION ALLOWANCES:

We record a valuation allowance to reduce our deferred tax asset to an
amount that will more likely than not be realized. While we have considered our
ability to generate future taxable income in assessing the need for the
allowance, in the event we were to determine that we would be able to realize
our deferred tax assets in the future in excess of the net recorded amount, an
adjustment to the deferred tax asset would increase income in the period such
determination was made.

Additionally, we have significant net operating loss carryforwards (NOLs)
that we have generated or acquired as part of past business combinations. Our
ability to fully utilize these NOL's is based on a number of factors including
ownership changes resulting from the issuance of or other changes in the
ownership of our equity securities. Existing and future ownership changes could
decrease our ability to fully utilize these NOL's therefore increasing our tax
provision in the period such determination was made.

RESULTS OF OPERATIONS

The following table presents, as a percentage of total revenue, certain
selected financial data for each of the three years in the period ended December
31:

- ---------------
(1) See Note 12 of Notes to Consolidated Financial Statements

REVENUE

YEAR ENDED DECEMBER 31, 2001 COMPARED TO DECEMBER 31, 2000

Net revenue of $63.9 million for 2001 increased by $14.8 million or 30%
from the comparable period in 2000. The increase in revenue was due to the
release of upgrades to products in our digital imaging product line which
resulted in increased unit sales as well as slightly higher average selling
prices associated with the upgraded products. In addition we generated revenue
from a significant contract with an OEM customer.

25

The increase in revenue came primarily from our OCR product family, which
increased by approximately $10.0 million from the comparable period in 2000. The
additional revenue growth of $4.8 million came primarily from our other flagship
products: electronic forms, paper management and development kit products. Late
in the fourth quarter we released OmniForm Premium and OmniForm 5.0 and during
the third quarter we released PaperPort Deluxe 8.0, which also contributed to
the revenue growth of the paper management family of products. We also benefited
to a smaller degree from speech and language product revenues from our
acquisition of the RealSpeak and Dragon speech and language products from L&H on
December 12, 2001. We expect that speech and language product revenues will
increase as a percentage of net revenue in future periods as we integrate the
assets from the L&H acquisition into our business.

Geographically, North America accounted for 79% of 2001 revenue and Europe
accounted for 21% versus 82% and 18%, respectively, for the comparable period in
2000. The increase in Europe in 2001 was associated with the release of the
international language versions of OmniPage 11 and PaperPort during the second
half of 2001. International revenue continues to grow as a percentage of net
revenue. We anticipate international revenue to be approximately 25% to 30% of
revenue in 2002 compared to 21% of revenue in 2001.

The breakdown of net revenue for 2001 was 46% VAR/retail, 18% direct, 30%
OEM, and 6% corporate. The breakdown of net revenue for the same period in 2000
was 50% VAR/retail, 18% direct, 28% OEM, and 4% corporate. We expect the revenue
mix for 2002 to shift to a higher concentration of corporate business offset by
a reduction in retail business. We expect OEM and direct to remain consistent
with 2001 levels as a percentage of revenue.

During 2001, Ingram Micro, a retail distributor, accounted for 28% of our
net revenue; Digital River our direct fulfillment partner, accounted for 15% of
our net revenue; and Xerox, a significant shareholder, related party and OEM
customer, accounted for 11% of our net revenue. During 2000, Ingram Micro
accounted for 27% of our net revenue; Digital River accounted for 11% of our net
revenue; and Xerox, accounted for 11% of our net revenue.

With the addition of the speech and language products from the L&H
acquisition in December 2001, we expect to increase our VAR/retail, re-seller
and OEM product offerings and revenues substantially in 2002.

The introduction of major new software products and enhancements of
existing products, as well as potential OEM agreements, are expected to have a
significant impact on our quarterly and annual revenue. As is characteristic of
the initial stages of personal computer product life cycles, we expect that
sales volumes of any new software product may increase in the first few months
following introduction. Thereafter, revenue may stabilize or decline until the
end of a product life cycle, at which time revenue may decline significantly, as
a result of unit sales and price reductions. Due to the inherent uncertainties
of product development and new product introductions, we cannot with certainty
predict the exact date in which a new product or version will be ready to ship.
Any delay in the scheduled release of major new products would have a material
adverse impact on our total net revenues and operating results.

YEAR ENDED DECEMBER 31, 2000 COMPARED TO DECEMBER 31, 1999

Total revenue of $49.1 million for 2000 increased 55% compared to 1999 of
$31.6 million. The increase in absolute dollars is primarily a result of a
broader product line due to the acquisition of Caere on March 13, 2000. During
2000 product sales through direct channels, including the web sites of some of
our OEM customers, online stores and our own web store accounted for $8.8
million, or 18% of our revenue, compared to 17% of revenue in 1999.

During 2000, Ingram Micro, a retail distributor, accounted for 27% of our
net revenue; Digital River, our direct fulfillment partner, accounted for 11% of
our net revenue; and Xerox, an OEM customer, accounted for 11% of our net
revenue. In 1999, Ingram Micro accounted for 24% of our revenue; Tech Data
accounted for 15%; and Xerox accounted for 14%.

Revenue derived outside of North America, primarily in Europe, was
approximately 18% and 13% of total revenue in 2000 and 1999, respectively.
International revenue in 2000 of $9.0 million, increased by $4.8 million from
1999 due primarily to the acquisition of Caere in March 2000. Since 1999
international sales

26

have been denominated primarily in local currencies and these sales are subject
to a number of risks inherent in doing business on an international level, such
as unexpected fluctuations in currency exchange rates, regulatory requirements,
import and export duties and restrictions, and the logistical difficulties of
managing multinational operations, any of which could adversely impact the
success of our international operations. The growth of our international
business will depend, in part, on our ability to increase awareness of our
products in international markets. See "Item 1 -- Business -- Marketing, Sales
and Distribution."

COST OF REVENUE

YEAR ENDED DECEMBER 31, 2001 COMPARED TO DECEMBER 31, 2000

Cost of revenue consists primarily of material costs, third party
royalties, fulfillment, and salaries for product support personnel and related
costs associated with contracts, which are accounted for under the percentage of
completion method of accounting. Currently our software products are
manufactured by Globalware Solutions on a worldwide basis, which also packages
and ships the majority of our products to customers. See "Item 1 -- Business --
Manufacturing."

Cost of revenue in 2001 was $12.8 million or 20% of revenue, compared to
$12.7 million or 26% of revenue in the comparable period of 2000. The decrease
in cost of revenue as a percentage of revenue from the comparable period in 2000
is directly attributed to the consolidation of our worldwide manufacturing
fulfillment activities and cost savings initiatives we introduced in the second
quarter of 2000. This decrease was partially offset by an increase in the cost
of revenue in the second half of 2001, as a result of costs associated with
engineering efforts under a significant OEM contract. We anticipate that cost of
revenue as a percentage of revenue will decrease slightly in 2002 due to higher
revenues over a relatively fixed cost base for certain manufacturing costs, a
pay for support program implemented in January 2002, and renegotiations with our
fulfillment partner and certain third party royalty contracts.

YEAR ENDED DECEMBER 31, 2000 COMPARED TO DECEMBER 31, 1999

Cost of revenue increased to $12.7 million or 26% of revenue in 2000
compared to $7.6 million or 24% of revenue in 1999. The increase in absolute
dollars and percentage of revenue was primarily attributable to the acquisition
of the Caere business in March 2000, which resulted in multiple manufacturing
providers, which reduced efficiencies and increased costs. By the end of 2000,
the Company consolidated its manufacturing providers.

RESEARCH AND DEVELOPMENT EXPENSES

YEAR ENDED DECEMBER 31, 2001 COMPARED TO DECEMBER 31, 2000

Research and development expenses consist primarily of salary and benefits
costs of engineers. Research and development costs were $14.0 million or 22% of
revenue in 2001, compared to $14.9 million or 31% of revenue in 2000. The
decrease in research and development expenses as a percentage of revenue is a
result of certain expenses associated with OEM engineering efforts being charged
to cost of revenues as well as increased revenues compared to the prior period.
We anticipate that research and development expenses as a percentage of revenue
will increase in 2002 to approximately 25% to 30% of revenue. The expected
increase is based upon the increased headcount and costs associated with the L&H
acquisition on December 12, 2001. We increased research and development
headcount by approximately 138 employees in connection with the L&H acquisition.
This compares to headcount of 118 prior to the L&H acquisition.

We believe that the development of new products and the enhancement of
existing products are essential to our success. Accordingly, we will continue to
invest in research and development activities. To date, we have not capitalized
any development costs as the cost incurred after technological feasibility but
before release of product is not significant. We will continue to monitor this
policy as we develop new or upgraded products.

27

YEAR ENDED DECEMBER 31, 2000 COMPARED TO DECEMBER 31, 1999

Research and development expenses consist primarily of salary and benefit
costs of engineers. Research and development costs were $14.9 million or 31% of
revenue in 2000, an increase of $8.0 million from the $6.9 million or 22% of
revenue reported in 1999. The increase in research and development spending is
due to the added software engineering headcount from the acquisition of Caere on
March 13, 2000 offset by the cost reduction actions in the second half of 2000.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

YEAR ENDED DECEMBER 31, 2001 COMPARED TO DECEMBER 31, 2000

Selling expenses include salaries, commissions, advertising, direct mail,
public relations, trade shows, travel and other related sales and marketing
expenses. General and administrative expenses include personnel costs for
administration, finance, human resources, information systems, and general
management in addition to legal and accounting expenses and other professional
services.

Selling, general