SCIENTIFIC LEARNING CORP - 10-K Annual Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2003 or

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

For the transition period from ___________ to _________________

COMMISSION FILE NO. 000-24547

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

DELAWARE		94-3234458
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

300 FRANK H. OGAWA PLAZA, SUITE 600
OAKLAND, CA 94612-2040
(Address of principal executive offices, including zip code)

510-444-3500
(Registrant’s telephone number, including area code)

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

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

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

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes: |_| No: |X|

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on June 30, 2003 as reported on the OTC Bulletin Board was approximately $25,362,500. Shares of Common Stock held by each executive officer and director and by certain persons who owned 5% or more of the registrant’s outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 15, 2004 the Registrant had outstanding 16,157,716 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant’s 2004 Annual Meeting of Stockholders to be held on June 7, 2004, are incorporated by reference in Part III.

TABLE OF CONTENTS

		PAGE NO.

PART I

Item 1.	Business	4
Item 2.	Properties	16
Item 3.	Legal Proceedings	16
Item 4.	Submission of Matters to a Vote of Security Holders	16

PART II

Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	19
Item 6.	Selected Financial Data	20
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	31
Item 8.	Financial Statements and Supplementary Data	32
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	49
Item 9A.	Controls and Procedures	49

PART III

Item 10.	Directors and Executive Officers of the Registrant	50
Item 11.	Executive Compensation	50
Item 12.	Security Ownership of Certain Beneficial Owners and Management	50
Item 13.	Certain Relationships and Related Transactions	50
Item 14.	Principal Accounting Fees and Services	50

PART IV

Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	51

SIGNATURES		55

SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

This report on Form 10-K, including the sections captioned “Item 1. Business,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Result of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or by other comparable terminology. These forward-looking statements relate to future events or conditions or our future performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from that expressed or implied by these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our actual results may differ materially from those expected or anticipated in the forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, risks and uncertainties discussed in this Report in Item 1, including but not limited to those discussed under the caption “Factors That May Affect our Results or Stock Price,” those described in “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and those that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

ITEM 1.

BUSINESS

We develop and distribute the Fast ForWord^® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to build the fundamental cognitive skills required to read and learn.

Reading is essential for success in school and in life, yet according to the National Assessment of Educational Progress conducted by the U.S. Department of Education, 69% of fourth graders in the U.S. are unable to read proficiently at grade level. Learning to read proficiently is a complex task involving multiple cognitive processes that have become much better understood in recent years. Our products incorporate learning from more than 30 years of research on the brain, language, and reading.

Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrate that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. Our major products include an optional easy-to-use web-based tool that provides reports on detailed learning results for individuals and groups of students.

To encourage best practices in the use of our products, we provide on-site and remote services, including product training and professional development, implementation management, consulting and technical installation. We also provide technical, professional and customer support and a wide variety of web-based resources.

At the end of 2003, approximately 2,200 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and over 325,000 individuals had enrolled in one of our products.

MARKETS

Our primary market is K-12 schools in the United States. In 2003, the K-12 sector represented more than 90% of our business. Since we began building our school sales force in late 1998, our business in K-12 schools has grown each year, both in absolute dollars and as a percentage of our business.

The K-12 market is large and is projected to grow. According to the National Center for Education Statistics, part of the U.S. Department of Education, and Market Data Retrieval, a supplier of market information to the education industry, U.S. K-12 schools now enroll more than 54 million students, and enrollment is projected to continue growing through 2013. There are approximately 14,200 public school districts in the U.S., and approximately 114,000 public and private school buildings, or sites.

Eduventures, a strategic consulting firm in the education industry, has estimated that in 2001, K-12 schools spent $3.2 billion (46% of the total amount schools spent on all instructional products) on supplementary materials of all types. Simba Information, Inc., a marketing information company, estimates the K-12 market for instructional software at $1.63 billion in 2003.

The general availability of funding for public schools fluctuates from time to time, and state and local funding is presently negatively affected by reduced levels of tax revenues due to the economic slowdown. During 2002 and 2003, the education technology industry generally experienced soft sales, typically attributed to tight funding. State and local education funding is expected to continue to be tight during 2004. If the economy continues to grow stronger, more funding may be available in 2005. Nevertheless, substantial federal funding resources remain, and many of those resources are focused on reading improvement.

The federal No Child Left Behind (NCLB) Act of 2001 established as important national priorities reading achievement and grade level proficiency accomplished through proven practices and products grounded in scientifically based research. Our products, which build language and reading skills and are based on more than 30 years of neuroscience and cognitive research, align well with these objectives.

For fiscal year 2005, President Bush’s education funding requests include $13.3 billion for Title 1, Part A, grants to local education agencies; $1.125 billion for Reading First; $132 million for Early Reading First; $12.2 billion for special education grants to states; $692 million for educational technology; $1 billion for 21^st Century Community Learning Centers; and $682 million for English Language Acquisition programs. All of these sources of federal funding have been used by our customers to purchase Fast ForWord licenses.

We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, so continuing to qualify for major sources of federal funding is critical to our sales success. The current federal budget deficit may impact the availability of federal education funding. For example, for 2005 the administration has requested no money for Comprehensive School Reform, Even Start and Dropout Prevention, and the funding for several other categories has stayed the same as 2004. Nevertheless, the total amount of federal funding for education has increased each year since 1996.

In addition to selling to K-12 schools, we also sell through private practice professionals, and to learning centers, hospitals, clinics and psychologists. These speech and language or other professionals recommend the use of our products to appropriate clients and then supervise the use of those products, often in connection with their other services. Since 1999, our business in this sector has decreased each year, both in absolute dollars and as a percentage of our business. We expect that this sector will continue to decline as a percentage of our business.

However, these professionals remain significant to us. Private practice professionals were our first market, and they have extensive knowledge about our products and their use that can be valuable for us and for all of our customers. These professionals sometimes provide contract services to schools, and from time to time recommend Fast ForWord products for students in those schools.

PRODUCTS

Our Fast ForWord software products develop cognitive skills required to read and learn effectively. Based on more than 30 years of research in neuroscience, reading and language, our products use established neuroscience principles to help students learn. Extensive efficacy research (see Outcomes and Scientific Basis below) has demonstrated the results that can be achieved through use of our products.

COGNITIVE SKILLS DEVELOPMENT

Reading and learning require a variety of foundational cognitive skills, all functioning together. The Fast ForWord products develop prerequisite skills that enable students to take greater advantage of their reading instruction and improve their reading proficiency. Fast ForWord products do this by developing Learning MAPs™ skills:

Memory. The ability to hold information short- and long-term, essential for comprehension of complex sentences and for remembering instructions.

Attention. The ability to focus on tasks and ignore distractions.

Processing. The ability to address information such as images and sounds quickly enough, and in the correct sequence, to discriminate their differences, a prerequisite for phonemic awareness (the ability to distinguish among and manipulate the smallest sounds in language that can change meaning) and reading.

Sequencing. The ability to quickly and accurately determine which of two events or stimuli comes first, which is supported by memory, attention, and processing. Sequencing is essential for developing phonemic awareness, word fluency, and oral and reading comprehension.

FAST POWER LEARNING™ FORMULA

Neuroscience research has demonstrated the importance of frequency, intensity, adaptivity, simultaneous development, and timely motivation for learning new tasks. The Fast ForWord products use these principles to help students learn more rapidly.

Frequency and intensity: Brain plasticity research demonstrates that completing a set of learning tasks in a frequent, intense timeframe is needed to make the changes in brain functioning that enhance learning. To maximize the efficacy of our products, we recommend protocols for our major products that require between 48 and 100 minutes of product use a day, 5 days per week.

During 2003, a significant portion of our research resources were devoted to developing alternate protocols to offer educators greater flexibility in fitting Fast ForWord products into school schedules, while maintaining the products’ effectiveness. Our original protocols required product use for 90 to 100 minutes per day, 5 days a week, for a period of 4 to 8 weeks. We have now introduced protocols for each of our major products that require only 48 to 50 minutes of use, 5 days a week, over a longer period of 6 to 10 weeks. Our research shows that students working under the new protocols achieve substantially the same results as those using the original protocols. The shortened daily time protocols make fitting our products into the school day much easier, although the required time commitment still can present challenges to selling and implementation.

Adaptivity: The interactive exercises in the Fast ForWord products adapt to each student’s skill level and progress, automatically adjusting content exposure in a variety of ways. For example, many of the exercises automatically adjust the specific content presented to the student so that the student can make correct responses approximately 80% of the time for each discrete skill. This adjustment is designed to keep the exercises challenging and engaging, while allowing the student to experience a feeling of accomplishment and to avoid the frequent failure that can discourage a student’s learning.

Simultaneous Development: The Fast ForWord products simultaneously develop both major and supporting cognitive skills, for enduring learning improvements. While each exercise focuses on a specific set of reading or language tasks, it is also designed to develop underlying cognitive skills such as memory, attention, processing and sequencing.

Timely Motivation: For the brain to learn, the student must be attentive and engaged, so motivation is critical to maintaining learning improvements. In the Fast ForWord products, learners are rewarded for a correct answer on their first attempt only, a scientifically validated motivational technique. Other motivational techniques include a bonus point system and the delivery of “mastery animations” that signify milestones as students progress.

PRODUCTS IN THE FAST FORWORD FAMILY

During 2003, our Fast ForWord family of products accounted for 81% of revenue. These software products function with a wide variety of hardware and software configurations and are designed to work with the computer technology widely available in schools and homes.

In 2003 we introduced the Fast ForWord Gateway Edition of our major products. The Gateway Edition was designed to:

•	Make our products easier to implement and use, through alternative protocol options, simplified administrative procedures, and a unified interface;

•	Improve student results, by adding easier introductory levels for some exercises and providing individualized intervention recommendations based on a student’s actual performance;

•	Better connect Fast ForWord use to classroom activities, through a teacher interface that aligns the Fast ForWord products to state learning standards and selected core reading programs; and

•	Provide additional progress tracking capabilities, including reports that enable sub-group tracking, to help educators respond to increased accountability demands.

Customers who purchased earlier editions and wish to move to the Fast ForWord Gateway Edition may do so for an additional charge.

Fast ForWord Language software includes seven exercises focused on developing oral language comprehension and listening skills, including phonological awareness (the understanding that words are composed of sounds and the ability to identify and manipulate the sounds of language), listening accuracy and comprehension, working memory, and familiarity with language structures, along with building the requisite underlying MAPs skills.

Fast ForWord Middle and High School software is designed for adolescents and teenagers who lack reading proficiency. The exercises are similar to those in Fast ForWord Language, but deliver content in an age-appropriate sports-themed user interface.

Fast ForWord Language to Reading software includes five exercises that help students make the link between spoken language and written language, focusing on word analysis, listening comprehension, working memory, grammar, syntax, and vocabulary, while continuing to further develop the underlying MAPs skills.

Fast ForWord to Reading is a series of products that build essential reading skills such as phonemic awareness, vocabulary, fluency, and comprehension while simultaneously developing the underlying MAPs skills. At more advanced levels, students use these products to build spelling skills and familiarity with writing conventions, extend word level knowledge of semantic, phonological, morphological and syntactic structures, and advance their sentence and passage comprehension skills. (Morphology relates to the use of words, letters, and letter combinations that change the meaning of a word. Syntax relates to how grammatical markers and words are combined to make meaningful sentences.) Each Fast ForWord to Reading product is correlated directly to generally-accepted grade-level reading standards. In 2003, we introduced the Fast ForWord to Reading 4 product, which is correlated to end of fourth grade standards and joined our earlier Fast ForWord to Reading 3 product. In 2004, we plan to introduce Fast ForWord to Reading 1 and Fast ForWord to Reading 2.

Our major products, Fast ForWord Language, Language to Reading, Middle & High School and Fast ForWord to Reading, include an optional remote progress tracking system, Fast ForWord Progress Tracker. This easy-to-use web-based tool provides reports on detailed learning results for individuals or groups of students for all exercises in each of these products. These reports, generated from learner data securely transmitted by customers to Scientific Learning’s database, permit educators to see exactly how each student is progressing on specific skills. Overview reports provide summary-level data for a class or other group and provide a quick update on the group’s progress and participation levels. Customers can configure the system to send automatic emails to parents, administrators or others to provide easy periodic updates. Progress Tracker data can be reported by subgroup, providing a tool for educators to analyze their progress towards their Annual Yearly Progress requirements, which are mandated by NCLB.

We also sell Fast ForWord Basics, software that prepares pre-readers aged 4 to 7 for learning and reading; Reading Edge, a reading assessment instrument for students from kindergarten to 2nd grade; and Fast ForWord Bookshelf, an early reading kit that includes five colorful storybooks and a multimedia CD-ROM.

LICENSE TERMS

We license our products in a variety of configurations to meet the customer’s needs. Schools typically purchase site or workstation licenses, which are available either for a perpetual term or on a subscription or limited term basis. The license package typically contains at least two of our major products and varying quantities of our other products. An annual support fee is included in the package license price. New customers are also required to purchase implementation services, which are critical to successful use of the products. Our license list prices range from $10,000 to $65,000 per site, depending on the number of products, the number of workstations, the duration of the license and the volume purchased.

Products licensed for administration by private practice professionals are generally purchased on a per product per student basis. Our major products list for $850 per product per student. The private practice professional charges separately for his or his services. Hospitals, clinics and learning centers purchase both per-product per-student licenses and site or workstation licenses, depending on their size and needs.

FAST FORWORD TO LEARNING SERVICES AND SUPPORT

One of our key strategic goals is to reach beyond early adopters and sell to a broader group of mainstream reading intervention customers. We believe that selling more services is critical to achieving that goal, because mainstream customers tend to require more implementation support than do early adopters. In 2003, services and support accounted for 19% of revenue, compared to 17% in 2002. At the end of 2003, our service and support organization included 23 employees, supplemented by 37 contractors who provide on-site customer training and technical services.

SERVICES

School districts have limited resources to support technology at dispersed sites, so they seek products that are easy to implement and maintain. To facilitate effective implementation, we offer product training, technical installation, implementation management, consulting, and professional development services. These services are generally provided on-site by independent contractors who have been trained and certified on our products. Some of these services are also offered remotely, including Fast ForWord Getting Started, a self-paced web-based course that provides training on the science behind and the use of our products.

To help our customers obtain the best possible student achievement results, our product training and professional development sessions provide an extensive hands-on introduction to our products, effective implementation strategies, and an introduction to the science behind our products. In addition, customers can look to Scientific Learning for implementation management services and consulting on data analysis and interpretation, intervention and motivation strategies, connecting with classroom teachers and other topics of interest to the customer.

We host forums, workshops, and seminars for customers and prospective customers. At these gatherings, speakers provide information on advances in neuroscience and learning, and current customers offer actual case studies on how Fast ForWord products impact student achievement. These sessions provide Fast ForWord users with opportunities to network and develop informal support relationships, and in some cases, are offered with continuing education credits.

SUPPORT

We provide extensive remote support to Fast ForWord customers, who can access our technical, professional, and customer support via telephone, email, and web-based chat, in whatever combination works best for them. Level 1 support services are provided by a third party that specializes in providing telephone support. More difficult questions are escalated to internal support staff. In our customer surveys, customers using Fast ForWord products generally give excellent ratings to the support they receive and the professionalism of our support team.

OUTCOMES and SCIENTIFIC BASIS

From the founding of our company, we have devoted significant resources to demonstrating that our products improve learning, and today we continue to accumulate outcomes data from students in classrooms across the country. Research by our users, independent academics and our own scientists has demonstrated that Fast ForWord products improve language and reading skills across a broad spectrum of demographic groups.

USER OUTCOMES

To date, more than 325,000 individuals have enrolled in Fast ForWord products, and we have accumulated research outcomes on more than 25,000 individuals, including approximately 17,000 controls. Gains have been confirmed among a variety of groups, including African-American students, Hispanic students, students with limited English proficiency, students struggling with reading, and students of low socio-economic status. Gains on specific reading skills have been confirmed using several standardized, nationally normed reading tests. In addition, schools that have used Fast ForWord products have provided us with state achievement test scores from students before and after they have used Fast ForWord products. Analyses of these data have demonstrated that following Fast ForWord participation, students, on average, achieve significant improvements on a wide variety of high-stakes tests.

BRAIN IMAGING AND READING IMPROVEMENTS

A Stanford University study of students aged 8 to 12 who were identified as dyslexic, published in 2003 in the Proceedings of the National Academy of Sciences, confirmed that after using Fast ForWord, students on average showed significant improvements in reading performance, coupled with changes in brain activation patterns. Before beginning the study, the students underwent assessments for reading, reading skills, and language, as well as functional magnetic resonance imaging (fMRI) of their brains during a series of reading-related tasks. The students then used the Fast ForWord Language product for five days a week, 100 minutes per day, for an average of 28 days. The fMRIs and assessment tests were then repeated. After Fast ForWord use, the brain activation patterns of the students showed increased neurological activity in regions of the brain involved in skills critical to reading. These later images more closely resemble the patterns exhibited by students reading on or above grade level. A control group showed no similar changes in fMRI results. The students who used the Fast ForWord product also showed statistically significant improvements in a variety of reading skills, including word decoding, single word reading, naming fluency, and reading comprehension.

RESEARCH BASIS and FIELD TRIALS

The technology that forms the basis of most of our major products grew out of a scientific collaboration between neuroscientists working at Rutgers, the State University of New Jersey (“Rutgers”) and the University of California at San Francisco (“UCSF”) combining insights about language development and learning to read with research on brain plasticity.

One of a child’s early tasks is to learn to extract meaning from speech by identifying its basic auditory building blocks, or phonemes. Children must be able to recognize and process these phonemes before they can become skilled in language or reading. The Rutgers group noted that children who have difficulty distinguishing between closely related phonemes frequently have problems in other language and cognitive skill areas as well, such as morphology, syntax, semantics, grammar, short-term memory, attention, and event sequencing. The UCSF group had long investigated how the human brain changes in response to stimuli, a phenomenon known as brain plasticity. Their work demonstrated that specific techniques drive the brain to change over time, adjusting how it processes information. Bringing together their work at Rutgers and UCSF, our founders developed computerized exercises that use thousands of repetitions, adapted according to complex and sophisticated formulas and presented with timely motivational sequences, to allow children to quickly master the language and cognitive skills that are critical to reading.

Results from the original research studies combining the work of our scientific founders were published in the journal Science in early 1996. These results were revalidated by a national field trial of Fast ForWord Language later in 1996, which demonstrated gains of one to two years on standardized tests of skills critical to reading, after just four to eight weeks of training. A second national field trial in 1997, among students in 19 public schools in nine districts across five states, demonstrated significant gains in language and reading skills as measured on standardized tests, yielding average improvement of more than 1 ½ years in four to eight weeks – gains that were significantly greater than those made by students in the control group.

SALES AND MARKETING

We sell to our principal market, K-12 school districts throughout the United States, primarily using a direct sales force. As of December 31, 2003, we employed 30 quota-bearing sales representatives, led by four regional sales directors. These sales personnel typically are experienced professionals with backgrounds in selling technology-based curriculum products to the K-12 segment. Most bring strong relationships with educators built over many years. We support our sales representatives with a strong field sales management team with over 100 years of collective experience in this market and with strategic consultants, who frequently are retired school district superintendents and other senior district administrators, and who have extensive experience and relationships in K-12 education.

To reach smaller and rural schools, to a limited extent we also sell our products through school consortiums and regional service centers.

We participate in industry conferences and trade shows and conduct our own Executive Forums for educational decision makers. Our sales force typically targets sales at the school district level, although early “seeding” sales are also made at the individual school level.

We sell to clinical professionals, learning centers, hospitals and clinics principally through direct marketing (mail, web and telesales) and conferences (both industry conferences and forums we conduct ourselves).

We have also recently begun to sell our products outside North America through resellers in a limited number of countries. To date, the level of these sales has been minimal.

COMPETITION

The educational market in which we operate is very competitive. We believe that the principal competitive factors in the industry are ability to deliver measurable improvements in student achievement, cost, existing relationships with customers, ability to provide effective and efficient product implementation, and ability to complement and supplement the school curriculum. We believe that we compete favorably on the basis of these factors.

Our products are highly differentiated by their neuroscience basis and their focus on the development of cognitive skills through scientifically based methods. However, we compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than Scientific Learning, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to language and reading are fundamentally different from the approach we take, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

DEVELOPMENT AND RESEARCH

The markets in which we compete are characterized by frequent product introductions and evolving educational standards and approaches. Our future success will depend in part on our ability to continue to enhance and update our existing products or to develop and successfully introduce new products.

Our research and development expenses were approximately $3.5 million, $3.0 million, and $3.4 million for the years ended December 31, 2003, 2002 and 2001, respectively. At December 31, 2003, 18 of our employees were engaged in research and development activities, which include both product development and outcomes research.

DEVELOPMENT

Our development efforts focus on making our products more effective and easier to use, and broadening our product line. All of our current development efforts are focused on products related to reading and language, principally for use in a school environment.

Our new products rely on market-tested technology and uniform platforms and are developed in a shared authoring environment, so that customers can easily broaden their Fast ForWord implementations, as well as move students easily among our products. We analyze the data that is uploaded through our Progress Tracker tool to identify trends in product use and efficacy and help us develop improvements to our products.

In 2003, we launched Fast ForWord Gateway Edition, a new edition of our major products. Our customers received the added features and benefits of the Gateway Edition enthusiastically. However, we encountered technical issues with the new release that required significant time from our sales and service teams. This led to additional service and support costs and slowed the purchasing decisions for a number of transactions, resulting in lower than expected fourth quarter sales.

In 2003 we also launched the second product in our Fast ForWord to Reading series, Fast ForWord to Reading 4. During 2004, we expect to launch two additional products in the Fast ForWord to Reading series, Fast ForWord to Reading 1 and 2, which are currently in development. We cannot guarantee that we will meet the projected introduction schedule for future products, or that future products will be free of technical issues or be well received in the market.

RESEARCH

We believe that the emphasis in the No Child Left Behind Act on scientifically based instructional approaches validates our long-standing support of research on the efficacy of our products, which has included projects at some of the country’s top research universities. We continue to support research to demonstrate the outcomes of our products, as well as to identify and support new product and product improvement opportunities.

Support of Outcomes Research

School districts throughout the country are studying the impact of Fast ForWord products on their students’ reading achievement. Many of these studies focus on outcomes related to state standards and accompanying state assessment programs. We encourage these studies, assist with data analysis when appropriate and, whenever practical, make the results available on our Scientific Learning web site.

Researchers at Stanford University are planning a randomized controlled study on the additive effects of using multiple Fast ForWord products. The study plans to include a wide variety of students in a broad spectrum of educational settings. An advisory board of reading research experts is planned to monitor the research design, methods and data analyses procedures. We are providing a donation to the Haan Foundation to fund a portion of the study.

Product Enhancements and New Products

The data that is uploaded to our database from participants who use our products is a valuable resource for improving our products. Analyzing the patterns among groups of participants allows us to understand, in detail, how students generally progress, where students have difficulty and where intervention might be appropriate. In 2003, we released alternate protocols for each of our major products after demonstrating that the alternate protocols resulted in substantially similar student progress as the original protocols, using analyses of students’ Progress Tracker data as well as pre and post test results. We also released Progress Tracker flags providing individualized intervention recommendations based on the student’s actual performance and new, easier introductory levels for exercises where students may tend to experience difficulty when starting the products. We continue to explore potential product enhancements and alternative usage protocols that will make our products more useful to educators and more effective for students.

INTELLECTUAL PROPERTY

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

At December 31, 2003, we held 50 issued U.S. patents and 5 pending U.S. applications. We also held 4 issued patents from other countries and had 13 applications pending abroad. We were the exclusive licensee under 11 issued U.S. patents, 3 issued foreign patents, and 2 pending foreign patent applications. The U.S. patents expire between 2014 and 2019.

We also have 17 US trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark. During 2002, we were involved in litigation regarding another party’s use of a mark that was similar to our Fast ForWord mark, which was resolved amicably.

The licensed patents and applications are owned by the Regents of the University of California and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2003, approximately 74% of our product booked sales were derived from selling products that use the licensed inventions. If we were to lose our rights under this license, it would materially harm our business. This license requires payment of royalties based upon cumulative net sales of our products, subject to certain minimum royalty amounts. In 2002 and each year thereafter, the minimum royalty payment is $150,000. In 2003, 2002 and 2001, we had approximately $909,000, $723,000 and $635,000, respectively in royalty and milestone expense under the license. The final milestone payment under the license was paid in 2001.

In September 2003, we transferred certain of our technology to Neuroscience Solutions Corporation (“NSC”) for use in the healthcare field. The transaction includes a license of the patents we own, a sublicense of the patents we license from UCSF and Rutgers, the license of certain software we developed, and the sale of some research-related assets. All of the rights licensed to NSC are limited to the healthcare field and most of the licenses are exclusive in that field. We will continue to use the licensed patents and technology in the fields of education and speech and language therapy, and retain all rights to our technology outside of the health field.

The rights were acquired by Neuroscience Solutions for a combination of cash, stock, and future royalties. The two companies also have agreed to share certain additional technology as it is developed. NSC is a San Francisco-based company that plans to develop and sell a series of software-based products for healthcare markets based on research in neuroplasticity. NSC’s first products are expected to focus on issues of aging. Dr. Michael M. Merzenich, who is a founder, director, significant stockholder and former officer of the Company, is also a founder, director, significant shareholder and officer of NSC.

ADDITIONAL INFORMATION

As of December 31, 2003, we had 130 full-time and three part-time employees. We believe our relations with employees are good. None of our employees is represented by a union or subject to collective bargaining agreements.

We maintain two websites, scientificlearning.com and brainconnection.com, which provide information and support. Scientificlearning.com provides information about our company and our products and services, as well as extensive technical and customer support resources. Brainconnection.com provides practical, easily understandable information about how the brain works and how students learn, web-based professional development courses on the brain, language, and reading, and links to information about Fast ForWord products that relate to the topics discussed on the site.

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

FACTORS THAT MAY AFFECT OUR RESULTS OR STOCK PRICE

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

The success of our business depends on increasing acceptance of our products in the K-12 sector, particularly among mainstream purchasers, who may be resistant to our non-traditional products.

To continue to grow, we need to increase the acceptance of our products among mainstream educational purchasers. At the end of 2003, approximately 2,200 schools had purchased at least $10,000 of our Fast ForWord product licenses and services and over 325,000 individuals had enrolled in one of our products. We believe that to date most educators who have used Fast ForWord products are “early adopters.” We believe that our success in moving our products beyond early adopters to the mainstream market will depend largely on the following critical factors:

•	Our ability to convince key education decision-makers to use Fast ForWord products even though our methods differ from the way schools have traditionally addressed reading problems. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.

•	Our ability to convince schools and teachers to incorporate our products into their curriculum. Our new protocols have significantly reduced the daily time required to use our program, significantly decreasing one of the most critical challenges in broadly implementing our products. However, implementing the products still requires a substantial time commitment, which can be difficult for schools.

•	Our ability to effectively implement our products in schools and better connect to classroom teachers, in a scaleable and efficient model.

•	Our ability to continue to demonstrate that our products achieve significant gains in student achievement. Unless our products are implemented well and using in accordance with one of our protocols, they may not achieve the desired student achievement results.

•	The availability of government funding for public school reading intervention purchases and for our products in particular. The general availability of funding for public schools fluctuates from time to time, and state and local funding is presently negatively affected by reduced levels of tax revenues due to the economic slowdown. During 2002 and 2003, the education technology industry generally experienced soft sales, typically attributed to tight funding. State and local education funding is expected to continue to be tight during 2004. However, if the economy continues to grow stronger, more funding may be available in 2005.

•	The extent to which our products qualify for federal education funding. Future federal education funding could be adversely affected by the federal budget deficit.

Our business experiences seasonal fluctuations and a long sales cycle, which may make it difficult to predict our results accurately.

Since our formation, our quarterly operating results have fluctuated significantly, and we expect these fluctuations to continue. Like other companies in the instructional market, our sales to K-12 schools are typically particularly slow in the first quarter. Demand for our products through private clinicians tends to be lower during the school year than in the summer, because our products’ intensive nature can be more conducive to use during school vacation.

In addition, the cost of some of our K-12 license packages requires multiples levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict. When a district decides to finance its license purchase, the time required to obtain these approvals can be extended even further. In addition, sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles. As a result, our sales cycle generally takes several months, and in some cases, can take a year or longer.

The timing of revenue recognized from our sales can also be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it may be difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be projected. See “Management’s Discussion and Analysis –Application of Critical Accounting Policies” for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of sales and revenue in a given quarter.

Our expense levels are based on our expectations of future revenues and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall.

We may experience difficulties in launching new products efficiently, without significant technical issues, and on schedule.

We are developing additional products in our Fast ForWord to Reading series as part of our strategy to reach mainstream reading intervention customers. Unexpected challenges could make these development projects longer or more expensive. In addition, we cannot be certain of market acceptance of our new products.

New technology products usually contain bugs that were not discovered in the testing process and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. During the second quarter of 2003, we launched the new Gateway Edition of our major products. Although our customers received the added features and benefits of the Gateway Edition enthusiastically, we encountered technical issues with the new release that required significant time from our sales and service teams. This led to additional service and support costs, and slowed the purchasing decisions for a number of transactions, resulting in lower than expected fourth quarter sales.

We may not be able to compete effectively in the education market.

The market in which we operate is very competitive. Our products are highly differentiated by their neuroscience basis and their focus on the development of cognitive skills through scientifically based methods. However, we compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than Scientific Learning, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Encouraged by the No Child Left Behind Act, competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

Our intellectual property rights may be challenged.

Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. In addition, we could become party to patent or trademark infringement claims, litigation or interference proceedings. These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights. Any such proceedings would result in substantial expense and significant diversion of management effort. An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

Our most important products are based on licensed inventions owned by two universities. If we were to lose our rights under this license, it would materially harm our business. The licensor may terminate the license if we fail to perform our obligations and do not timely cure the violation. We believe that we are currently in compliance with the license in all material respects.

We have only recently become profitable.

We started operations in February 1996 and until this year incurred significant operating losses. In the second quarter of 2004, we recorded our first operating profit, and in the third quarter, our first net profit. 2004 was our first profitable year. At December 31, 2003, we had an accumulated deficit of approximately $81 million from inception. We first generated positive cash flow from operating activities in 2002 and our cash flow from operations was again positive in 2003. During 2004, our objectives include increasing our profit margin and generating positive cash flow from operations. However, accomplishing these objectives will require achieving higher sales goals in a soft K-12 market, which depends on many factors, some of which are outside of our control. To meet our sales targets, we will need to make substantial expenditures. We cannot assure you that we will meet our targets with respect to sales, revenues or operating results.

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

At March 1, 2004, Warburg, Pincus Ventures, our largest shareholder, owned approximately 47% of the Company’s outstanding stock and, in the aggregate, our directors and executive officers and their affiliates beneficially owned more than 64% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.

Our common stock is thinly traded and its price is volatile.

Our common stock presently trades on the Nasdaq Small Cap Market, and our trading volume is low. For example, during the fourth quarter of 2003, our average daily trading volume was approximately 8,400 shares. The market price of our common stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations.

After our initial public offering, our common stock was traded on the Nasdaq National Market. On July 22, 2002, we were delisted from the Nasdaq National Market for failure to meet the market capitalization or tangible net assets alternative tests. Our common stock then traded on OTC Bulletin Board until December 30, 2003, when we became listed on the Nasdaq Small Cap Market.

Our charter provisions could have the effect of delaying or preventing corporate takeovers.

Our certificate of incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The authority to issue this preferred stock could enable our board of directors to deter acquisitions of our company. Additionally, our certificate of incorporation and bylaws also provide for a classified board of directors, prevent stockholders from acting by written consent, disallow cumulative voting and require advance notice of director nominations and stockholder proposals, all of which could have the effect of delaying or preventing corporate takeovers.

ITEM 2.

PROPERTIES

We lease approximately 30,500 square feet of office space in Oakland, California under a lease that expires in December 2013. The lease includes two five-year options to extend the term of the lease. We believe our facilities are sufficient for our operations currently and should be adequate to meet our needs for at least the next two years.

ITEM 3.

LEGAL PROCEEDINGS

None

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

EXECUTIVE OFFICERS

The following table sets forth various information concerning our executive officers, as of March 19, 2004:

NAME	AGE	POSITION

Robert C. Bowen	62	Chairman and Chief Executive Officer

James R. Bray	59	Vice President, Business Development and Government Affairs

Linda L. Carloni	50	Vice President, General Counsel and Secretary

Glenn G. Chapin	48	Vice President, Sales

Jane A. Freeman	50	Sr. Vice President, Chief Financial Officer, and Treasurer

Dr. William M. Jenkins	53	Sr. Vice President, Product Development

Dr. Steven L. Miller	40	Sr. Vice President, Research and Outcomes

Gillian M. Rutter	48	Vice President, Operations

Sherrelle J. Walker	57	Chief Education Officer

Robert C. Bowen joined us as Chairman and Chief Executive Officer in June 2002. From 1989 to 2001, he served as a senior executive and officer of National Computer Systems, a provider of educational assessment and administrative software and services. His last assignment there, from 1995 to 2001, was as President of NCS Education, a leading provider of enterprise software for K-12 school districts. NCS was acquired by Pearson, PLC, in 2000. After retiring from NCS in 2001, Mr. Bowen consulted for various businesses in education until joining us. Previously, Mr. Bowen held senior executive positions with other leading education and publishing companies, including seventeen years with McGraw-Hill. Early in his career, Mr. Bowen was a high school math teacher, a coach, and a school district administrator. Mr. Bowen received his bachelor’s and master’s degrees from the University of Tennessee, Chattanooga.

James R. Bray joined us as Vice President, Business Development and Government Affairs in January 2003. Starting in 1990, Mr. Bray held a variety of executive positions at NCS Pearson and its predecessors in their education, assessment, and testing products businesses. From 1999 through 2002, Mr. Bray was Vice President Business Development of Pearson Education Technologies and its predecessors. During 2001 and 2002, Mr. Bray also served as chairman of NCS Pearson’s corporate marketing committee. During 1998 and 1999 Mr. Bray was Vice President and General Manager of Realskills, an NCS company. Prior to joining NCS, Mr. Bray spent more than 20 years at IBM/Science Research Associates in Chicago. Mr. Bray is a former member of the St. Paul (Minn.) School District Foundation and received his bachelor’s degree in marketing from Northwestern University.

Linda L. Carloni joined the Company as General Counsel in October 1999, became our Secretary in March 2000 and was elected Vice President in June 2000. From April 1996 to September 1999, Ms. Carloni was a founder and Vice President of Alere Medical Incorporated, a healthcare services start-up. From May 1994 to April 1996, Ms. Carloni served as a senior licensing officer for the University of California Office of Technology Transfer. From April 1992 to April 1994, Ms. Carloni was a partner at the law firm of Cooley Godward LLP. Earlier in her career, Ms. Carloni was the general counsel of Nellcor Incorporated, a medical device company, and an associate and a partner at Cooley Godward. She received her bachelor’s degree in political science from Case Western Reserve University and her law degree from Boalt Hall School of Law at the University of California, Berkeley.

Glenn G. Chapin joined the Company as Vice President, Sales in April 2001. Prior to joining the Company, Mr. Chapin served as a Regional Vice President at CompassLearning, an educational technology company starting in 1995. Prior to CompassLearning, Mr. Chapin was a sales executive for NCS where he held positions of increasing responsibility over a 15-year period from serving as the Midwest territory sales representative to Southern Region Sales VP. Mr. Chapin is a graduate of St. John Fischer College in Rochester, NY where he received his Bachelor of Science degree in Business Administration.

Jane A. Freeman is our Senior Vice President, Chief Financial Officer and Treasurer. She joined us as Vice President, Finance and Treasurer in August 1999 and was named Chief Financial Officer in January 2000. She was elected Senior Vice President in January 2004. She also served as our Vice President Business Development from August 1999 until June 2000. From April 1988 through December 1998, she was employed by Rockefeller & Co., a global investment firm where she served on the Management Committee of the firm. She is a director of three mutual funds managed by Harding Loevner, LLP. Ms. Freeman holds a B.A. in mathematics and chemistry and an M.B.A. (with distinction) from Cornell University and a License in Applied Economics from the University of Louvain in Belgium.

Dr. William M. Jenkins was elected Senior Vice President, Product Development in November 2000. Dr. Jenkins is a founder and served as our Vice President, Product Development from June 1997 until November 2000. From March 1996 to June 1997, Dr. Jenkins was our Vice President, Research and Development. From 1990 to 1996, Dr. Jenkins was an Adjunct Associate Professor at UCSF. Dr. Jenkins is the principal developer of our current software products. Dr. Jenkins holds a B.S. in Psychology, an M.A. in Psychobiology and a Ph.D. in Psychobiology from Florida State University, with additional post-doctoral training from UCSF.

Dr. Steven L. Miller was elected Senior Vice President, Research and Outcomes in November 2000. Dr. Miller is a founder and served as our Vice President in charge of research or outcomes research from June 1997 until November 2000. From May 1996 to June 1997, Dr. Miller was our Vice President, Professional Relations and Outcomes. From September 1991 to May 1996, he held research appointments at the Center for Molecular and Behavioral Neuroscience at Rutgers. Dr. Miller has extensive experience in organizing clinical research studies and conducting longitudinal studies of children and adults who have language and reading problems. Dr. Miller holds a B.A. in Psychology from Bloomsburg University of Pennsylvania, an M.A. in Neuroscience from the University of Hartford and a Ph.D. in Psychology from the University of North Carolina at Greensboro. He received additional training in Clinical Neuropsychology at the Bowman Gray School of Medicine at Wake Forest University.

Gillian M. Rutter joined us as Vice President, Operations in October 2002. Prior to joining us, Ms. Rutter had served as vice president of professional and technical services for NCS Learn (Pearson Education) beginning in 2000. From 1994 through 2000, she was the vice president of customer support for NovaNET, an E-learning company. Earlier in her career, Ms. Rutter worked in management and field positions at Jostens Learning, an educational software company. Ms. Rutter began her career as an elementary and middle school teacher and was a master of teacher training in Tucson, Arizona. She holds a bachelor of science in elementary education and a bachelor of science in special education and learning disabled K-12 from the University of Arizona.

Sherrelle J. Walker joined us as Chief Education Officer in July 2002. Prior to joining us, Ms. Walker had served as Vice President Curriculum at NCS Pearson, an educational software company beginning in 1998. During 1998, Ms. Walker was vice president products at American Cybercasting Corporation, which provided on-line curriculum products for teachers and students. Ms. Walker also has more than 25 years experience as an educator and educational administrator, beginning as a teacher in the Hartford Public Schools, and serving as an Assistant Principal, Principal and Director of Secondary Education in the Renton, Washington Public Schools and as Assistant Superintendent of the public schools in Federal Way, Washington. Ms. Walker played a leading role in the development of the Washington State Essential Academic Learning Requirements and has been an adjunct professor at the University of Washington. Ms. Walker completed her BS in teaching at Hampton University in Hampton Virginia, and her MA at the University of Connecticut.

PART II

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

(a) Market Information. Our common stock currently is traded on the Nasdaq Small Cap Market under the symbol “SCIL”. From July 22, 2002 until December 30, 2003, our common stock was traded on the OTC Bulletin Board. From January 1, 2002 through July 21, 2002, our common stock was traded on the Nasdaq National Market. The following table sets forth, for the periods indicated, the closing high and low sales prices per share of our common stock as reported on the Nasdaq National Market, the OTC Bulletin Board or the Nasdaq Small Cap Market, as applicable.

	High		Low

2002
First quarter	$	2.900	$	1.110
Second quarter	$	2.001	$	1.200
Third quarter	$	1.650	$	0.700
Fourth quarter	$	2.400	$	1.210

2003
First Quarter	$	3.100	$	1.400
Second Quarter	$	4.500	$	2.300
Third Quarter	$	5.150	$	4.100
Fourth Quarter	$	5.000	$	4.150

Holders. As of March 18, 2004, the approximate number of stockholders of record of our common stock was 145.

Dividend Policy. We have never declared or paid cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. Our current Loan and Security Agreement with Comerica Bank provides that we may not pay any dividends other than stock dividends during the term of the Agreement.

Securities Authorized for Issuance under Equity Compensation Plans. For information regarding securities authorized for issuance under equity compensation plans, see Item 12.

(b) Not applicable

ITEM 6. SELECTED FINANCIAL DATA

In thousands, except per share amounts

Year ended December 31,

2003

2002

2001

2000

1999

Statement of Operations Data:

Revenues (2):