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EX-31.2 - EXHIBIT 31.2 - ROSETTA STONE INCa12312016exhibit312.htm
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EX-10.45 - EXHIBIT 10.45 - ROSETTA STONE INCa12312016exhibit1045.htm
EX-10.37 - EXHIBIT 10.37 - ROSETTA STONE INCa12312016exhibit1037.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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, 2016
Commission file number: 1-34283
Rosetta Stone Inc.
(Exact name of registrant as specified in its charter)
Delaware
(State of incorporation)
 
043837082
(I.R.S. Employer
Identification No.)
1621 North Kent Street, Suite 1200
Arlington, Virginia
(Address of principal executive offices)
 
22209
(Zip Code)

Registrant's telephone number, including area code:
703-387-5800
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock, par value $0.00005 per share
 
New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o    No ý
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 ý    No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
 
Accelerated filer ý
 
Non-accelerated filer o
 
Smaller reporting company o
 
 
 
 
 (Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o    No ý
The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $159.3 million as of June 30, 2016 (based on the last sale price of such stock as quoted on the New York Stock Exchange). All executive officers and directors of the registrant and all persons filing a Schedule 13D with the Securities and Exchange Commission in respect of registrant's common stock have been deemed, solely for the purpose of the foregoing calculation, to be "affiliates" of the registrant.
As of March 8, 2017, there were 22,161,289 shares of common stock outstanding.
Documents incorporated by reference: Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the 2017 Annual Meeting of Stockholders to be held on May 19, 2017 are incorporated by reference into Part III.




TABLE OF CONTENTS
 
 
 
 
 
Page



PART I
FORWARD-LOOKING STATEMENTS

        This Annual Report on Form 10-K, including the documents incorporated by reference, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by non-historical statements and often include words such as "outlook," "potential," "believes," "expects," "anticipates," "estimates," "intends," "plans," "seeks" or words of similar meaning, or future-looking or conditional verbs, such as "will," "should," "could," "may," "might," "aims," "intends," or "projects,” or similar words and phrases. These statements may include, but are not limited to, statements relating to: our business strategy; guidance or projections related to revenue, Adjusted EBITDA, bookings, and other measures of future economic performance; the contributions and performance of our businesses, including acquired businesses and international operations; projections for future capital expenditures; and other guidance, projections, plans, objectives, and related estimates and assumptions.  A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances. In addition, forward-looking statements are based on the Company’s current assumptions, expectations and beliefs and are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. Some important factors that could cause actual results, performance or achievement to differ materially from those expressed or implied by these forward-looking statements include, but are not limited to: the risk that we are unable to execute our business strategy; declining demand for our language learning solutions; the risk that we are not able to manage and grow our business; the impact of any revisions to our pricing strategy; the risk that we might not succeed in introducing and producing new products and services; the impact of foreign exchange fluctuations; the adequacy of internally generated funds and existing sources of liquidity, such as bank financing, as well as our ability to raise additional funds; the risk that we cannot effectively adapt to and manage complex and numerous technologies; the risk that businesses acquired by us might not perform as expected; and the risk that we are not able to successfully expand internationally. We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments or otherwise, except as required by law. These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements risks and uncertainties that are more fully described in the Company's filings with the U.S. Securities and Exchange Commission (SEC), including those described below in this Annual Report on Form 10-K in Part I, Item 1A: "Risk Factors" and Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations,” those described elsewhere in this Annual Report on Form 10-K, and those described from time to time in our future reports filed with the Securities and Exchange Commission. 



Item 1.    Business
Overview
Rosetta Stone Inc. (“Rosetta Stone,” “the Company,” “we” or “us”) is dedicated to changing people's lives through the power of language and literacy education. Our innovative digital solutions drive positive learning outcomes for the inspired learner at home or in schools and workplaces around the world.
Founded in 1992, Rosetta Stone's language division uses cloud-based solutions to help all types of learners read, write, and speak more than 30 languages. Lexia Learning, Rosetta Stone's literacy education division, was founded more than 30 years ago and is a leader in the literacy education space. Today, Lexia helps students build fundamental reading skills through its rigorously researched, independently evaluated, and widely respected instruction and assessment programs. Rosetta Stone Inc. was incorporated in Delaware in 2005.
As our Company has evolved, we believe that our Enterprise & Education Language and Literacy segments are our largest opportunities for long-term value creation. The customers in these markets have needs that recur each year, creating a more predictable sales opportunity. This need profile also fits well with our suite of language and literacy products, and the well-known Rosetta Stone brand. We also believe the demand is growing for e-learning based literacy solutions in the U.S. and English language-learning around the globe.
As a result, we are emphasizing the development of products and solutions for Corporate and K-12 learners who need to speak and read English. This focus extends to the Consumer segment, where we continue to make product investments serving the needs of passionate language-learners who are motivated, results focused and willing to pay for a quality language-learning experience.
To position the organization for success, our focus is on the following priorities:
1.
Grow literacy sales and market share by providing fully aligned digital instruction and assessment tools for K-12, building a direct distribution sales force to augment our historical reseller model, and continuing to develop our implementation services business;
2.
Position our Enterprise & Education Language segment for profitable growth by focusing our direct sales on our best geographies and customer segments, partnering with resellers in other geographies and successfully delivering our CatalystTM product to Corporate customers. Catalyst integrates our Foundations, Advantage, and Advanced English for Business products with enhanced reporting, assessment and administrator tools that offers a simple, more modern, metrics-driven suite of tools that are results-oriented and easily integrated with leading corporate language-learning systems;
3.
Maximize the profitability of our Consumer language business by providing an attractive value proposition and a streamlined, mobile-oriented product portfolio focused on consumers' demand, while optimizing our marketing spend appropriately;
4.
Seek opportunities to leverage our language assets including our content, tools and pedagogy, as well as our well-known Rosetta Stone brand, through partnerships with leading players in key markets around the world; and
5.
Continue to identify opportunities to become more efficient.
In pursuing these priorities, we will (i) allocate capital to the areas of our business that we believe have the greatest value creation potential, including our Lexia literacy business, (ii) focus our businesses on their best customers, including K-12 learners primarily in North America, Corporate learners primarily in North America and Northern Europe in our Enterprise & Education Language segment, and passionate learners in the U.S. and select non-U.S. geographies in our Consumer language business, and (iii) optimize the sales and marketing costs for these businesses and the costs of our business overall.
Business Segments
Our business is organized into three operating segments: Enterprise & Education Language, Literacy, and Consumer. The Enterprise & Education Language segment derives language-learning revenues from sales to educational institutions, corporations, and government agencies worldwide under a Software-as-a-Service ("SaaS") model. The Literacy segment derives revenue under a SaaS model from the sales of literacy solutions to educational institutions serving grades K through 12. The Consumer segment derives revenue from sales to individuals and retail partners worldwide. For additional information regarding our segments, see Note 17 of Item 8, Financial Statements and Supplementary Data. Prior periods are presented consistently with our current operating segments and definition of segment contribution.

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Products and Services
Enterprise & Education Language:
Enterprise & Education Language-Learning Solutions: Rosetta Stone provides a series of web-based subscriptions to interactive language-learning solutions for schools, business and other organizations that are primarily available online. Our core language-learning suite offers courses and practice applications in multiple languages, each leveraging our proprietary context-based immersion methodology, speech recognition engine and innovative technology features. Available in 24 languages and designed for beginner to intermediate language learners, Rosetta Stone Foundations builds fundamental language skills. Rosetta Stone Advantage is available for all proficiency levels in 9 of the 24 languages and focuses on improving everyday and business language skills. Our Advanced English for Business solution serves multinational companies seeking to build their employees’ English language proficiency so they are able to communicate and operate in a global business environment. In 2016, we completed the development of Catalyst, which consolidates and aligns our Foundations, Advantage and Advanced English for Business products into a single solution for our enterprise customers. Catalyst provides streamlined access and simplified pricing for the full suite of English and world language learning content, along with assessment, placement, ongoing reporting and demonstration of results, all of which address important customer needs to focus and demonstrate payback. Specifically designed for use with our language-learning solutions, our Enterprise & Education Language customers may also purchase our audio practice products and live tutoring sessions to enhance the learning experience.
Literacy:
Literacy Solutions: Our Lexia Learning suite of subscription-based English literacy-learning and assessment solutions provide explicit, systematic, personalized fundamental reading instruction for students of all abilities. This research-proven technology based approach accelerates reading skills development, predicts students' year-end performance and provides teachers with data-driven action plans to help differentiate instruction. Lexia Reading Core5 is available for all abilities from pre-K through grade 5. Our reading intervention program, Lexia Strategies, is designed for struggling readers in grades 6 and above. Lexia RAPID Assessment is a computer-adaptive screener and diagnostic tool for grades K-12 that identifies and monitors reading and language skills to provide actionable data for instructional planning. Lexia's solutions deliver norm-referenced performance data and analysis to enable teachers to monitor and modify their instruction to address specific student needs. These literacy solutions are provided under web-based subscriptions.
Our Enterprise & Education Language and Literacy customers can maximize their learning solutions with administrative tools, professional services and custom solutions.
Administrative Tools: Our Enterprise & Education Language and Literacy learning programs come with a set of administrative tools for performance monitoring, and to measure and track learner progress. Administrators can use these tools to access real-time dynamic reports and identify each learner's strengths and weaknesses.
Professional Services: Professional services provide our customers with access to experienced training, implementation and support resources. Our team works directly with customers to plan, deploy, and promote the program for each organization, incorporate learning goals into implementation models, prepare and motivate learners, and integrate the Enterprise & Education Language and Literacy solutions into technical infrastructure.
Custom Solutions: Rosetta Stone offers tailored solutions to help organizations maximize the success of their learning programs. Our current custom solutions include curriculum development, global collaboration programs that combine language education with business culture training, and language courses for mission-critical government programs.
Consumer:
Rosetta Stone also offers a broad portfolio of technology-based learning products for personal use to the global consumer. Our interactive portfolio of language-learning solutions is powered by our widely recognized brand, and building on our 24-year heritage in language-learning.
Many of our Rosetta Stone consumer products and services are available in flexible and convenient formats for tablets and smartphones. Our mobile apps enable learners to continue their lessons on the go and extend the learning experience away from a computer. Progress automatically syncs to meet our customers' lifestyles. These apps may be available for download through the Apple App Store, Google Play, and Amazon App Store for Android.
Rosetta Stone Language-Learning Solutions: Rosetta Stone provides intuitive, easy-to-use language-learning programs that can be purchased as software subscription or in perpetual formats including digital download, CD, or in-app purchase.

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Our language-learning suite offers courses and practice applications in multiple languages, each leveraging our proprietary immersion methodology, speech recognition engine and innovative technology features. Beginner to intermediate language-learning products are available in 30 languages to build fundamental language skills. More advanced language-learning products are available in 9 of the 30 languages. We also offer online services to enhance and augment our learners' capabilities. Our Online Tutoring is an online service that provides conversational coaching sessions with native speakers to practice skills and experience direct interactive dialogue. Our Online Games and Activities are online services that provide a world-wide community for users around the world with games, online chat, read-along stories, and other features to improve language skills. Our current suite of mobile language-learning apps includes companions to our computer-based language-learning apps which enables learners to access their language program anytime anywhere.
Software Developments:
Our offering portfolio is a result of significant investment in software development. Our software development efforts include the design and build of software solutions across a variety of devices, pedagogy and curriculum development, and the creation of learning content.  Our development team builds new solutions and enhances or maintains existing solutions. We have specific expertise in speech recognition technology, iterative and customer-focused software development, instructional design, and language acquisition. We continue to evaluate changes to our solutions to strengthen our brand and improve the relevance of our offering portfolio.
Our research and development expenses were $26.3 million, $29.9 million, and $33.2 million for the years ended December 31, 2016, 2015 and 2014, respectively.
Customers and Distribution Channels
No customer accounted for more than 10% of the Company's revenue during the years ended December 31, 2016, 2015 or 2014. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant.
Enterprise & Education Language:
Our Enterprise & Education Language distribution channel is focused on targeted sales activity primarily through a direct sales force in five markets: K-12 schools, colleges and universities, government agencies, not-for-profit organizations, and corporations. Our Enterprise & Education language-learning customers include the following:
Educational Institutions.    These customers include primary and secondary schools and colleges and universities.
Government Agencies and Not-for-Profit Organizations.    These customers include government agencies and organizations developing workforces that serve non-native speaking populations, offering literacy programs, and preparing members for overseas missions.
Corporations.    We promote interest in this market with onsite visits, trade show and seminar attendance, speaking engagements, and direct mailings.
Third-party Resellers and Partners. We utilize third-party resellers and partners to provide our language-learning solutions to businesses, schools, and public-sector organizations in markets predominantly outside the U.S.
Literacy:
Our Literacy distribution channel utilizes a direct sales force as well as relationships with third-party resellers focused on the sale of Lexia solutions to K-12 schools.
Consumer:
Our Consumer distribution channel comprises a mix of our call centers, websites, third party e-commerce websites, app-stores, consignment distributors, select retail resellers, and daily deal partners. We believe these channels complement each other, as consumers who have seen our direct-to-consumer advertising may purchase at our retailers, and vice versa.
Direct to consumer.    Sales generated through either our call centers, our e-commerce website at www.rosettastone.com, and app stores.
Indirect to consumer. Sales generated through arrangements with third-party e-commerce websites such as the Apple App Store, and consignment distributors such as Wynit Distribution and Software Packaging Associates.
Retailers.    Our retailers enable us to provide additional points of contact to educate consumers about our solutions, expand our presence beyond our own websites, and further strengthen and enhance our brand image. Our retail relationships

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include Amazon.com, Barnes & Noble, Target, Best Buy, Books-a-Million, Sam's Club, Staples, and others in and outside of the U.S. We also partner with daily deal resellers.
Home School.    We promote interest in the language-learning market through advertising in publications focused on home schooling and attending local trade shows.
Sourcing and Fulfillment
Consistent with the SaaS model in our Enterprise & Education Language and Literacy segments, our strategy in the Consumer segment is to shift the sales mix away from CD-based product sales toward a cloud-based software subscription in order to reduce costs associated with physical packaging and distribution.
Our physical inventory utilizes a flexible, diversified and low-cost manufacturing base. We use third-party contract manufacturers and suppliers to obtain substantially all of our product and packaging components and to manufacture finished products. We believe that we have good relationships with our manufacturers and suppliers and that there are alternative sources in the event that one or more of these manufacturers or suppliers is not available. We continually review our manufacturing and supply needs against the capacity of our contract manufacturers and suppliers with a view to ensuring that we are able to meet our production goals, reduce costs and operate more efficiently.
Competition
Rosetta Stone competes in several categories within the technology-based learning industry, including consumer, enterprise and educational language learning, and literacy.
The language-learning market is highly fragmented globally and consists of a variety of instructional and learning modes: classroom instruction utilizing the traditional approach of memorization, grammar and translation; immersion-based classroom instruction; self-study books, audio recordings and software that rely primarily on grammar and translation; and free online and mobile offerings that provide content and opportunities to practice writing and speaking. In the enterprise and education-focused language market, we compete with EF English Live (formerly EF Englishtown), Global English, Wall Street English (Pearson), inlingua, Imagine Learning, Transparent Language, Duolingo, Middlebury Interactive Languages, Speexx as well as many private language schools and other classroom-based courses. Within consumer-focused language learning, our competitors include Berlitz (Benesse Holdings), Pimsleur (Simon & Schuster, part of CBS Corporation), Living Language (Penguin Random House, a joint venture of Pearson and Bertelsmann), McGraw-Hill Education, Duolingo, Inc., Fluenz, Busuu Ltd., Babbel (operated by Lesson Nine GmbH) and many other small and regionally-focused participants. In addition there are several competitors that are primarily focused on teaching English including Open English (Open English LLC), EF English Live and Inglés Sin Barreras.
In the literacy category, we compete primarily in the K-12 digital reading space in the U.S. with Imagine Learning, Scientific Learning, Odyssey (Compass Learning), Renaissance, Houghton Mifflin Harcourt, Curriculum Associates, and iStation.
Seasonality
Our business is affected by variations in seasonal trends. Within our Enterprise & Education Language segment, sales in our education, government, and corporate sales channels are seasonally stronger in the second half of the calendar year due to purchasing and budgeting cycles. Literacy segment sales are seasonally stronger in the second and third quarters of the calendar year corresponding to the end and beginning of school district budget years. Consumer sales are affected by seasonal trends associated with the holiday shopping season. In particular, we generate a significant portion of our Consumer sales in the fourth quarter during the period beginning on Black Friday through the end of the calendar year.
Our operating segments are affected by different sales-to-cash patterns. Consumer sales typically turn to cash more quickly than Enterprise & Education Language and Literacy sales, which tend to have longer collection cycles. Historically, in the first half of the year we have been a net user of cash and in the second half of the year we have been a net generator of cash.
Intellectual Property
Our intellectual property is critical to our success. We rely on a combination of measures to protect our intellectual property, including patents, trade secrets, trademarks, trade dress, copyrights and non-disclosure and other contractual arrangements. In certain circumstances, we may sub-license our intellectual property including our trademarks and software for use in certain markets.
We have ten U.S. patents, fourteen foreign patents and several U.S. and foreign patent applications pending that cover various aspects of our language-learning and literacy technologies.

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We have registered a variety of trademarks, including our primary or house marks, Rosetta Stone, The Blue Stone Logo, Lexia Learning, Lexia, Fit Brains, and Catalyst. These trademarks are the subject of either registrations or pending applications in the U.S., as well as numerous countries worldwide where we do business. We have been issued trademark registrations for our yellow color from the U.S. Patent and Trademark Office. We intend to continue to strategically register, both domestically and internationally, trademarks we use today and those we develop in the future. We believe that the distinctive marks that we use in connection with our solutions are important in building our brand image and distinguishing our offerings from those of our competitors. These marks are among our most valuable assets.
In addition to our distinctive marks, we own numerous registered and unregistered copyrights, and trade dress rights, to our products and packaging. We intend to continue to strategically register copyrights in our various products. We also place significant value on our trade dress, which is the overall image and appearance of our products, as we believe that our trade dress helps to distinguish our products in the marketplace from our competitors.
Since 2006, we have held a perpetual, irrevocable and worldwide license from the University of Colorado allowing us to use speech recognition technology for language-learning solutions. Since 2014, we have also held a commercial license from the Florida State University Research Foundation allowing us to use certain computer software and technology in our literacy offerings. These types of arrangements are often subject to royalty or license fees.
We diligently protect our intellectual property through the use of patents, trademarks and copyrights and through enforcement efforts in litigation. We routinely monitor for potential infringement in the countries where we do business. In addition, our employees, contractors and other parties with access to our confidential information are required to sign agreements that prohibit the unauthorized disclosure of our proprietary rights, information and technology.
Employees
As of December 31, 2016, we had 1,012 total employees, consisting of 717 full-time and 295 part-time employees. We have employees in France and Spain who are represented by a collective bargaining agreement. We believe that we have good relations with our employees.
Financial Information by Segment and Geographic Area
For a discussion of financial information by segment and geographic area, see Note 17 of Item 8, Financial Statements and Supplementary Data contained in this Annual Report on Form 10-K.
Available Information
This Annual Report on Form 10-K, along with our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through our website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission ("SEC"). Our website address is www.rosettastone.com. The information contained in, or that can be accessed through, our website is not part of, and is not incorporated into, this Annual Report on Form 10-K.
The SEC maintains a website that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC's website at www.sec.gov.
Item 1A.    Risk Factors
The following description of risk factors includes any material changes to, and supersedes the description of, risk factors associated with our business previously disclosed in our Quarterly Report on Form 10-Q filed on November 7, 2016 with the SEC for the period ended September 30, 2016. An investment in our common stock involves a substantial risk of loss. Investors should carefully consider these risk factors, together with all of the other information included herewith, before deciding to purchase shares of our common stock. If any of the following risks actually occur, our business, financial condition, or results of operations could be materially adversely affected. In such case, the market price of our common stock could decline and all or part of an investment may be lost.
The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as general economic conditions and geopolitical events. Further, additional risks not currently known to us or that we currently believe are immaterial could have a material adverse effect on our business, financial condition, cash flows and results of operations. In addition to the other information set forth in this annual report on Form 10-K, you should carefully consider the risk factors discussed below and in other documents we file with the SEC that could materially affect our business, financial condition, cash flows or future results.

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We might not be successful in executing our strategy of focusing on the Enterprise & Education Language and Literacy segments and on more passionate language learners in the Consumer segment, and our company reorganization and realignment might not produce the desired results.
We are continuing to undertake a strategic reorganization and realignment of our business to maximize profitable growth in our Enterprise & Education Language segment by serving the needs of corporate and K-12 language learners, and prioritizing those who wish to speak and read English. In addition, we are now focusing on the needs of more passionate language learners in our Consumer segment, rather than addressing the needs of the mass marketplace. If we do not successfully execute our strategy, our revenue and profitability could decline. Our recent strategy changes include actions to reduce headcount, exit unprofitable geographies, and other savings initiatives. These cost reduction efforts could harm our business and results of operations by distracting management and employees, causing difficulty in hiring, motivating and retaining talented and skilled personnel, and creating uncertainty among our customers and vendors that could lead to delays or unexpected costs. Also, our ability to achieve anticipated cost savings and other benefits from these efforts is subject to many estimates and assumptions, which are subject to significant business, economic, and competitive uncertainties and contingencies, some of which are beyond our control. If these estimates and assumptions are incorrect, or if other unforeseen events occur, our business and financial results could be adversely affected.
Our actual operating results may differ significantly from our guidance.
Historically, our practice has been to release guidance regarding our future performance that represents management's estimates as of the date of release. This guidance, which includes forward-looking statements, is based on projections prepared by management. These projections are not prepared with a view toward compliance with published guidelines of the American Institute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside party confirms or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto.
Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges or as single point estimates, but actual results could differ materially. The principal reason that we release guidance is to provide a basis for management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by any such persons.
Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions in the guidance furnished by us will not materialize or will vary significantly from actual results. Accordingly, our guidance is only an estimate of what management believes is realizable as of the date of release. Actual results may vary from our guidance and the variations may be material. We expressly disclaim any obligations to update or revise any guidance, whether as a result of new information, future events or otherwise, except as required by law. In light of the foregoing, investors are urged not to rely upon, or otherwise consider, our guidance in making an investment decision in respect of our common stock.
Any failure to successfully implement our strategy or the occurrence of any of the events or circumstances set forth in these "Risk Factors" and elsewhere in this annual report on Form 10-K could result in the actual operating results being different from our guidance, and such differences may be adverse and material.
Intense competition in our industry may hinder our ability to attract and retain customers and generate revenue, and may diminish our margins.
The business environment in which we operate is rapidly evolving, highly fragmented and intensely competitive, and we expect competition to persist and intensify. Increased competition could adversely affect operating results by causing lower demand for our products and services, reduced revenue, more product returns, price reductions or concessions, reduced gross margins and loss of customers.
Many of our current and potential domestic and international competitors have substantially greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition in some locations, as well as in some cases, lower costs. Some competitors offer more differentiated products (for example, online learning as well as physical classrooms and textbooks) that may allow them to more flexibly meet changing customer preferences. The resources of our competitors also may enable them to respond more rapidly to new or emerging technologies and changes in customer requirements and preferences and to offer lower prices than ours or to offer free language-learning software or online services. We may not be able to compete successfully against current or future competitors.
There are a number of free online language-learning opportunities to learn grammar, pronunciation, vocabulary (including specialties in areas such as medicine and business), reading, and conversation by means of podcasts and MP3s,

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mobile applications, audio courses and lessons, videos, games, stories, news, digital textbooks, and through other means. We estimate that there are thousands of free mobile applications on language-learning; free products are provided in at least 50 languages by private companies, universities, and government agencies. Low barriers to entry allow start-up companies with lower costs and less pressure for profitability to compete with us. Competitors that are focused more on user acquisition rather than profitability and funded by venture capital may be able to offer products at significantly lower prices or for free. As free online translation services improve and become more widely available and used, people may generally become less interested in language learning. Although we also offer free products such as mobile apps, if we cannot successfully attract users of these free products and convert a sufficient portion of these free users into paying customers, our business could be adversely affected. If free products become more engaging and competitive or gain widespread acceptance by the public, demand for our products could decline or we may have to lower our prices, which could adversely impact our revenue and other results.
Historically a substantial portion of our revenue has been generated from our Consumer business. If we fail to accurately anticipate consumer demand and trends in consumer preferences, our brands, sales and customer relationships may be harmed.
Demand for our consumer focused language-learning software products and related services is subject to rapidly changing consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:
identify, anticipate, understand and respond to these trends in a timely manner;
introduce appealing new products and performance features on a timely basis;
provide appealing solutions that engage our customers;
adapt and offer our products and services using rapidly evolving, widely varying and complex technologies;
anticipate and meet consumer demand for additional languages, learning levels and new platforms for delivery;
effectively position and market our products and services;
identify and secure cost-effective means of marketing our products to reach the appropriate consumers;
identify cost-effective sales distribution channels and other sales outlets where interested consumers will buy our products;
anticipate and respond to consumer price sensitivity and pricing changes of competitive products; and
identify and successfully implement ways of building brand loyalty and reputation.
We anticipate having to make investments in new products in the future and we may incur significant expenses without achieving the anticipated benefits of our investment or preserving our brand and reputation. Investments in new products and technology are speculative, the development cycle for products may exceed planned estimates and commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. Customers might not perceive our latest offerings as providing significant new value and may reduce their purchases of our offerings, unfavorably impacting revenue. We might not achieve significant revenue from new product and service investments for a number of years, if at all. We also might not be able to develop new solutions or enhancements in time to capture business opportunities or achieve sustainable acceptance in new or existing marketplaces. Furthermore, consumers may defer purchases of our solutions in anticipation of new products or new versions from us or our competitors. A decline in consumer demand for our solutions, or any failure on our part to satisfy such changing consumer preferences, could harm our business and profitability.
If the recognition by schools and other organizations of the value of technology-based education does not continue to grow, our ability to generate revenue from organizations could be impaired.
Our success depends in part upon the continued adoption by organizations and potential customers of technology-based education initiatives. Some academics and educators oppose online education in principle and have expressed concerns regarding the perceived loss of control over the education process that could result from offering courses online. If the acceptance of technology-based education does not continue to grow, our ability to continue to grow our Enterprise & Education Language business could be impaired.

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We depend on discretionary consumer spending in the Consumer segment of our business. Adverse trends in general economic conditions, including retail and online shopping patterns or consumer confidence, as well as other external consumer dynamics may compromise our ability to generate revenue.
The success of our business depends to a significant extent upon discretionary consumer spending, which is subject to a number of factors, including general economic conditions, consumer confidence, employment levels, business conditions, interest rates, availability of credit, inflation, and taxation. Adverse trends in any of these economic indicators may cause consumer spending to decline, which could adversely affect our sales and profitability.
Because a significant portion of our Consumer sales are made to or through retailers and distributors, none of which has any obligation to sell our products, the failure or inability of these parties to sell our products effectively could reduce our revenue and profitability.
We rely on retailers and distributors, together with our direct sales force, to sell our products. Our sales to retailers and distributors are concentrated on a key group that is comprised of a mix of websites, such as Amazon.com and the Apple App Store, select retail resellers such as Barnes & Noble, Best Buy, Target, Books-a-Million, Staples, and Sam's Club, and consignment distributors such as Wynit Distribution and Software Packaging Associates.
We have no control over the quantity of products that these retailers and distributors purchase from us or sell on our behalf, we do not have long-term contracts with any of them, and they have no obligation to offer or sell our products or to give us any particular shelf space or product placement within their stores. Thus, there is no guarantee that this source of revenue will continue at the same level as it has in the past or that these retailers and distributors will not promote competitors' products over our products or enter into exclusive relationships with our competitors. Any material adverse change in the principal commercial terms, material decrease in the volume of sales generated by our larger retailers or distributors or major disruption or termination of a relationship with these retailers and distributors could result in a significant decline in our revenue and profitability. Furthermore, product display locations and promotional activities that retailers undertake can affect the sales of our products. The fact that we also sell our products directly could cause retailers or distributors to reduce their efforts to promote our products or stop selling our products altogether.
Many traditional physical retailers are experiencing diminished foot traffic and sales. For our retail business, even though online sales have increased in popularity and are growing in importance, we continue to depend on sales that take place in physical stores and shopping malls. Reduced customer foot traffic in these stores and malls is likely to reduce their sales of our products. In addition, if one or more of these retailers or distributors are unable to meet their obligations with respect to accounts payable to us, we could be forced to write off accounts receivable with such accounts. Any bankruptcy, liquidation, insolvency or other failure of any of these retailers or distributors could result in significant financial loss and cause us to lose revenue in future periods.
Price changes and other concessions could reduce our revenue.
We continue to test and offer changes to the pricing of our products. If we reduce our prices in an effort to increase our sales, this could have an adverse impact on our revenue to the extent that unit sales do not increase in a sufficient amount to compensate for the lower pricing. Reducing our pricing to individual consumers could also cause us to have to lower pricing to our Enterprise & Education Language customers. Any increase in the taxation of online sales could have the effect of a price increase to consumers and could cause us to have to lower our prices or could cause sales to decline. It is uncertain whether we will need to lower prices to effectively compete and what other short-term or long-term impacts could be.
We also may provide our retailers and distributors with price protection on existing inventories, which would entitle these retailers and distributors to credit against amounts owed with respect to unsold packaged product under certain conditions. These price protection reserves could be material in future periods.
In the U.S. and Canada, we offer consumers who purchase our packaged software and audio practice products directly from us a 30-day, unconditional, full money-back refund. We also permit some of our retailers and distributors to return packaged products, subject to certain limitations. We establish revenue reserves for packaged product returns based on historical experience, estimated channel inventory levels, the timing of new product introductions and other factors. If packaged product returns exceed our reserve estimates, the excess would offset reported revenue, which could adversely affect our reported financial results.
Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing.
Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing, including our ability to:
appropriately and efficiently allocate our marketing for multiple products;

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accurately identify, target and reach our audience of potential customers with our marketing messages;
select the right marketplace, media and specific media vehicle in which to advertise;
identify the most effective and efficient level of spending in each marketplace, media and specific media vehicle;
determine the appropriate creative message and media mix for advertising, marketing and promotional expenditures;
effectively manage marketing costs, including creative and media expenses, in order to maintain acceptable customer acquisition costs;
differentiate our products as compared to other products;
create greater awareness of our new products our brands and learning solutions;
drive traffic to our e-commerce website, call centers, distribution channels and retail partners; and
convert customer inquiries into actual orders.
Our planned marketing may not result in increased revenue or generate sufficient levels of product and brand name awareness, and we may not be able to increase our net sales at the same rate as we increase our advertising expenditures.
Some of our radio, television, print, and online advertising has been through the purchase of "remnant" advertising segments. These segments are random time slots and publication dates that have remained unsold and are offered at discounts to advertisers who are willing to be flexible with respect to time slots. There is a limited supply of this type of advertising and the availability of such advertising may decline or the cost of such advertising may increase. In addition, if we increase our marketing budget it cannot be assured that we can increase the amount of remnant advertising at the discounted prices we have obtained in the past. If any of these events occur, we may purchase time slots and publication dates at higher prices, which would increase our costs.
We engage in an active public relations program, including through social media sites such as Facebook and Twitter. We also seek new customers through our online marketing efforts, including paid search listings, banner ads, text links and permission-based e-mails, as well as our affiliate and reseller programs. If one or more of the search engines or other online sources on which we rely for website traffic were to modify their general methodology for how they display our websites, resulting in fewer consumers clicking through to our websites, our sales could suffer. If any free search engine on which we rely begins charging fees for listing or placement, or if one or more of the search engines or other online sources on which we rely for purchased listings, modifies or terminates its relationship with us, our expenses could rise, we could lose customers and traffic to our websites could decrease.
We dynamically adjust our mix of marketing programs to acquire new customers at a reasonable cost with the intention of achieving overall financial goals. If we are unable to maintain or replace our sources of customers with similarly effective sources, or if the cost of our existing sources increases, our customer levels and marketing expenses may be adversely affected.
Our international businesses may not succeed and impose additional and unique risks.
Our business strategy contemplates stabilizing and reducing the losses we have experienced internationally. In March 2016, as part of the 2016 Restructuring Plan, we initiated actions to withdraw our direct sales presence in almost all of our non-U.S. and non-northern European geographies related to the distribution of the Enterprise & Education Language offerings. These operations added sales, but at too high a cost and without the near-term ability to capture scale efficiencies. We continuously review and optimize certain of our website sales channels in Europe, Asia and Latin America. In addition, we continue to optimize our indirect sales channels in Europe, Asia and Latin America through reseller and other arrangements with third parties. If we are unable to stabilize and reduce losses in our international operations successfully and in a timely manner, our business, revenue and financial results could be harmed. Such stabilization and reduction may be more difficult or take longer than we anticipate, and we may not be able to successfully market, sell, deliver and support our products and services internationally to the extent we expect.
If we are unable to continually adapt our products and services to mobile devices and technologies other than personal computers and laptops, and to adapt to other technological changes and customer needs generally, we may be unable to attract and retain customers, and our revenue and business could suffer.
We need to anticipate, develop and introduce new products, services and applications on a timely and cost-effective basis that keeps pace with technological developments and changing customer needs. The process of developing new high technology products, services and applications and enhancing existing products, services and applications is complex, costly and uncertain, and any failure by us to anticipate customers' changing needs and emerging technological trends accurately

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could significantly harm our ability to attract and retain customers and our results of operations. For example, the number of individuals who access the Internet through devices other than a personal computer, such as tablet computers, mobile devices, televisions and set-top box devices, has increased dramatically and this trend is likely to continue. Our products and services may not work or be viewable on these devices because each manufacturer or distributor may establish unique technical standards for such devices. Accordingly, we may need to devote significant resources to the creation, support and maintenance of such versions. If we fail to develop or sell products and services on a cost-effective basis that respond to these or other technological developments and changing customer needs, we may be harmed in our ability to attract and retain customers, and our revenue and business could suffer. Furthermore, our customers who view our advertising via mobile devices might not buy our products to the same extent that they do when viewing our advertising via personal computers or laptops. Accordingly, if we cannot convince customers to purchase our products via mobile devices, our business and results of operations could be harmed to the extent that the trend to mobile devices continues.
We offer our software products on operating systems and platforms including Windows, Macintosh, Apple OS, Android, and Amazon apps. The demand for traditional desktop computers has been declining, while the demand for mobile devices such as notebook computers, smartphones and tablets has been increasing, which means that we must be able to market to potential customers and to provide customers with access to and use of our products and services on many platforms and operating systems, as they may be changed from time to time. To the extent new releases of operating systems, including for mobile and non-PC devices, or other third-party products, platforms or devices make it more difficult for our products to perform, and our customers use alternative technologies, our business could be harmed.
Our software products must interoperate with computer operating systems of our customers. If we are unable to ensure that our products interoperate properly with customer systems, our business could be harmed.
Our products must interoperate with our customers' computer systems, including the network, security devices and settings, and student learning management systems of our Enterprise & Education Language and Literacy customers. As a result, we must continually ensure that our products interoperate properly with these varied and customized systems. Changes in operating systems, the technologies we incorporate into our products or the computer systems our customers use may damage our business.
Our products and internal systems rely on software that is highly technical and maintained by third parties and if such third-party software contains undetected errors or vulnerabilities or if it not supported or updated to keep pace with current computer hardware, our business could be adversely affected.
Our products and internal systems rely on software, including software developed or maintained internally and/or by third parties, that is highly technical and complex. In addition, our products and internal systems depend on the ability of such software to store, retrieve, process, and manage immense amounts of data. Such software has contained, and may now or in the future contain, undetected errors, bugs, or vulnerabilities. Some errors may only be discovered after the code has been released for external or internal use. Errors, vulnerabilities, or other design defects within the software on which we rely may result in a negative experience for users and marketers who use our products, delay product introductions or enhancements, result in measurement or billing errors, compromise our ability to protect the data of our users and/or our intellectual property or lead to reductions in our ability to provide some or all of our services.
For example, we rely on Adobe Flash as a platform for our software. Adobe Flash is one of the most versatile programming systems available and is unique in its ability to allow the integration of many forms of electronic formatted media into an interactive and user friendly system. However, in July 2015, certain vulnerabilities discovered in Adobe Flash led to temporary interruption of support for Adobe Flash by popular web browsers. As a result, some software makers are opting to exclude Adobe Flash from their web browsers. If similar interruptions occur in the future and disrupt our ability to provide our products to some or all of our users, our ability to generate revenue would be harmed. Additionally, if Adobe Flash were to become deleted from Adobe’s product line or become not supported or updated to keep pace with current computer hardware, then our software products would become obsolete very quickly. Any errors, bugs, vulnerabilities, or defects discovered in the software on which we rely, and any associated degradations or interruptions of service, could result in damage to our reputation, loss of users, loss of revenue, or liability for damages, any of which could adversely affect our business and financial results.
If there are changes in the spending policies or budget priorities for government funding of colleges, universities, schools, other education providers, or government agencies, we could lose revenue.
Many of our Enterprise & Education Language or Literacy customers are colleges, universities, primary and secondary schools and school districts, other education providers, armed forces and government agencies that depend substantially on government funding. Accordingly, any general decrease, delay or change in federal, state or local funding for colleges, universities, primary and secondary schools and school districts, or other education providers or government agencies that use

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our products and services could cause our current and potential customers to reduce their purchases of our products and services, to exercise their right to terminate licenses, or to decide not to renew licenses, any of which could cause us to lose revenue. In addition, a specific reduction in governmental funding support for products such as ours would also cause us to lose revenue and could adversely affect our overall gross margins.
Some of our Enterprise & Education Language and Literacy business is characterized by a lengthy and unpredictable sales cycle, which could delay new sales.
We face a lengthy sales cycle between our initial contact with some potential Enterprise & Education Language and Literacy customers and the signing of license agreements with these customers. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of such Enterprise & Education Language and Literacy sales. A delay in or failure to complete license transactions could cause us to lose revenue, and could cause our financial results to vary significantly from quarter to quarter. Our sales cycle varies widely, reflecting differences in our potential Enterprise & Education Language and Literacy customers' decision-making processes, procurement requirements and budget cycles, and is subject to significant risks over which we have little or no control, including:
customers' budgetary constraints and priorities;
the timing of our customers' budget cycles;
the need by some customers for lengthy evaluations that often include administrators and faculties; and
the length and timing of customers' approval processes.
As we pursue a 100% SaaS-based model for our Consumer business and sell our solutions as subscriptions, rather than packaged software, our revenue, results of operations and cash flow could be negatively impacted.
Historically, we have predominantly sold our packaged software programs under a perpetual license for a single upfront fee and recognized 65-90% of the revenue at the time of sale. Certain of our online products are sold under different subscription terms, from short-term (less than one year) to long-term (typically 36-months) subscriptions with a corresponding license term. Typically, long-term subscriptions include substantially higher discounts, resulting in less cash and revenue from the initial sale to the customer and selling a higher proportion of long-term subscriptions could have a substantially negative impact on our revenue, results of operations and cash flow in any quarterly reporting period. Furthermore, to the extent that customers use our products and services for only a short time after purchase, online subscription customers could be less likely to renew their subscriptions beyond the initial term with the effect that we could earn less revenue over time from each customer than historically.
Our revenue is subject to seasonal and quarterly variations, which could cause our financial results to fluctuate significantly.
We have experienced, and we believe we will continue to experience, substantial seasonal and quarterly variations in our revenue, cash flows and net income. These variations are primarily related to increased sales of our Consumer products and services in the fourth quarter, especially during the holiday selling season, as well as higher sales to governmental, educational institutions, and corporations in the second half of the calendar year. We sell to a significant number of our retailers, distributors and Enterprise & Education Language customers on a purchase order basis and we receive orders when these customers need products and services. As a result, their orders are typically not evenly distributed throughout the year. Our quarterly results of operations also may fluctuate significantly as a result of a variety of other factors, including the timing of holidays and advertising initiatives, changes in our products, services and advertising initiatives and changes in those of our competitors. Budgetary constraints of our Enterprise & Education Language and Literacy customers may also cause our quarterly results to fluctuate.
As a result of these seasonal and quarterly fluctuations, we believe that comparisons of our results of operations between different quarters are not necessarily meaningful and that these comparisons are not reliable as indicators of our future performance. In addition, these fluctuations could result in volatility and adversely affect our cash flows. Any seasonal or quarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors, which could cause the price of our common stock to fluctuate significantly.
Acquisitions, joint ventures and strategic alliances may have an adverse effect on our business.
We have made and may continue to make acquisitions or enter into joint ventures and strategic alliances as part of our long-term business strategy. Such transactions may result in use of our cash resources, dilutive issuances of our equity securities, or incurrence of debt. Such transactions also involve significant challenges and risks including that the transaction does not advance our business strategy, that we do not realize a satisfactory return on our investment, that we experience

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difficulty integrating new technology, employees, and business systems, that we divert management's attention from our other businesses or that we acquire undiscovered liabilities such as patent infringement claims or violations of the U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws. It may take longer than expected to realize the full benefits, such as increased revenue, enhanced efficiencies, or more customers, or those benefits may ultimately be smaller than anticipated, or may not be realized. These events and circumstances could harm our operating results or financial condition.
Our possession and use of personal information presents risks and expenses that could harm our business. If we are unable to protect our information technology network against service interruption or failure, misappropriation or unauthorized disclosure or manipulation of data, whether through breach of our network security or otherwise, we could be subject to costly government enforcement actions and litigation and our reputation may be damaged.
Our business involves the collection, storage and transmission of personal, financial or other information that is entrusted to us by our customers and employees. Our information systems also contain the Company's proprietary and other confidential information related to our business. Our efforts to protect such information may be unsuccessful due to the actions of third parties, computer viruses, physical or electronic break-ins, catastrophic events, employee error or malfeasance or other attempts to harm our systems. Possession and use of personal information in conducting our business subjects us to legislative and regulatory obligations that could require notification of data breaches, restrict our use of personal information, and hinder our ability to acquire new customers or market to existing customers. Some of our commercial partners may receive or store information provided by us or our users through our websites. If these third parties fail to adopt or adhere to adequate information security practices, or fail to comply with our online policies, or in the event of a breach of their networks, our customers' data may be improperly accessed, used or disclosed. As our business and the regulatory environment evolve in the U.S. and internationally, we may become subject to additional and even more stringent legal obligations concerning our treatment of customer information. We have incurred, and will continue to incur, expenses to comply with privacy and security standards and protocols imposed by law, regulation, industry standards or contractual obligations.
Despite our precautions and significant ongoing investments to protect against security risks, data protection breaches, cyber-attacks and other intentional disruptions of our products and offerings, we may be a target of attacks specifically designed to impede the performance of our products and offerings and harm our reputation as a company. If our systems are harmed or fail to function properly or if third parties improperly obtain and use the personal information of our customers or employees, we may be required to expend significant resources to repair or replace systems or to otherwise protect against security breaches or to address problems caused by the breaches. A major breach of our network security and systems could have serious negative consequences for our businesses, including possible fines, penalties and damages, reduced customer demand for our products and services, harm to our reputation and brand, and loss of our ability to accept and process customer credit card orders. Any such access, disclosure or other loss of information could result in legal claims or proceedings and regulatory penalties, disrupt our operations and result in a loss of confidence in our products and services, which could lead to a material and adverse effect on our business, reputation or financial results.
We may incur significant costs related to maintaining data security and in the event of any data security breaches that could compromise our information technology network security, trade secrets and customer data.
        The secure processing, maintenance and transmission of personal, financial or other information that is entrusted to us by our customers is critical to our operations and business strategy, and we devote significant resources to protecting such information. The expenses associated with protecting such information could reduce our operating margins. Additionally, threats to our information technology network security can take a variety of forms. Individual hackers and groups of hackers, and sophisticated organizations or individuals may threaten our information technology network security. Cyber attackers may develop and deploy malicious software to attack our services and gain access to our networks or data centers, hold access to critical systems or information for ransom, or act in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats and attacks are constantly evolving, thereby increasing the difficulty of detecting and successfully implementing measures to defend against them. We may be unable to anticipate potential techniques or implement adequate preventative measures in time. Cyber threats and attacks can have cascading impacts that unfold with increasing speed across internal networks and systems. Breaches of our network, credit card processing information, or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, cause product development delays, compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property or other assets, expose us to contractual or regulatory audit or investigation, require us to allocate additional resources to alternative and potentially more costly technologies more frequently than anticipated, or otherwise adversely affect our business. We maintain cyber risk insurance, but our policy coverage limits may not be sufficient to cover all of our losses caused by any future information security-related breaches or events.

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Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy and data protection. Changes in regulations or customer concerns regarding privacy and protection of customer data, or any failure to comply with such laws, could adversely affect our business.
Federal, state, and international laws and regulations govern the collection, use, retention, disclosure, sharing and security of data that we receive from and about our customers. The use of consumer data by online service providers and advertising networks is a topic of active interest among federal, state, and international regulatory bodies, and the regulatory environment is unsettled and rapidly evolving. Many states have passed new laws impacting required notifications to customers and/or state agencies where there is a security breach involving personal data, such as California’s Information Practices Act.
We also face similar risks in international markets where our products, services and apps are offered. Foreign data protection, privacy, competition, and other laws and regulations can impose different obligations or be more restrictive than those in the United States. We are subject to international laws and regulations that dictate whether, how, and under what circumstances we can transfer, process and/or receive transnational data that is critical to our operations and ability to provision our products and perform services for our customers, including data relating to users, customers, or partners outside the United States, and those laws and regulations are uncertain and subject to change.
Recent legal developments in Europe have created complexity and compliance uncertainty regarding certain transfers of information from Europe to the U.S. For example, in October 2015, the European Court of Justice invalidated the 2000 US-EU Safe Harbor program as a legitimate and legally authorized basis on which U.S. companies, including Rosetta Stone, could rely for the transfer of personal data from the European Union to the United States. The European Union and United States recently agreed to an alternative transfer framework for data transferred from the European Union to the United States, called the Privacy Shield Framework. Rosetta Stone participates and has certified to its compliance to the Privacy Shield Framework. However, this new framework also faces a number of legal challenges, is subject to an annual review that could result in changes to our obligations, and also may be challenged by national regulators or private parties. In addition, other available bases on which to rely for the transfer of EU personal data outside of the European Economic Area, such as standard Model Contractual Clauses (MCCs), have also been subjected to regulatory or judicial scrutiny. This has resulted in some uncertainty, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business.
If one or more of the legal bases for transferring personal data from Europe to the United States is invalidated, or if we are unable to transfer personal data between and among countries and regions in which Rosetta Stone operates, it could affect the manner in which we provide our services or adversely affect our financial results. Any failure, or perceived failure, by us to comply with or make effective modifications to our policies, or to comply with any federal, state, or international privacy, data-retention or data-protection-related laws, regulations, orders or industry self-regulatory principles could result in proceedings or actions against us by governmental entities or others, a loss of customer confidence, damage to the Rosetta Stone brands, and a loss of customers, which could potentially have an adverse effect on our business. In addition, various federal, state and foreign legislative or regulatory bodies may enact new or additional laws and regulations concerning privacy, data-retention and data-protection issues, including laws or regulations mandating disclosure to domestic or international law enforcement bodies, which could adversely impact our business, our brand or our reputation with customers. For example, some countries are considering laws mandating that personal data regarding customers in their country be maintained solely in their country. Having to maintain local data centers and redesign product, service and business operations to limit personal data processing to within individual countries could increase our operating costs significantly. In addition, the European Commission has approved a data protection regulation, known as the General Data Protection Regulation (GDPR), which has been finalized and is due to come into force in or around May 2018. The GDPR will include additional operational and other requirements for companies that receive or process personal data of residents of the European Union that are different than those currently in place in the European Union, and that will include significant penalties for non-compliance. 
The interpretation and application of privacy, data protection and data retention laws and regulations are often uncertain and in flux in the U.S. and internationally. Complying with these varying international requirements could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business and operating results. In addition, these laws may be interpreted and applied inconsistently from country to country and inconsistently with our current policies and practices, complicating long-range business planning decisions. If privacy, data protection or data retention laws are interpreted and applied in a manner that is inconsistent with our current policies and practices we may be deemed non-compliant, subject to legal or regulatory process, fined or ordered to change our business practices in a manner that could cause use to incur substantial costs, or that adversely impacts our business or operating results.

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We are subject to U.S. and foreign government regulation of online services which could subject us to claims, judgments, and remedies, including monetary liabilities and limitations on our business practices.
We are subject to regulations and laws directly applicable to providers of online services. The application of existing domestic and international laws and regulations to us relating to issues such as user privacy and data protection, data security, defamation, promotions, billing, consumer protection, accessibility, content regulation, quality of services, and intellectual property ownership and infringement in many instances is unclear or unsettled. Also, the collection and protection of information from children under the age of 13 is subject to the provisions of the Children's Online Privacy Protection Act (COPPA), which is particularly relevant to our learning solutions focused on children. In addition, we will also be subject to any new laws and regulations directly applicable to our domestic and international activities. Internationally, we may also be subject to laws regulating our activities in foreign countries and to foreign laws and regulations that are inconsistent from country to country. We may incur substantial liabilities for expenses necessary to defend litigation in connection with such regulations and laws or to comply with these laws and regulations, as well as potential substantial penalties for any failure to comply.
Changes in how network operators handle and charge for access to data that travel across their networks could adversely impact our business.
We rely upon the ability of customers to access many of our products through the Internet. To the extent that network operators implement usage based pricing, including meaningful bandwidth caps, or otherwise try to monetize access to their networks by data providers, we could incur greater operating expenses and our customer acquisition and retention could be negatively impacted. Furthermore, to the extent network operators were to create tiers of Internet access service and either charge us for or prohibit us from being available through these tiers, our business could be negatively impacted.
We are exposed to risks associated with credit card and payment fraud, and with our obligations under rules on credit card processing and alternative payment methods, which could cause us to lose revenue or incur costs. We depend upon our credit card processors and payment card associations.
As an e-commerce provider that accepts debit and credit cards for payment, we are subject to the Payment Card Industry Data Security Standard ("PCI DSS"), issued by the PCI Council. PCI DSS contains compliance guidelines and standards with regard to our network security surrounding the physical and electronic storage, processing and transmission of individual cardholder data. Despite our compliance with these standards and other information security measures, we cannot guarantee that all our information technology systems are able to prevent, contain or detect any cyber attacks, cyber terrorism, or security breaches from currently known viruses or malware, or viruses or malware that may be developed in the future. To the extent any disruption results in the loss, damage or misappropriation of information, we may be adversely affected by claims from customers, financial institutions, regulatory authorities, payment card associations and others. In addition, the cost of complying with stricter privacy and information security laws and standards could be significant.
We are subject to rules, regulations and practices governing our accepted payment methods which could change or be reinterpreted to make it difficult or impossible for us to comply. A failure to comply with these rules or requirements could make us subject to fines and higher transaction fees and we could lose our ability to accept these payment methods. We depend upon our credit card processors to carry out our sales transactions and remit the proceeds to us. At any time, credit card processors have the right to withhold funds otherwise payable to us to establish or increase a reserve based on their assessment of the inherent risks of credit card processing and their assessment of the risks of processing our customers’ credit cards. If our credit card processors exercise their right to establish or increase a reserve, it may adversely impact our liquidity. Our business and results of operations could be adversely affected if these changes were to occur.
The uncertainty surrounding the terms of the United Kingdom's withdrawal from the European Union and its consequences could cause disruptions and create uncertainty to our businesses and adversely impact consumer and investor confidence in our products and services.
In June 2016, a majority of voters in the United Kingdom elected to withdraw from the European Union in a national referendum (also referred to as "Brexit"). The referendum was advisory, and by the terms of the Treaty on European Union, any withdrawal is subject to a negotiation period that could last at least two years after the government of the United Kingdom formally initiates the withdrawal process. The ultimate effects of Brexit on us are difficult to predict, but because we currently conduct business in the United Kingdom and in Europe, the results of the referendum and any eventual withdrawal could cause disruptions and create uncertainty to our businesses, including affecting the business of and/or our relationships with our customers and suppliers, as well as altering the relationship among tariffs and currencies, including the value of the British pound and the Euro relative to the U.S. dollar. Such disruptions and uncertainties could adversely affect our financial condition, operating results, and cash flows. Additionally, Brexit could result in legal uncertainty and potentially divergent national laws and regulations as new legal relationships between the United Kingdom and the European Union are established. The ultimate

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effects of Brexit on us will also depend on the terms of any agreements the United Kingdom and the European Union make to retain access to each other's respective markets either during a transitional period or more permanently. Any of these effects, among others, could materially adversely affect our business, business opportunities, results of operations, and financial condition.
Uncertainty in the global geopolitical landscape from recent events may impede the implementation of our strategy outside the United States.
There may be uncertainty as to the position the United States will take with respect to world affairs and events following the 2016 U.S. presidential election and related change in political agenda, coupled with the transition of administrations. This uncertainty may include such issues as U.S. support for existing treaty and trade relationships with other countries. This uncertainty, together with other key global events during 2016 (such as the continuing uncertainty arising from the Brexit referendum in the United Kingdom as well as ongoing terrorist activity), may adversely impact (i) the ability or willingness of non-U.S. companies to transact business in the United States, including with the Company (ii) regulation and trade agreements affecting U.S. companies, (iii) global stock markets (including the New York Stock Exchange on which our common stock is traded), and (iv) general global economic conditions. All of these factors are outside of our control, but may nonetheless cause us to adjust our strategy in order to compete effectively in global markets.
Any significant interruptions in the operations of our website, call center or third-party call centers, especially during the holiday shopping season, could cause us to lose sales and disrupt our ability to process orders and deliver our solutions in a timely manner.
We rely on our website, an in-house call center and third-party call centers, over which we have little or no control, to sell our solutions, respond to customer service and technical support requests and process orders. These activities are especially important during the holiday season and in particular the period beginning on Black Friday through the end of the calendar year. Any significant interruption in the operation of these facilities, including an interruption caused by our failure to successfully expand or upgrade our systems or to manage these expansions or upgrades, or a failure of third-party call centers to handle higher volumes of use, could reduce our ability to receive and process orders and provide products and services, which could result in cancelled sales and loss of revenue and damage to our brand and reputation. These risks are more important during the holiday season, when many sales of our products and services take place.
We structure our marketing and advertising to drive potential customers to our website and call centers to purchase our solutions. If we experience technical difficulties with our website or if our call center operators do not convert inquiries into sales at expected rates, our ability to generate revenue could be impaired. Training and retaining qualified call center operators is challenging due to the expansion of our product and service offerings and the seasonality of our business. If we do not adequately train our call center operators, they may not convert inquiries into sales at an acceptable rate.
If any of our products or services contain defects or errors or if new product releases or services are delayed, our reputation could be harmed, resulting in significant costs to us and impairing our ability to sell our solutions.
If our products or services contain defects, errors or security vulnerabilities, our reputation could be harmed, which could result in significant costs to us and impair our ability to sell our products in the future. In the past, we have encountered product development delays due to errors or defects. We would expect that, despite our testing, errors could be found in new products and product enhancements in the future. Significant errors in our products or services could lead to, among other things:
delays in or loss of marketplace acceptance of our products and services;
diversion of our resources;
a lower rate of license renewals or upgrades for Consumer, Literacy and Enterprise & Education Language customers;
injury to our reputation;
increased service expenses or payment of damages; or
costly litigation.
If we fail to effectively upgrade our information technology systems, we may not be able to accurately report our financial results or prevent fraud.
As part of our efforts to continue improving our internal control over financial reporting, we plan to continue to upgrade our existing financial information technology systems in order to automate several controls that are currently performed manually. We may experience difficulties in transitioning to these upgraded systems, including loss of data and decreases in productivity, as personnel become familiar with these new systems. In addition, our management information systems will

18


require modification and refinement as our business needs change, which could prolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If we experience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management information systems or respond to changes in our business needs, we may not be able to effectively manage our business and we may fail to meet our reporting obligations. In addition, as a result of the automation of these manual processes, the data produced may cause us to question the accuracy of previously reported financial results.
Failure to maintain the availability of the systems, networks, databases and software required to operate and deliver our Internet-based products and services could damage our reputation and cause us to lose revenue.
We rely on internal and external systems, networks and databases maintained by us and third-party providers to process customer orders, handle customer service requests, and host and deliver our Internet-based learning solutions. Any damage, interruption or failure of our systems, networks and databases could prevent us from processing customer orders and result in degradation or interruptions in delivery of our products and services. Notwithstanding our efforts to protect against interruptions in the availability of our e-commerce websites and Internet-based products and services, we do occasionally experience unplanned outages or technical difficulties. In addition, we do not have complete redundancy for all of our systems. In the event of an interruption or system event we may be unable to meet contract service level requirements, or we could experience an unrecoverable loss of data which could cause us to lose customers and could harm our reputation and cause us to face unexpected liabilities and expenses. If we continue to expand our business, we will put additional strains on these systems. As we continue to move additional product features to online systems or place more of our business online, all of these considerations will become more significant.
We may also need to grow, reconfigure or relocate our data centers in response to changing business needs, which may be costly and lead to unplanned disruptions of service.
We may incur losses associated with currency fluctuations and may not be able to effectively hedge our exposure, which could impair our financial performance.
Our operating results are subject to fluctuations in foreign currency exchange rates. We currently do not attempt to mitigate a portion of these risks through foreign currency hedging, based on our judgment of the appropriate trade-offs among risk, opportunity and expense. In the future, we might choose to engage in foreign currency hedging transactions, which would involve different risks and uncertainties.
Our revolving credit facility contains borrowing limitations and other restrictive covenants and the failure to maintain a sufficient borrowing base or to comply with such covenants could prevent us from borrowing funds, and could cause any outstanding debt to become immediately payable, which might adversely impact our business. 
Our revolving credit facility contains borrowing limitations based on a combination of our cash balance and eligible accounts receivable balances and financial covenants currently applicable to us, as well as a number of restrictive covenants, including restrictions on incurring additional debt, making investments and other restricted payments, selling assets, paying dividends and redeeming or repurchasing capital stock and debt, subject to certain exceptions. Collectively, these borrowing limitations and covenants could constrain our ability to grow our business through acquisition or engage in other transactions. During the term of our $25.0 million revolving credit facility, we are also subject to certain financial covenants that require us to maintain a minimum liquidity amount and minimum financial performance requirements, as defined in the credit agreement. If we are not able to comply with all of these covenants, for any reason, we would not be able to borrow funds under the facility, and some or all of any outstanding debt could become immediately due and payable which could have a material adverse effect on our liquidity and ability to conduct our business.
A significant deterioration in our profitability and/or cash flow caused by prolonged economic instability could reduce our liquidity and/or impair our financial ratios, and trigger a need to raise additional funds from the capital markets and/or renegotiate our banking covenants.
To the extent economic difficulties continue, our revenue, profitability and cash flows could be significantly reduced. A liquidity shortfall may delay certain development initiatives or may expose us to a need to negotiate further funding. While we anticipate that our existing cash and cash equivalents, together with availability under our existing revolving credit facility, cash balances and cash from operations, will be sufficient to fund our operations for at least the next 12 months, we may need to raise additional capital to fund operations in the future or to finance acquisitions. If we seek to raise additional capital in order to meet various objectives, including developing future technologies and services, increasing working capital, acquiring businesses and responding to competitive pressures, capital may not be available on favorable terms or may not be available at all. A lack of sufficient capital resources could significantly limit our ability to take advantage of business and strategic opportunities. Any additional capital raised through the sale of equity securities would dilute our stock ownership. If adequate

19


additional funds are not available, we may be required to delay, reduce the scope of, or eliminate material parts of our business strategy, including potential additional acquisitions or development of new products, services and technologies.
We might require additional funds from what we internally generate to support our business which might not be available on acceptable terms or at all.
We might need to further reduce costs or raise additional funds through public or private financings or borrowings in order to maintain our operations at their current level, develop or enhance products, fund expansion, respond to competitive pressures or to acquire complementary products, businesses or technologies. If required, additional financing might not be available on terms that are favorable to us, if at all. If we raise additional funds through the issuance of debt, equity or convertible debt securities, these securities might have rights, preferences and privileges senior to those of our current stockholders.
If our goodwill or indefinite-lived intangible assets become impaired, we may be required to record a significant non-cash charge to earnings.
Under accounting principles generally accepted in the U.S. ("GAAP"), we review our goodwill and indefinite lived intangible assets for impairment at least annually and when there are changes in circumstances. Factors that may be considered a change in circumstances include a decline in stock price and market capitalization, expected future cash flows and slower growth rates in our industry. We may be required to record significant charges to earnings in our financial statements during the period in which any impairment of our goodwill or indefinite lived intangible assets is determined, resulting in a negative effect on our results of operations.
We may have exposure to greater than anticipated tax liabilities.
We are subject to income and indirect tax in the U.S. and many foreign jurisdictions. The application of indirect taxes (such as sales and use tax, value-added tax, goods and services tax, business tax and gross receipt tax) to our businesses and to our users is complex, uncertain and evolving, in part because many of the fundamental statutes and regulations that impose indirect taxes were established before the adoption and growth of the Internet and e-commerce.  We are subject to audit by multiple tax authorities throughout the world.  Although we believe our tax estimates are reasonable and accurate, the final determination of tax audits and any related litigation could be materially different from our historical tax provisions and accruals.  The results of an audit or litigation could have a material adverse effect on our financial statements in the period or periods for which that determination is made. 
In addition, the United States government and other governments are considering and may adopt tax reform measures that could impact future effective tax rates favorably or unfavorably affected by changes in tax rates, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws or their interpretation. Such changes could have a material adverse impact on our financial results. Further, any changes to the U.S. or any foreign jurisdictions’ tax laws, tax rates, or the interpretation of such tax laws, including the Base Erosion Profit Shifting project being conducted by the Organization for Economic Co-operation and Development could significantly impact how U.S. multinational corporations are taxed. Although we cannot predict whether or in what form any legislation changes may pass, if enacted it could have a material adverse impact on our tax expense, deferred tax assets and cash flows.
Our deferred tax assets may not be fully realizable.
We record tax valuation allowances to reflect uncertainties about whether we will be able to realize some of our deferred tax assets before they expire. Our tax valuation allowance is based on our estimates of taxable income for the jurisdictions in which we operate and the period over which our deferred tax assets will be realizable. In the future, we could be required to increase the valuation allowance to take into account additional deferred tax assets that we may be unable to realize. An increase in the valuation allowance would have an adverse impact, which could be material, on our income tax provision and net income in the period in which we record the increase.
Protection of our intellectual property is limited, and any misuse of our intellectual property by others, including software piracy, could harm our business, reputation and competitive position.
Our intellectual property is important to our success. We believe our trademarks, copyrights, trade secrets, patents, pending patent applications, trade dress and designs are valuable and integral to our success and competitive position. To protect our proprietary rights, we rely on a combination of patents, copyrights, trademarks, trade dress, trade secret laws, confidentiality procedures, contractual provisions and technical measures. However, even if we are able to secure such rights in the United States, the laws of other countries in which our products are sold may not protect our intellectual property rights to the same extent as the laws of the United States.

20


In addition to issued patents, we have several patent applications on file in the U.S. and other countries. However, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. Even if patents are issued from our patent applications, which are not certain, they may be challenged, circumvented or invalidated in the future. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as with any technology, competitors may be able to develop similar or superior technologies now or in the future. In addition, we have not emphasized patents as a source of significant competitive advantage and have instead sought to primarily protect our proprietary rights under laws affording protection for trade secrets, copyright and trademark protection of our products, brands, and other intellectual property where available and appropriate. These measures afford only limited protection and may be challenged, invalidated or circumvented by third parties. In addition, these protections may not be adequate to prevent our competitors or customers from copying or reverse-engineering our products. Third parties could copy all or portions of our products or otherwise obtain, use, distribute and sell our proprietary information without authorization. Third parties may also develop similar or superior technology independently by designing around our intellectual property, which would decrease demand for our products. In addition, our patents may not provide us with any competitive advantages and the patents of others may seriously impede our ability to conduct our business.
We protect our products, trade secrets and proprietary information, in part, by requiring all of our employees to enter into agreements providing for the maintenance of confidentiality and the assignment of rights to inventions made by them while employed by us. We also enter into non-disclosure agreements with our technical consultants, customers, vendors and resellers to protect our confidential and proprietary information. We cannot guarantee that our confidentiality agreements with our employees, consultants and other third parties will not be breached, that we will be able to effectively enforce these agreements, that we will have adequate remedies for any breach, or that our trade secrets and other proprietary information will not be disclosed or will otherwise be protected.
We rely on contractual and license agreements with third parties in connection with their use of our products and technology. There is no guarantee that such parties will abide by the terms of such agreements or that we will be able to adequately enforce our rights, in part because we rely, in many instances, on "click-wrap" and "shrink-wrap" licenses, which are not negotiated or signed by individual licensees. Accordingly, some provisions of our licenses, including provisions protecting against unauthorized use, copying, transfer, resale and disclosure of the licensed software program, could be unenforceable under the laws of several jurisdictions.
Protection of trade secret and other intellectual property rights in the places in which we operate and compete is highly uncertain and may involve complex legal questions. The laws of countries in which we operate may afford little or no protection to our trade secrets and other intellectual property rights. Although we defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety of techniques, preventing unauthorized use or infringement of our intellectual property rights is inherently difficult. Despite our enforcement efforts against software piracy, we could lose significant revenue due to illegal use of our software and from counterfeit copies of our software. If piracy activities increase, it could further harm our business.
We also suspect that competitors might try to illegally use our proprietary information and develop products that are similar to ours, which may infringe on our proprietary rights. In addition, we could potentially lose trade secret protection for our source code if any unauthorized disclosure of such code occurs. The loss of trade secret protection could make it easier for third parties to compete with our products by copying functionality. In addition, any changes in, or unexpected interpretations of, the trade secret and other intellectual property laws in any country in which we operate may compromise our ability to enforce our trade secret and intellectual property rights. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our confidential information and trade secret protection. If we are unable to protect our proprietary rights or if third parties independently develop or gain access to our or similar technologies, our business, revenue, reputation and competitive position could be harmed.
Third-party use of our trademarks as keywords in Internet search engine advertising programs may direct potential customers to competitors' websites, which could harm our reputation and cause us to lose sales.
Competitors and other third parties, including counterfeiters, purchase our trademarks and confusingly similar terms as keywords in Internet search engine advertising programs in order to divert potential customers to their websites. Preventing such unauthorized use is inherently difficult. If we are unable to protect our trademarks and confusingly similar terms from such unauthorized use, competitors and other third parties may drive potential online customers away from our websites to competing and unauthorized websites, which could harm our reputation and cause us to lose sales.

21


Our trademarks are limited in scope and geographic coverage and might not significantly distinguish us from our competition.
We own several U.S. trademark registrations, including registrations of the Rosetta Stone, Lexia Learning, Lexia, Fit Brains and Catalyst trademarks, as well as U.S. registrations of the color yellow as a trademark. In addition, we hold common law trademark rights and have trademark applications pending in the U.S. and abroad for additional trademarks. Even if federal registrations and registrations in other countries are granted to us, our trademark rights may be challenged. It is also possible that our competitors will adopt trademarks similar to ours, thus impeding our ability to build brand identity and possibly leading to customer confusion. In fact, various third parties have registered trademarks that are similar to ours in the U.S. and overseas. Furthermore, notwithstanding the fact that we may have secured trademark rights for our various trademarks in the U.S. and in some countries where we do business, in other countries we may not have secured similar rights and, in those countries there may be third parties who have prior use and prior or superior rights to our own. That prior use, prior or superior right could limit use of our trademarks and we could be challenged in our efforts to use our trademarks. We could incur substantial costs in prosecuting or defending trademark infringement suits. If we fail to effectively enforce our trademark rights, our competitive position and brand recognition may be diminished.
We must monitor and protect our Internet domain names to preserve their value. We may be unable to prevent third parties from acquiring domain names that are similar to, infringe on or otherwise decrease the value of our trademarks.
We own several domain names related to our business. Third parties may acquire substantially similar domain names or Top Level Domains ("TLDs") that decrease the value of our domain names and trademarks and other proprietary rights which may adversely affect our business. Third parties also may acquire country-specific domain names in the form of Country Code TLDs that include our trademarks or similar terms and which prevent us from operating country-specific websites from which customers can view our products and engage in transactions with us. Moreover, the regulation of domain names in the U.S. and foreign countries is subject to change. Governing bodies could appoint additional domain name registrars, modify the requirements for holding domain names or release additional TLDs. As a result, we may have to incur additional costs to maintain control over potentially relevant domain names or may not maintain exclusive rights to all potentially relevant domain names in the U.S. or in other countries in which we conduct business, which could harm our business or reputation. Moreover, attempts may be made to register our trademarks as new TLDs or as domain names within new TLDs and we will have to make efforts to enforce our rights against such registration attempts.
Our business depends on our strong brands, and failing to maintain or enhance the Rosetta Stone brands in a cost-effective manner could harm our operating results.
Maintaining and enhancing our brands is an important aspect of our efforts to attract new customers and expand our business. We believe that maintaining and enhancing our brands will depend largely on our ability to provide high-quality, innovative products, and services, which we might not do successfully. Our brands may be negatively impacted by a number of factors such as service outages, product malfunctions, data protection and security issues, and exploitation of our trademarks by others without permission.
Further, while we attempt to ensure that the quality of our brands is maintained by our licensees, our licensees might take actions that could impair the value of our brands, our proprietary rights, or the reputation of our products. If we are unable to maintain or enhance our brands in a cost-effective manner, or if we incur excessive expenses in these efforts, our business, operating results and financial condition could be harmed.
Claims that we misuse the intellectual property of others could subject us to significant liability and disrupt our business.
As we expand our business and develop new technologies, products and services, we may become subject to material claims of infringement by competitors and other third parties with respect to current or future products, e-commerce and other web-related technologies, online business methods, trademarks or other proprietary rights. Our competitors, some of which may have made significant investments in competing products and technologies, and may have, or seek to apply for and obtain, patents, copyrights or trademarks that will prevent, limit or interfere with our ability to make, use and sell our current and future products and technologies, and we may not be successful in defending allegations of infringement of these patents, copyrights or trademarks. Further, we may not be aware of all of the patents and other intellectual property rights owned by third parties that may be potentially adverse to our interests. We may need to resort to litigation to enforce our proprietary rights or to determine the scope and validity of a third-party's patents or other proprietary rights, including whether any of our products, technologies or processes infringe the patents or other proprietary rights of third parties. We may incur substantial expenses in defending against third-party infringement claims regardless of the merit of such claims. The outcome of any such proceedings is uncertain and, if unfavorable, could force us to discontinue advertising and sale of the affected products or impose significant penalties, limitations or restrictions on our business. We do not conduct comprehensive patent searches to determine whether the technologies used in our products infringe upon patents held by others. In addition, product development

22


is inherently uncertain in a rapidly evolving technological environment in which there may be numerous patent applications pending, many of which are confidential when filed, with regard to similar technologies.
We do not own all of the software, other technologies and content used in our products and services, and the failure to obtain rights to use such software, other technologies and content could harm our business.
Some of our products and services contain intellectual property owned by third parties, including software that is integrated with internally developed software and voice recognition software, which we license from third parties. From time to time we may be required to renegotiate with these third parties or negotiate with new third parties to include their technology or content in our existing products, in new versions of our existing products or in wholly new products. We may not be able to negotiate or renegotiate licenses on commercially reasonable terms, or at all, and the third-party software may not be appropriately supported, maintained or enhanced by the licensors. If we are unable to obtain the rights necessary to use or continue to use third-party technology or content in our products and services, this could harm our business, by resulting in increased costs, or in delays or reductions in product shipments until equivalent software could be developed, identified, licensed and integrated.
Our use of open source software could impose limitations on our ability to commercialize our products.
We incorporate open source software into our products and may use more open source software in the future. The use of open source software is governed by license agreements. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that these licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. Therefore, we could be required to seek licenses from third parties in order to continue offering our products, make generally available, in source code form, proprietary code that links to certain open source modules, re-engineer our products, discontinue the sale of our products if re-engineering could not be accomplished on a cost-effective and timely basis, or become subject to other consequences. In addition, open source licenses generally do not provide warranties or other contractual protections regarding infringement claims or the quality of the code. Thus, we may have little or no recourse if we become subject to infringement claims relating to the open source software or if the open source software is defective in any manner.
We offer Consumer language-learning packages that include perpetual software and online services that have increased our costs as a percentage of revenue, and these and future product introductions may not succeed and may harm our business, financial results and reputation.
Our Consumer language-learning packages integrate our language-learning software solutions with online services, which provide opportunities for practice with dedicated language conversation coaches and other language learners to increase language socialization. The costs associated with the online services included with these software packages decrease margins. Customers may choose to not engage with conversation coaches or be willing to pay higher prices to do so. In addition, we are required to defer recognition of all or a portion of each sale of this packaged software over the duration of our online service periods. We cannot assure you that our future software package offerings will be successful or profitable, or if they are profitable, that they will provide an adequate return on invested capital. If our software package offerings are not successful, our business, financial results and reputation may be harmed.
Substantially all of our inventory is located in one warehouse facility. Any damage or disruption at this facility could cause significant financial loss, including loss of revenue and harm to our reputation.
Substantially all of our inventory is located in one warehouse facility. We could experience significant interruption in the operation of this facility or damage or destruction of our inventory due to natural disasters, accidents, failures of the inventory locator or automated packing and shipping systems or other events. If a material portion of our inventory were to be damaged or destroyed, we might be unable to meet our contractual obligations which could cause us significant financial loss, including loss of revenue and harm to our reputation. As our business continues to move online, we expect that this risk will diminish over time.
Our business could be impacted as a result of actions by activist shareholders or others.
We may be subject, from time to time, to legal and business challenges in the operation of our company due to proxy contests, shareholder proposals, media campaigns and other such actions instituted by activist shareholders or others. Responding to such actions could be costly and time-consuming, disrupt our operations, may not align with our business strategies and could divert the attention of our Board of Directors and senior management from the pursuit of current business strategies. Perceived uncertainties as to our future direction as a result of shareholder activism or potential changes to the composition of the Board of Directors may lead to the perception of a change in the direction of the business or other instability that may make it more difficult to attract and retain qualified personnel and business partners, and could have a materially adverse effect on the Company’s stock price.

23


Provisions in our organizational documents and in the Delaware General Corporation Law may prevent takeover attempts that could be beneficial to our stockholders.
Provisions in our second amended and restated certificate of incorporation and second amended and restated bylaws, and in the Delaware General Corporation Law, may make it difficult and expensive for a third party to pursue a takeover attempt we oppose even if a change in control of our Company would be beneficial to the interests of our stockholders. Any provision of our second amended and restated certificate of incorporation or second amended and restated bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock. Our Board of Directors has the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the powers, preferences and rights of each series without stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisition proposals or make it more difficult for a third party to gain control of our Company, or otherwise could adversely affect the market price of our common stock. Further, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. This section generally prohibits us from engaging in mergers and other business combinations with stockholders that beneficially own 15% or more of our voting stock, or with their affiliates, unless our directors or stockholders approve the business combination in the prescribed manner.
Item 1B.    Unresolved Staff Comments
None.
Item 2.    Properties
As of December 31, 2016, our corporate headquarters are located in Arlington, Virginia, where we occupy approximately 13,000 square feet of space on the top floor of an office building under a lease that ends January 31, 2020. For more information about our Arlington, Virginia lease and subleases, please see Note 16 of Item 8, Financial Statements and Supplementary Data. We currently own one facility in Harrisonburg, Virginia, that provides operations and customer support services. We lease another facility in Virginia for use as a packing and distribution center for all of our U.S. and some of our international fulfillment.
In addition, the Company leases property in various locations in the U.S. and around the world as sales offices, for research and development activities, operations, product distribution, data centers, and market research. We utilize international locations in or near cities including the following: London, United Kingdom; Vancouver, Canada; and Cologne, Germany.  Our offices and facilities are used across multiple segments. We believe our offices and facilities are adequate for our current needs.
Item 3.    Legal Proceedings
Information with respect to this item may be found in Note 16 of Item 8, Financial Statements and Supplementary Data, which is incorporated herein by reference.
Item 4.    Mine Safety Disclosures
Not applicable.

24


PART II
Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
Our common stock is listed on the New York Stock Exchange, or NYSE, under the symbol "RST." There were approximately 88 stockholders of record of our common stock as of March 8, 2017 when the last reported sales price of our common stock on the NYSE was $7.69 per share. The following table sets forth, for each of the periods indicated, the high and low reported sales price of our common stock on the NYSE.
 
 
High
 
Low
Year ended December 31, 2016
 
 
 
 
Fourth Quarter
 
$
9.20

 
$
6.80

Third Quarter
 
9.22

 
7.44

Second Quarter
 
8.46

 
6.68

First Quarter
 
8.60

 
6.17

Year ended December 31, 2015
 
 
 
 
Fourth Quarter
 
$
8.22

 
$
6.31

Third Quarter
 
8.50

 
6.40

Second Quarter
 
9.19

 
6.39

First Quarter
 
10.37

 
7.16

Dividends
We have not paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain all available funds and any future earnings to support the operation of and to finance the growth and development of our business. Further, our revolving credit facility contains financial and restrictive covenants that, among other restrictions and subject to certain exceptions, limit our ability to pay dividends.
Securities Authorized For Issuance Under Equity Compensation Plans
For information regarding securities authorized for issuance under equity compensation plans, see Part III "Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."
Purchases of Equity Securities
Our revolving credit facility contains financial and restrictive covenants that, among other restrictions and subject to certain limitations, limit our ability to repurchase our shares.
Stockholder Return Performance Presentation
The following graph compares the change in the cumulative total stockholder return on our common stock during the 5-year period from December 31, 2011 through December 31, 2016, with the cumulative total return on the NYSE Composite Index and the SIC Code Index that includes all U.S. public companies in the Standard Industrial Classification (SIC) Code 7372-Prepackaged Software. The comparison assumes that $100 was invested on December 31, 2011 in our common stock and in each of the foregoing indices and assumes reinvestment of dividends, if any.

25


k325yearreturngraph.jpg
The foregoing graph shall not be deemed to be filed as part of this Annual Report on Form 10-K and does not constitute soliciting material and should not be deemed filed or incorporated by reference into any other filing of the Company under the Securities Act, or the Exchange Act, except to the extent we specifically incorporate the graph by reference.
Item 6.    Selected Consolidated Financial Data
The following tables set forth selected consolidated statement of operations data, balance sheet data, and other data for the periods indicated. The selected consolidated statement of operations data for the years ended December 31, 2016, 2015, 2014, 2013 and 2012, and the selected consolidated balance sheet data as of December 31, 2016, 2015, 2014, 2013 and 2012 have been derived from our audited consolidated financial statements. The selected consolidated financial data should be read in conjunction with the information under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our consolidated financial statements, the related notes and the accompanying independent registered public accounting firm’s report, which are included in “Item 8. Financial Statements and Supplementary Data.” Our historical results for any prior period are not necessarily indicative of results to be expected in any future period.


26


 
 
Year Ended December 31,
 
 
2016(1)
 
2015(2)
 
2014(3)
 
2013(4)
 
2012(5)
 
 
(in thousands, except per share data)
Selected Statements of Operations Data:
 
 
 
 
 
 
 
 
 
 
Revenue
 
$
194,089

 
$
217,670

 
$
261,853

 
$
264,645

 
$
273,241

Gross profit
 
159,768

 
179,143

 
208,799

 
218,931

 
224,331

Loss from operations
 
(26,920
)
 
(43,813
)
 
(78,850
)
 
(18,442
)
 
(5,266
)
Net loss
 
(27,550
)
 
(46,796
)
 
(73,706
)
 
(16,134
)
 
(33,985
)
 
 
 
 
 
 
 
 
 
 
 
Loss per share attributable to common stockholders:
 
 
 
 
 
 
 
 
 
 
Basic
 
$
(1.25
)
 
$
(2.17
)
 
$
(3.47
)
 
$
(0.75
)
 
$
(1.61
)
Diluted
 
$
(1.25
)
 
$
(2.17
)
 
$
(3.47
)
 
$
(0.75
)
 
$
(1.61
)
 
 
 
 
 
 
 
 
 
 
 
Other Selected Data:
 
 
 
 
 
 
 
 
 
 
Total stock-based compensation expense
 
$
4,906

 
$
7,195

 
$
6,762

 
$
9,241

 
$
8,009

Total intangible amortization expense
 
$
4,351

 
$
5,192

 
$
6,263

 
$
1,822

 
$
40

_______________________________________________________________________________

(1)
As discussed in Notes 1 and 13 of Item 8, Financial Statements and Supplementary Data, the Company announced and initiated restructuring actions in the first quarter of 2016 to exit the direct sales presence in almost all of its non-U.S. and non-northern European geographies related to the distribution of its Enterprise & Education Language offerings. Under this initiative, the Company made headcount reductions, office lease terminations, and other cost reductions in France, China, Brazil, Canada, Spain, Mexico, U.S. and the U.K.
(2)
As discussed in Notes 1 and 13 of Item 8, Financial Statements and Supplementary Data, the Company undertook restructuring actions in the first quarter of 2015 to focus on the Enterprise & Education business and optimize the Consumer business for profitability. Under this initiative, the Company undertook headcount and cost reductions to areas including Consumer sales and marketing, Consumer product investment, and general and administrative functions.
(3)
The Company acquired Vivity Labs, Inc. on January 2, 2014 and Tell Me More S.A. on January 9, 2014. The results of operations from these entities have been included from the acquisition date.
(4)
The Company acquired Livemocha, Inc. on April 1, 2013 and acquired Lexia Learning Systems, Inc. on August 1, 2013. The results of operations from these entities have been included from the acquisition date.
(5)
The Company established a full valuation allowance to reduce the deferred tax assets of the Korea, Brazil, Japan and U.S. subsidiaries. The establishment of the valuation allowance resulted in a non-cash charge of $29.7 million during the year ended December 31, 2012.
 
 
As of December 31,
 
 
2016
 
2015
 
2014
 
2013
 
2012
 
 
(in thousands)
Selected Consolidated Balance Sheet Data:
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
36,195

 
$
47,782

 
$
64,657

 
$
98,825

 
$
148,190

Total assets
 
194,310

 
228,543

 
288,173

 
290,776

 
279,405

Total deferred revenue
 
141,457

 
142,748

 
128,169

 
78,857

 
63,416

Notes payable and capital lease obligation
 
2,559

 
3,143

 
3,748

 
242

 
5

Total stockholders' (deficit) equity
 
(1,659
)
 
22,410

 
63,445

 
131,243

 
148,194


Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations
        This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The MD&A should be read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking

27


statements as a result of a number of factors, including those discussed under ("Risk Factors") and elsewhere in this Annual Report on Form 10-K.
Overview
Rosetta Stone is dedicated to changing people's lives through the power of language and literacy education. Our innovative digital solutions drive positive learning outcomes for the inspired learner at home or in schools and workplaces around the world. Founded in 1992, Rosetta Stone's language division uses cloud-based solutions to help all types of learners read, write, and speak more than 30 languages. Lexia Learning, Rosetta Stone's literacy education division, was founded more than 30 years ago and is a leader in the literacy education space. Today, Lexia helps students build fundamental reading skills through its rigorously researched, independently evaluated, and widely respected instruction and assessment programs. Rosetta Stone Inc. was incorporated in Delaware in 2005.
The Enterprise & Education Language segment derives revenue from sales to educational institutions, corporations, and government agencies worldwide. The Literacy segment derives revenue from the sales of literacy solutions to educational institutions serving grades K through 12. The Consumer segment derives revenue from sales to individuals and retail partners. Our Enterprise & Education Language distribution model is focused on targeted sales activity primarily through a direct sales force in five markets: K-12 schools; colleges and universities; federal government agencies; corporations; and not-for-profit organizations. Our Literacy distribution channel utilizes a direct sales force as well as relationships with third-party resellers focused on the sale of Lexia Learning solutions to K-12 schools. Our Consumer distribution channel comprises a mix of our call centers, websites, app-stores, third party e-commerce websites, select retail resellers, such as Amazon.com, Barnes & Noble, Target, Best Buy, Books-a-Million, Sam's Club, Staples, consignment distributors such as Wynit Distribution and Software Packaging Associates, and daily deal partners.
As our Company has evolved, we believe that our Enterprise & Education Language and Literacy segments are our largest opportunities for long-term value creation. The customers in these markets have needs that recur each year, creating a more predictable sales opportunity. This need profile also fits well with our suite of language and literacy products and the well-known Rosetta Stone brand. We also believe the demand is growing for e-learning based literacy solutions in the U.S. and English language-learning around the globe.
As a result, we are emphasizing the development of products and solutions for Corporate and K-12 learners who need to speak and read English. This focus extends to the Consumer segment where we continue to make product investments serving the needs of passionate language learners who are motivated, results focused and willing to pay for a quality language-learning experience.
To position the organization for success, our focus is on the following priorities:
1.
Grow literacy sales and market share by providing fully aligned digital instruction and assessment tools for K-12, building a direct distribution sales force to augment our historical reseller model, and continuing to develop our implementation services business;
2.
Position our Enterprise & Education Language business for profitable growth by focusing our direct sales on our best geographies and customer segments, partnering with resellers in other geographies and successfully delivering our Catalyst product to Corporate customers. Catalyst integrates our Foundations, Advantage, and Advanced English for Business products with enhanced reporting, assessment, and administrator tools that offers a simple, more modern, metrics-driven suite of tools that are results-oriented and easily integrated with leading corporate language-learning systems;
3.
Maximize the profitability of our Consumer language business by providing an attractive value proposition and a streamlined, mobile-oriented product portfolio focused on customers' demand, while optimizing our marketing spend appropriately;
4.
Seek opportunities to leverage our language assets including our content, tools and pedagogy, as well as our well-known Rosetta Stone brand, through partnerships with leading players in key markets around the world, and
5.
Continue to identify opportunities to become more efficient.
In pursuing these priorities, we will (i) allocate capital to the areas of our business that we believe have the greatest value creation potential, including our Lexia literacy business, (ii) focus our businesses on their best customers, including K-12 learners primarily in North America, Corporate learners primarily in North America and Northern Europe in our Enterprise & Education Language segment, and passionate learners in the U.S. and select non-U.S. markets in our Consumer language business, and (iii) optimize the sales and marketing costs for these businesses and the costs of our business overall.

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In March 2016, we announced the 2016 Restructuring Plan ("2016 Restructuring Plan"), outlining our withdrawal of the direct sales presence in almost all of our non-U.S. and non-northern European geographies related to the distribution of the Enterprise & Education Language offerings. These operations added sales, but at too high a cost and without the near-term ability to capture scale efficiencies. Where appropriate, we will seek to operate through partners in the geographies being exited. We have also initiated processes to close our software development operations in France and China. These actions were in addition to the 2015 Restructuring Plan to accelerate and prioritize our focus on satisfying the needs of the more passionate learners in the Unites States and select non-U.S. geographies in the Consumer language segment. In March 2015, we initiated a plan (the "2015 Restructuring Plan") to make reductions to Consumer sales and marketing, Consumer product investment, and general and administrative costs. See Note 2 and Note 13 of Item 8, Financial Statements and Supplementary Data for additional information about these strategic undertakings.
In conjunction with the 2016 and 2015 Restructuring Plans, outside financial and legal advisors have been retained to assist management and the Board of Directors with their ongoing comprehensive review to analyze potential options to improve financial performance and enhance shareholder value.
In March 2016, we announced our strategy to position the organization for success and we have prioritized the growth of literacy sales and have begun to take actions to align resources to drive this growth. As a result of this shift, we reevaluated our segment structure. Prior to the strategy shift, we were managed in two operating segments (Enterprise & Education and Consumer). Following the shift, we are managed in three operating segments (Enterprise & Education Language, Literacy, and Consumer). We discuss the profitability of each segment in terms of segment contribution. Segment contribution is the measure of profitability used by our Chief Operating Decision Maker. Segment contribution includes segment revenue and expenses incurred directly by the segment, including material costs, service costs, customer care and coaching costs, sales and marketing expense and bad debt expense. Prior periods have been reclassified to reflect our current segment presentation and definition of segment contribution.
For the year ended December 31, 2016, Enterprise & Education Language segment contribution increased to $28.3 million with a segment contribution margin of 39%, compared to $21.3 million with a segment contribution margin of 28% for the year ended December 31, 2015. The dollar and margin increases were primarily due to the cost reduction initiatives in early 2016 as compared to the prior year. Literacy segment contribution increased to $5.6 million with segment contribution margin of 17% for the year ended December 31, 2016 as compared to a segment contribution of $0.7 million and a segment contribution margin of 3% for the year ended December 31, 2015. The dollar and margin increases were primarily due to the larger revenue base on which segment contribution is calculated, offset by an increase in sales and marketing expense due to the transition to a direct sales team and support infrastructure. The margin improvement partially related to the effect of purchase accounting that will diminish over time. Consumer segment contribution decreased to $21.1 million with a contribution margin of 24% for the year ended December 31, 2016, from $30.0 million with a contribution margin of 25% for the year ended December 31, 2015. The dollar and margin decreases were primarily due to a decrease in Consumer revenue of $31.7 million.
For the year ended December 31, 2015, Enterprise & Education Language segment contribution increased to $21.3 million with a segment contribution margin of 28%, compared to $16.9 million with a segment contribution margin of 23% for the year ended December 31, 2014. The dollar and margin increases were primarily due to the increase in Enterprise & Education revenue which was slightly offset by an increase in direct sales related expenses. Literacy segment contribution increased to $0.7 million with segment contribution margin of 3% for the year ended December 31, 2015, as compared to a segment contribution loss of $3.0 million and a segment contribution margin of negative 30% for the year ended December 31, 2014. The dollar and margin increases were primarily due to the impacts of purchase accounting. Consumer segment contribution increased to $30.0 million with a contribution margin of 25% for the year ended December 31, 2015, from $28.0 million with a contribution margin of 16% for the year ended December 31, 2014. The dollar and margin increases in Consumer segment contribution was primarily due to cost reduction initiatives.
Over the last few years, our Consumer strategy has been to shift more and more of our Consumer business to online subscriptions (with access across the web and apps) and away from perpetual digital download and CD packages. We believe that these online subscription formats provide customers with an overall better experience, flexibility to use our products on multiple platforms (tablets, smartphones and computers), and provide a more economical and relevant way for us to deliver our products to customers. One challenge to encouraging customers to enter into or renew a subscription arrangement is that usage of our product varies greatly, ranging from customers that purchase but do not have any usage to customers with high usage. The majority of purchasers tend towards the lower end of that spectrum, with most usage coming in the first few months after purchase and declining over time - similar to a gym membership. We expect the trend in Consumer subscription sales to accelerate through the end of 2017 as customer preferences continue to move towards cross-platform experiences. Our goal is to move almost entirely all of our Consumer business to subscription sales by the end of 2017.

29


For additional information regarding our segments, see Note 17 of Item 8, Financial Statements and Supplementary Data. For additional information regarding fluctuations in segment revenue, see Results of Operations, below. Prior periods have been reclassified to reflect our current operating segments presentation and definition of segment contribution.
Components of Our Statement of Operations
Revenue
We derive revenue from sales of language-learning and literacy solutions. Revenue is presented as subscription and service revenue or product revenue in our consolidated financial statements. Subscription and service revenue consists of sales from web-based software subscriptions, online services, professional services, and certain mobile applications. Our online services are typically sold in short-term service periods and include dedicated online conversational coaching services and access to online communities of language learners. Our professional services include training and implementation services. Product revenue primarily consists of revenue from our perpetual language-learning product software, our audio practice products, and certain mobile applications. Our audio practice products are often combined with our language-learning software and sold as a solution.
In the Consumer market, our perpetual product software is often bundled with our short-term online conversational coaching and online community services and sold as a package. Approximately $39 in revenue per unit is derived from these short-term online services. As a result, we typically defer 10% to 35% of the revenue of each of these bundled sales to be recognized over the term of the service period. The content of our perpetual product software and our web-based language-learning subscription offerings are the same. We offer our customers the ability to choose which format they prefer without differentiating the learning experience.
We sell our solutions directly and indirectly to individuals, educational institutions, corporations, and governmental agencies. We sell to enterprise and education organizations primarily through our direct sales force as well as through our network of resellers and organizations who typically gain access to our solutions under a web-based subscription service. We distribute our Consumer products predominantly through our direct sales channels, primarily utilizing our websites and call centers, which we refer to as our direct-to-consumer channel. We also distribute our Consumer products through select third-party retailers and distributors. For purposes of explaining variances in our revenue, we separately discuss changes in our Enterprise & Education Language, Literacy, and our Consumer segments because the customers and revenue drivers of these channels are different.
Within our Enterprise & Education Language segment, sales in our education, government, and corporate sales channels are seasonally stronger in the second half of the calendar year due to purchasing and budgeting cycles. Literacy segment sales are seasonally stronger in the third quarter of the calendar year corresponding to school district budget years. Consumer sales are affected by seasonal trends associated with the holiday shopping season. We expect these trends to continue.
Cost of Subscription and Service Revenue and Cost of Product Revenue
Cost of subscription and service revenue primarily represents costs associated with supporting our web-based subscription services and online language-learning services, which includes online language conversation coaching, hosting costs, and depreciation. We also include the cost of credit card processing and customer technical support in both cost of subscription and service revenue and cost of product revenue. Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute our products. Such costs include packaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty fees and inventory storage, obsolescence and shrinkage.
Operating Expenses
We classify our operating expenses into the following categories: sales and marketing, research and development, and general and administrative. When certain events occur, we also recognize operating expenses related to asset impairment and operating lease terminations.
Our operating expenses primarily consist of personnel costs, direct advertising and marketing expenses, and professional fees associated with contract product development, legal, accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses, stock-based compensation and employee benefit costs. Included within our operating expenses are restructuring costs that consist primarily of employee severance and related benefit costs, contract termination costs, and other related costs associated with our restructuring activities.
Sales and Marketing.    Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print, radio, online and other direct marketing activities, personnel costs for our sales and marketing staff, and

30


commissions earned by our sales personnel. Sales commissions are generally paid at the time the customer is invoiced. However, sales commissions are deferred and recognized as expense in proportion to when the related revenue is recognized.
Research and Development.    Research and development expenses consist primarily of employee compensation costs, consulting fees, and overhead costs associated with development of our solutions. Our development efforts are primarily based in the U.S. and are devoted to modifying and expanding our offering portfolio through the addition of new content, as well as new paid and complementary products and services to our language-learning and literacy solutions.
General and Administrative.    General and administrative expenses consist primarily of shared services, such as personnel costs of our executive, finance, legal, human resources and other administrative personnel, as well as accounting and legal professional services fees including professional service fees related to acquisitions and other corporate expenses.
Impairment.   Impairment expenses consist primarily of goodwill impairment, impairment of long-lived assets, and impairment expense related to the abandonment of previously capitalized internal-use software projects.
Lease Abandonment and Termination.   Lease abandonment and termination expenses include the recognition of costs associated with the termination or abandonment of our office operating leases, such as early termination fees and expected lease termination costs.
Interest and Other Income (Expense)
Interest and other income (expense) primarily consist of interest income, interest expense, foreign exchange gains and losses, income from litigation settlements, and income or loss from equity method investments. Interest income represents interest received on our cash and cash equivalents. Interest expense is primarily related to interest on our capital leases and amortization of deferred financing fees associated with our revolving credit facility. Fluctuations in foreign currency exchange rates in our foreign subsidiaries cause foreign exchange gains and losses. Legal settlements are related to agreed upon settlement payments from various anti-piracy enforcement efforts. Income or loss from equity method investments represents our proportionate share of the net income or loss of our investment in entities accounted for under the equity method.
Income Tax Expense (Benefit)
Income tax expense (benefit) consists of federal, state and foreign income taxes.
We regularly evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce the deferred tax assets to an amount that is more likely than not to be realized (a likelihood of more than 50 percent). Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate.
The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. We assess the likelihood that the deferred tax assets will be realizable at each reporting period, and the valuation allowance will be adjusted accordingly, which could materially affect our financial position and results of operations.
Critical Accounting Policies and Estimates
In presenting our financial statements in conformity with GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures.
Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Our future estimates may change if the underlying assumptions change. Actual results may differ significantly from these estimates.
We believe that the following critical accounting policies involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary for readers to understand and evaluate our consolidated financial statements contained in this annual report on Form 10-K. See Note 2 of Item 8, Financial Statements and Supplementary Data for a complete description of our significant accounting policies.
Revenue Recognition
Our primary sources of revenue are web-based software subscriptions, online services, perpetual product software, and bundles of perpetual product software and online services. We also generate revenue from the sale of audio practice products,

31


mobile applications, and professional services. Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. Revenue is recorded net of discounts and net of taxes.
We identify the units of accounting contained within our sales arrangements and in doing so, we evaluate a variety of factors including whether the undelivered element(s) have value to the customer on a stand-alone basis or if the undelivered element(s) could be sold by another vendor on a stand-alone basis.
For multiple element arrangements that contain perpetual software products and related online services, we allocate the total arrangement consideration to the deliverables based on the existence of vendor-specific objective evidence of fair value ("VSOE"). We generate a portion of Consumer revenue from the CD and digital download formats of the Rosetta Stone language-learning product which are typically multiple-element arrangements that contain two deliverables: perpetual software, delivered at the time of sale, and online service, which is considered an undelivered software-related element. The online service includes access to conversational coaching services. Because we only sell the perpetual language-learning software on a stand-alone basis in our homeschool version, we do not have a sufficient concentration of stand-alone sales to establish VSOE for the perpetual product. Where VSOE of the undelivered online services can be established, arrangement consideration is allocated using the residual method. We determine VSOE by reference to the range of comparable stand-alone renewal sales of the online service. We review these stand-alone sales on a quarterly basis. VSOE is established if at least 80% of the stand-alone sales are within a range of plus or minus 15% of a midpoint of the range of prices, consistent with generally accepted industry practice. Where VSOE of the undelivered online services cannot be established, revenue is deferred and recognized commensurate with the delivery of the online services.
For non-software multiple element arrangements we allocate revenue to all deliverables based on their relative selling prices. Our non-software multiple element arrangements primarily occur as sales to our Enterprise & Education Language and Literacy customers, and to a lesser extent to our Consumer customers. These arrangements can include web-based subscription services, audio practice products and professional services or any combination thereof. We do not have a sufficient concentration of stand-alone sales of the various deliverables noted above to our customers, and therefore cannot establish VSOE for each deliverable. Third party evidence of fair value does not exist for the web-based subscription, audio practice products and professional services due to the lack of interchangeable language-learning products and services within the market. Accordingly, we determine the relative selling price of the web-based subscription, audio practice products and professional services deliverables included in our non-software multiple element arrangements using our best estimate of selling price. We determine our best estimate of selling price based on our internally published price list which includes suggested sales prices for each deliverable based on the type of client and volume purchased. This price list is derived from past experience and from the expectation of obtaining a reasonable margin based on our cost of each deliverable.
In the U.S. and Canada, we offer consumers who purchase our packaged software and audio practice products directly from us a 30-day, unconditional, full money-back refund. We also permit some of our retailers and distributors to return unsold packaged products, subject to certain limitations. We estimate and establish revenue reserves for packaged product returns at the time of sale based on historical return rates, estimated channel inventory levels, the timing of new product introductions, and other factors.
We distribute products and services both directly to the end customer and indirectly through resellers. Our resellers earn commissions generally calculated as a fixed percentage of the gross sale to the end customer. We evaluate each of our reseller relationships to determine whether the revenue recognized from indirect sales should be the gross amount of the contract with the end customer or reduced for the reseller commission. In making this determination we evaluate a variety of factors including whether we are the primary obligor to the end customer.
Revenue for web-based subscriptions and online services is recognized ratably over the term of the subscription or service period, assuming all revenue recognition criteria have been met. Our CD and digital download formats of Rosetta Stone language-learning products are typically bundled with an online service where customers are allowed to begin their online services at any point during a registration window, which is typically up to six months from the date of purchase from us or an authorized reseller. The online services that are not activated during this registration window are forfeited and revenue is recognized upon expiry. Revenue from non-refundable upfront fees that are not related to products already delivered or services already performed is deferred and recognized ratably over the term of the related arrangement because the period over which a customer is expected to benefit from the service that is included within our subscription arrangements does not extend beyond the contractual period. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement.
Software products are sold to end user customers and resellers. In many cases, revenue from sales to resellers is not contingent upon resale of the software to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audio practice products is recognized as the products are shipped and title passes

32


and risks of loss have been transferred. For many product sales, these criteria are met at the time the product is shipped. For some sales to resellers and certain other sales, we defer revenue until the customer receives the product because we legally retain a portion of the risk of loss on these sales during transit. In other cases where packaged software products are sold to resellers on a consignment basis, revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remaining revenue recognition criteria have been met. Cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identifiable benefit is identified and the fair value is reasonably determinable. Price protection for changes in the manufacturer suggested retail value granted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue at the time of sale.
We offer our U.S. and Canada consumers the ability to make payments for packaged software purchases in installments over a period of time, which typically ranges between three and five months. Given that these installment payment plans are for periods less than 12 months, a successful collection history has been established and these fees are fixed and determinable, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met.
In connection with packaged software product sales and web-based software subscriptions, technical support is provided to customers, including customers of resellers, via telephone support at no additional cost for up to six months from the time of purchase. As the fee for technical support is included in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenue is recognized together with the software product and web-based software subscription revenue. Costs associated with technical support are accrued at the time of sale.
Sales commissions from non-cancellable web-based software subscription contracts are deferred and amortized in proportion to the revenue recognized from the related contract.
Stock-Based Compensation
All stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date. For options granted with service and/or performance conditions, the fair value of each grant is estimated on the date of grant using the Black-Scholes option pricing model. For options granted with market-based conditions, the fair value of each grant is estimated on the date of grant using the Monte-Carlo simulation model. Determining the fair value at the grant date requires the use of estimates, including expected term, future stock price volatility, forfeiture rates, and risk-free interest rate.
As we do not have sufficient historical option exercise experience that spans the full 10 year contractual term for determining the expected term of options granted, we estimate the expected term of options using a combination of historical information and the simplified method. We use our own historical stock price data to estimate a forfeiture rate and expected volatility over the most recent period commensurate with the estimated expected term of the awards. For the risk free interest rate, we use a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.
Stock-based compensation expense associated with service-based equity awards is recognized in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statement of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. For equity awards granted with market-based conditions, stock compensation expense is recognized in the statement of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions. Stock compensation expense is recognized based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation.
Goodwill
The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006, the acquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009, the acquisitions of Livemocha and Lexia in 2013 and the acquisitions of Vivity and Tell Me More in 2014.
As of December 31, 2016, our reporting units are: Enterprise & Education Language, Literacy, Consumer Language, and Consumer Fit Brains. Each of these businesses is considered a reporting unit for goodwill impairment testing purposes. Consumer Language and Consumer Fit Brains are components of the Consumer operating segment.
We test goodwill for impairment annually on June 30 of each year at the reporting unit level using a fair value approach or more frequently, if impairment indicators arise. We have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value, a "Step 0" analysis. If, based on a review of qualitative factors, it is more likely than not that the fair value of a reporting unit is less than its carrying value, we perform "Step 1" of the traditional two-step goodwill impairment test by comparing the fair value of a reporting unit with its

33


carrying amount. If the carrying value exceeds the fair value, we measure the amount of impairment loss in "Step 2", if any, by comparing the implied fair value of the reporting unit goodwill to its carrying amount.
The factors that we consider important in a qualitative analysis, and which could trigger an interim impairment review, include, but are not limited to: a significant decline in the market value of our common stock for a sustained period; a material adverse change in economic, financial, market, industry or sector trends; a material failure to achieve operating results relative to historical levels or projected future levels; and significant changes in operations or business strategy. We evaluate our reporting units with remaining goodwill balances on a quarterly basis to determine if a triggering event has occurred. We will continue to review for impairment indicators.
In estimating the fair value of our reporting units in Step 1, we use a variety of techniques including the income approach (i.e., the discounted cash flow method) and the market approach (i.e., the guideline public company method). Our projections are estimates that can significantly affect the outcome of the analysis, both in terms of our ability to accurately project future results and in the allocation of fair value between reporting units.
Consistent with our election in prior annual tests, we exercised our option to bypass Step 0 for all reporting units with remaining goodwill balances in connection with the annual goodwill impairment analysis performed as of June 30, 2016. The Enterprise & Education Language and Literacy reporting unit tests both resulted in fair values that substantially exceeded the carrying values, and therefore no goodwill impairment charges were recorded in connection with the annual analysis for these reporting units.
The Consumer Fit Brains reporting unit was also evaluated, which resulted in a fair value that was significantly below the carrying value. The decrease in fair value was due to the second quarter 2016 strategy update for the Consumer Fit Brains business. The Consumer Fit Brains reporting unit was no longer considered central to our core strategy to focus on language and literacy learning. Due to the continued declines in operations since the $5.6 million partial impairment in the fourth quarter of 2015, we revised the Consumer Fit Brains financial projections in the second quarter of 2016 assuming reduced media spend and reduced revenue in 2016 and beyond. The change in operating plans and the lack of cushion since the fourth quarter 2015 impairment resulted in an implied fair value of goodwill that was significantly below its carrying value. As a result, we recorded a second quarter impairment loss of $1.7 million, which represented a full impairment of the remaining Consumer Fit Brains reporting unit's goodwill. The impairment charge was recorded in the "Impairment" line on the statement of operations.
We routinely review goodwill at the reporting unit level for potential impairment as part of our internal control framework. As of December 31, 2016, the Enterprise & Education Language and Literacy reporting units are the only reporting units with remaining goodwill balances. In the fourth quarter of 2016, we evaluated these reporting units to determine if a triggering event has occurred. As of December 31, 2016, the Company concluded that there were no indicators of impairment that would cause us to believe that it is more likely than not that the fair value of any such reporting units is less than the carrying value. Accordingly, a detailed impairment test has not been performed and no goodwill impairment charges were recorded in connection with the interim impairment reviews of any such reporting units.
Intangible Assets
Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark, and other intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives. Intangible assets with finite lives are reviewed routinely for potential impairment as part of our internal control framework. Annually, as of December 31, and more frequently if a triggering event occurs, we review the Rosetta Stone trade name, our only indefinite-lived intangible asset, to determine if indicators of impairment exist. We have the option to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative test. If necessary, the quantitative test is performed by comparing the fair value of indefinite-lived intangible assets to the carrying value. In the event the carrying value exceeds the fair value of the assets, the assets are written down to their fair value.
During the second quarter of 2016, we revised the business outlook and financial projections for the Consumer Fit Brains reporting unit, which prompted a long-lived intangible asset impairment analysis of the Consumer Fit Brains tradename, developed technology, and customer relationships. The carrying values of the intangible assets exceeded the estimated fair values. As a result, we recorded an impairment loss of $1.2 million associated with the impairment of the remaining carrying value of the Consumer Fit Brains long-lived intangible assets as of June 30, 2016. The impairment charge was recorded in the "Impairment" line on the statement of operations.
During the fourth quarter of 2016, we elected to bypass the qualitative assessment and performed the quantitative assessment. In the quantitative assessment, we noted that the fair value of the Rosetta Stone trade name exceeded the carrying value. There has been no impairment of intangible assets during the years ending December 31, 2015 and 2014.

34


Valuation of Long-Lived Assets
As part of our internal control framework we evaluate the recoverability of our long-lived assets. An impairment of long-lived assets is recognized in the event that the net book value of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the period of identification to the extent the carrying amount of an asset exceeds the fair value of such asset. During 2016, 2015, and 2014, we recorded $1.0 million, $1.1 million, and $0.2 million in impairment expense related to the abandonment of software projects that were previously capitalized.
Restructuring Costs
As part of the 2016 and 2015 Restructuring Plans, we announced and initiated actions to reduce headcount and other costs in order to support our strategic shift in business focus. In connection with these plans, we incurred restructuring related costs, including employee severance and related benefit costs, contract termination costs, and other related costs. These costs are included within Cost of Sales and our Sales and marketing, Research and development, and General and administrative operating expense categories in our consolidated statements of operations.
Employee severance and related benefit costs primarily include cash payments, outplacement services, continuing health insurance coverage, and other benefits. Where no substantive involuntary termination plan previously exists, these severance costs are generally considered “one-time” benefits and recognized at fair value in the period in which a detailed plan has been approved by management and communicated to the terminated employees. Severance costs pursuant to ongoing benefit arrangements, including termination benefits provided for in existing employment contracts, are recognized when probable and reasonably estimable.
Contract termination costs include penalties to cancel certain service and license contracts and costs to terminate operating leases. Contract termination costs are recognized at fair value in the period in which the contract is terminated in accordance with the contract terms.
Other related costs generally include external consulting and legal costs associated with the strategic shift in business focus. Such costs are recognized at fair value in the period in which the costs are incurred.
Income Taxes
We believe that the accounting estimate for the realization of deferred tax assets is a critical accounting estimate because judgment is required in assessing the likely future tax consequences of events that have been recognized in our financial statements or tax returns. Although it is possible there will be changes that are not anticipated in our current estimates, we believe it is unlikely such changes would have a material period-to-period impact on our financial position or results of operations.
We use the asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax bases of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred tax liabilities are recognized for taxable temporary differences.
We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that such assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessed quarterly based on the more-likely-than-not realization threshold criterion. In the assessment, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of statutory carryforward periods, our experience with operating loss and tax credit carryforwards not expiring unused, and tax planning alternatives. Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support a reversal.
In assessing the recoverability of our deferred tax assets, we consider all available evidence, including:
the nature, frequency, and severity of cumulative financial reporting losses in recent years;

the carryforward periods for the net operating loss, capital loss, and foreign tax credit carryforwards;

predictability of future operating profitability of the character necessary to realize the asset;

prudent and feasible tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets; and

35



the effect of reversing taxable temporary differences.
The evaluation of the recoverability of the deferred tax assets requires that we weigh all positive and negative evidence to reach a conclusion that it is more likely than not that all or some portion of the deferred tax assets will not be realized. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed. Our valuation allowance analysis considers a number of factors, including our cumulative losses in recent years, our expectation of future taxable income and the time frame over which our net operating losses expire.
As of December 31, 2016, a full valuation allowance exists for the U.S., Japan, China, Hong Kong, Mexico, Spain, Brazil, Canada, and France where we have determined the deferred tax assets will not more likely than not be realized.
All of the jurisdictions mentioned above, with the exception of China, have cumulative losses and pre-tax losses for the most recent year ended December 31, 2016. The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. We will continue to assess the likelihood that the deferred tax assets will be realizable at each reporting period and the valuation allowance will be adjusted accordingly, which could materially affect our financial position and results of operations.
As of December 31, 2016 and 2015, our net deferred tax liability was $6.2 million and $5.0 million, respectively.
Going Concern Assessment
The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Management has evaluated whether relevant conditions or events, considered in the aggregate, indicate that there is substantial doubt about the Company's ability to continue as a going concern. Substantial doubt exists when conditions and events, considered in the aggregate, indicate it is probable that the Company will be unable to meet its obligations as they become due within one year after the financial statement issuance date. The assessment is based on the relevant conditions that are known or reasonable knowable as of March 14, 2017
The assessment of our ability to meet our future obligations is inherently judgmental, subjective and susceptible to change. The inputs that we considered important in a going concern analysis, include, but are not limited to, our 2017 cash flow forecast, 2017 operating budget, and long-term plan that extends beyond 2017. These inputs consider information including, but not limited to, our financial condition, liquidity sources, obligations due within one year after the financial statement issuance date, funds necessary to maintain operations, and financial conditions, including negative financial trends or other indicators of possible financial difficulty.
We have considered both quantitative and qualitative factors as part of the assessment that are known or reasonably knowable as of March 14, 2017, and concluded that conditions and events considered in the aggregate, do not indicate that it is probable that we will be unable to meet obligations as they become due through the one year period following the financial statement issuance date.
Recently Issued Accounting Standards
For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 2 of Item 8, Financial Statements and Supplementary Data, which is incorporated herein by reference.

36


Results of Operations
The following table sets forth our consolidated statement of operations for the periods indicated.
 
 
Year Ended December 31,
 
 
2016
 
2015
 
2014
 
 
(in thousands, except per share data)
Statements of Operations Data:
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
Subscription and service
 
$
154,336

 
$
151,701

 
$
125,602

Product
 
39,753

 
65,969

 
136,251

Total revenue
 
194,089

 
217,670

 
261,853

Cost of revenue:
 
 
 
 
 
 
Cost of subscription and service revenue
 
23,676

 
21,629

 
18,862

Cost of product revenue
 
10,645

 
16,898

 
34,192

Total cost of revenue
 
34,321

 
38,527

 
53,054

Gross profit
 
159,768

 
179,143

 
208,799

Operating expenses
 
 
 
 
 
 
Sales and marketing
 
114,340

 
136,084

 
173,208

Research and development
 
26,273

 
29,939

 
33,176

General and administrative
 
40,501

 
50,124

 
57,120

Impairment
 
3,930

 
6,754

 
20,333

Lease abandonment and termination
 
1,644

 
55

 
3,812

Total operating expenses
 
186,688

 
222,956

 
287,649

Loss from operations
 
(26,920
)
 
(43,813
)
 
(78,850
)
Other income and (expense):
 
 
 
 
 
 
Interest income
 
46

 
23

 
17

Interest expense
 
(470
)
 
(378
)
 
(233
)
Other income and (expense)
 
2,297

 
(1,469
)
 
(1,129
)
Total other income and (expense)
 
1,873

 
(1,824
)
 
(1,345
)
Loss before income taxes
 
(25,047
)
 
(45,637
)
 
(80,195
)
Income tax expense (benefit)
 
2,503

 
1,159

 
(6,489
)
Net loss
 
$
(27,550
)
 
$
(46,796
)
 
$
(73,706
)
Loss per share:
 
 
 
 
 
 
Basic
 
$
(1.25
)
 
$
(2.17
)
 
(3.47
)
Diluted
 
$
(1.25
)
 
$
(2.17
)
 
$
(3.47
)
Common shares and equivalents outstanding:
 
 
 
 
 
 
Basic weighted average shares
 
21,969

 
21,571

 
21,253

Diluted weighted average shares
 
21,969

 
21,571

 
21,253

Stock-based compensation included in:
 
 
 
 
 
 
Cost of revenue
 
48

 
101

 
108

Sales and marketing
 
998

 
1,327

 
1,975

Research and development
 
709

 
841

 
958

General and administrative
 
3,151

 
4,926

 
3,721

Total stock-based compensation expense
 
$
4,906

 
$
7,195

 
$
6,762


37


Comparison of the Year Ended December 31, 2016 and the Year Ended December 31, 2015
Our total revenue decreased to $194.1 million for the year ended December 31, 2016 from $217.7 million for the year ended December 31, 2015. The change in total revenue was primarily due to a decrease in Consumer revenue of $31.7 million and a slight decrease in Enterprise & Education Language revenue of $4.0 million, which were partially offset by an increase in Literacy revenue of $12.2 million.
We reported an operating loss of $26.9 million for the year ended December 31, 2016 compared to an operating loss of $43.8 million for the year ended December 31, 2015. Operating expense decreased $36.3 million, comprised of decreases of $21.7 million in sales and marketing expenses, $9.6 million in general and administrative expenses, $3.7 million in research and development expenses, and $2.8 million in impairment expenses. The decrease in general and administrative expenses and sales and marketing expenses reflects the continued savings as a result of the 2016 Restructuring Plan and other ongoing expense reduction actions. The $36.3 million reduction in operating expenses were partially offset by a decrease in gross profit of $19.4 million, driven by a decrease of $4.2 million in cost of revenue, which was offset by a $23.6 million decrease in revenue, and a slight increase of $1.6 million in lease abandonment and termination expenses associated with the space consolidation and move to our new headquarters.
Revenue by Operating Segment
The following table sets forth revenue for our three operating segments for the years ended December 31, 2016 and 2015:
 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
 
 
2015
 
 
 
Change
 
% Change
 
 
(in thousands, except percentages)
Enterprise & Education Language
 
$
72,083

 
37.1
%
 
$
76,129

 
35.0
%
 
$
(4,046
)
 
(5.3
)%
Literacy
 
34,123

 
17.6
%
 
21,928

 
10.0
%
 
$
12,195

 
55.6
 %
Consumer
 
87,883

 
45.3
%
 
119,613

 
55.0
%
 
$
(31,730
)
 
(26.5
)%
Total Revenue
 
$
194,089

 
100.0
%
 
$
217,670

 
100.0
%
 
$
(23,581
)
 
(10.8
)%
Enterprise & Education Language Segment
Total Enterprise & Education Language revenue decreased $4.0 million, or 5%, from $76.1 million for the year ended December 31, 2015 to $72.1 million for the year ended December 31, 2016. The decrease in Enterprise & Education Language revenue reflects a decrease of $5.3 million in the corporate channel, which was partially offset by increases of $0.7 million and $0.5 million in our non-profit and education sales channels, respectively. We expect revenue associated with the Enterprise & Education Language segment will slightly decline in the near term, due to the execution of our strategy to exit our direct presence in unprofitable geographies and manage this business for profitable growth. Where appropriate, we will seek to operate in the geographies we exit through partners. Our goal is to offset this decline with growth in our retained channels. We expect to continue to balance investments and adjust our cost structure to align scale without impacting growth.
Literacy Segment
Literacy revenue increased $12.2 million, or 56%, from $21.9 million for the year ended December 31, 2015 to $34.1 million for the year ended December 31, 2016, partially reflecting the impact of purchase accounting. Adjusting for the impact of purchase accounting on Literacy revenue, revenue would have been $38.4 million for the year ended December 31, 2016 compared to $29.8 million for the year ended December 31, 2015, and the Literacy pro-forma growth would have been 29% year-over-year. The revenue growth was due to increased market share associated with new literacy offerings, a larger revenue capacity associated with the move from resellers to a direct sales team, and an increase in implementation services. We will continue to experience the purchase accounting impacts for the Literacy segment through 2017 due to the typical subscription length. As a result, we expect year-over-year revenues to become more comparable as we move beyond the purchase accounting impact, which we expect to result in lower growth rates than what we experienced during 2016. We anticipate additional investments in the Literacy business to grow this segment.
Consumer Segment
Consumer revenue decreased $31.7 million, or 27%, from the year ended December 31, 2015 to the year ended December 31, 2016. This decrease was largely due to reductions in revenue from our direct-to-consumer, retail, and homeschool sales channels of $18.1 million, $11.6 million, and $2.4 million, respectively. These declines reflect the decision to significantly curtail promotional pricing under our shift in strategy. The reduction in the retail channel was due in part to the planned reduction in the suggested retail value in the U.S. which impacted Consumer revenue by $3.6 million. The reduction in

38


homeschool revenue was primarily due to the sale of the Korea entity in the third quarter of 2015. In connection with our recent shift in strategy, we continue to manage the Consumer business for a targeted bottom-line result which has resulted in a decline in scale which we expect to continue. Our Consumer business is seasonal and typically peaks in the fourth quarter during the holiday shopping season.
Revenue by Subscription and Service Revenue and Product Revenue
We categorize and report our revenue in two categories—subscription and service revenue and product revenue. Subscription and service revenue includes web-based software subscriptions, online services, as well as revenues from professional services. Subscription and service revenues are typically deferred at the time of sale and then recognized ratably over the subscription or service period. Product revenue includes revenues allocated to our perpetual language-learning product software, revenues from the sale of audio practice products, and sales of certain mobile applications. We bundle our perpetual product software typically with online services. As a result, we typically defer 10% to 35% of the revenue of each of these bundled sales. We recognize the deferred revenue associated with the online services over the term of the service period.
The following table sets forth revenue for subscription and service revenue and product revenue for the years ended December 31, 2016 and 2015:
 
 
Year ended December 31,
 
 
 
2016 versus 2015
 
 
2016
 
 
 
2015
 
 
 
Change
 
% Change
 
 
(in thousands, except percentages)
Subscription and service revenue
 
$
154,336

 
79.5
%
 
$
151,701

 
69.7
%
 
$
2,635

 
1.7
 %
Product revenue
 
39,753

 
20.5
%
 
65,969

 
30.3
%
 
(26,216
)
 
(39.7
)%
Total revenue
 
$
194,089

 
100.0
%
 
$
217,670

 
100.0
%
 
$
(23,581
)
 
(10.8
)%
Subscription and Service Revenue
Subscription and service revenue increased $2.6 million, or 2%, to $154.3 million for the year ended December 31, 2016. An increase in Literacy segment revenue, which entirely falls within the subscription and service revenue category, contributed $12.2 million of the $2.6 million increase, due in part to the write-down effects of purchase accounting on the pre-acquisition deferred revenue balances associated with the Lexia acquisition. Within the Enterprise & Education Language segment, the corporate sales channel decreased by $4.3 million, which was partially offset by an increase in the education sales channel of $0.9 million. Consumer segment subscription and service revenue declined in the direct-to-consumer, homeschool, and retail channels of $4.3 million, $1.6 million, and $1.6 million, respectively, due to the Consumer decline in revenue associated with our recent shift in strategy to focus on the passionate learner. In the Consumer segment, we have begun shifting sales from our box-based and perpetual download products to similarly priced long-term subscription products. However, it is important to note that these subscribers generally only stay for the duration of the subscription period, which could negatively impact our revenue in the future. We are testing shorter duration subscriptions which if we are successful in achieving an adequate level of renewals, allow pricing that has the potential to open up new customer demographics. If, over time, more of our Consumer products are sold through shorter-term subscriptions it would have the effect of spreading the receipt of cash from those sales over the initial sale period and any subsequent renewals. Our goal is to be almost entirely subscription-based by the end of 2017.
Product Revenue
Product revenue decreased $26.2 million, or 40%, to $39.8 million during the year ended December 31, 2016 from $66.0 million during the year ended December 31, 2015. Product revenue primarily decreased $13.8 million and $10.1 million in our direct-to-consumer and retail sales channels, respectively, within the Consumer segment. The decrease in retail sales is due in part to the reduction in suggested retail value in the U.S. which negatively impacted product revenue by $3.6 million. Product revenue also decreased due to the ongoing transition of our sales model towards subscription sales rather than perpetual license and box product sales, with an objective to be nearly all subscription-based by the end of 2017.
Cost of Subscription and Service Revenue and Product Revenue and Gross Profit
The following table sets forth cost of subscription and service revenue and product revenue, as well as gross profit for the years ended December 31, 2016 and 2015:

39


 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Revenue:
 
 
 
 
 
 
 
 
Subscription and service
 
$
154,336

 
$
151,701

 
$
2,635

 
1.7
 %
Product
 
39,753

 
65,969

 
(26,216
)
 
(39.7
)%
Total revenue
 
194,089

 
217,670

 
(23,581
)
 
(10.8
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of subscription and service revenue
 
23,676

 
21,629

 
2,047

 
9.5
 %
Cost of product revenue
 
10,645

 
16,898

 
(6,253
)
 
(37.0
)%
Total cost of revenue
 
34,321

 
38,527

 
(4,206
)
 
(10.9
)%
Gross profit
 
$
159,768

 
$
179,143

 
$
(19,375
)
 
(10.8
)%
Gross profit percentages
 
82.3
%
 
82.3
%
 
%
 
 
Total cost of revenue decreased $4.2 million for the year ended December 31, 2016 from $38.5 million for the year ended December 31, 2015. The decrease in total cost of revenue was primarily due to a decline in product revenue which also reflects the ongoing shift of the Consumer segment towards subscriptions which resulted in decreases in inventory expense, freight and payment processing fees, and professional services. Inventory expense declined $2.7 million due to the decrease in box product sales. Freight and processing fees decreased $2.1 million due to the decrease in box product sales, which was slightly offset by an increase in amortization of capitalized internal-use software costs.
Cost of Subscription and Service Revenue
Cost of subscription and service revenue for the year ended December 31, 2016 was $23.7 million, an increase of $2.0 million, or 9% from the year ended December 31, 2015. As a percentage of subscription and service revenue, cost of subscription and service revenue increased slightly to 15% from 14% for the year ended December 31, 2016 compared to the prior year period. The dollar increase in cost of subscription and service revenue was primarily due to increases in amortization of capitalized internal-use software costs and other allocable costs due to the shift in sales mix to subscription service sales.
Cost of Product Revenue
Cost of product revenue for the year ended December 31, 2016 was $10.6 million, a decrease of $6.3 million or 37% compared to $16.9 million for the year ended December 31, 2015. As a percentage of product revenue, cost of product revenue slightly increased to 27% for the year ended December 31, 2016 from 26% as compared to the prior year period.  The dollar decrease in cost of product revenue is primarily due to decreases of $1.8 million, $1.4 million, $0.8 million, and $0.6 million in inventory costs, payroll and benefits, freight costs, and payment processing fees respectively, due to the shift away from hard product sales to online subscription sales.
Gross Profit
Gross profit decreased $19.4 million to $159.8 million for the year ended December 31, 2016 compared to $179.1 million for the year ended December 31, 2015. Gross profit percentage remained flat at 82% for both the years ended December 31, 2016 and December 31, 2015. The dollar decrease in gross profit was primarily due to the decrease in revenue.
Operating Expenses
 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Sales and marketing
 
$
114,340

 
$
136,084

 
$
(21,744
)
 
(16.0
)%
Research and development
 
26,273

 
29,939

 
(3,666
)
 
(12.2
)%
General and administrative
 
40,501

 
50,124

 
(9,623
)
 
(19.2
)%
Impairment
 
3,930

 
6,754

 
(2,824
)
 
(41.8
)%
Lease abandonment and termination
 
1,644

 
55

 
1,589

 
2,889.1
 %
Total operating expenses
 
$
186,688

 
$
222,956

 
$
(36,268
)
 
(16.3
)%

40


In the first quarter of 2016, we announced and initiated actions to exit the direct sales presence in almost all of our non-U.S. and non-northern European geographies related to the distribution of our Enterprise & Education Language offerings and to close our software development operations in France and China. In the first quarter of 2015, we announced and initiated actions to reduce headcount and other costs in order to support our 2015 strategic shift in business focus.
Included within our operating expenses are restructuring charges related to the 2016 and 2015 Restructuring Plans which relate to employee severance and related benefits costs incurred in connection with headcount reductions, contract termination costs, and other related costs. As a result of these actions, we realized reductions in our operating expenses, primarily associated with reduced payroll and benefits costs.
The following table presents restructuring costs associated with the 2016 and 2015 Restructuring Plans included in the related line items of our results from operations:
 
 
Year ended December 31,
 
 
2016
 
2015
 
 
(in thousands)
Cost of revenue
 
$
573

 
$
113

Sales and marketing
 
2,324

 
4,492

Research and development
 
913

 
602

General and administrative
 
1,383

 
3,584

Total
 
$
5,193

 
$
8,791

While there were restructuring plans initiated in each of the years ended December 31, 2016 and 2015, the severance expenses in 2015 were greater than the severance expenses in 2016, primarily due to a larger number of headcount reductions in senior management in 2015.
Sales and Marketing Expenses
Sales and marketing expenses for the year ended December 31, 2016 were $114.3 million, a decrease of $21.7 million, or 16%, from the year ended December 31, 2015. As a percentage of total revenue, sales and marketing expenses decreased to 59% for the year ended December 31, 2016, from 63% for the year ended December 31, 2015. The decrease in sales and marketing expense was primarily due to decreases in media and marketing spend, payroll and benefits, and professional services. Media expenses decreased $8.0 million, comprised of a reduction of $4.1 million in online and social media and a decrease of $3.9 million in offline media. Marketing expenses decreased $1.8 million due to overall decreased spend in advertising and retail visual displays due to the change in focus in the general consumer market. Payroll and benefit expense decreased $6.4 million primarily due to the reduction in headcount which resulted in lower salary expense, severance expense, and stock compensation expense. Professional services expenses declined $3.5 million related to a $1.1 million contract termination fee associated with the 2015 Restructuring Plan and other reductions in the consumer market. We intend to continue to optimize our Consumer media and marketing costs and manage the Consumer business for profitability and plan to manage the sales and marketing expenses to drive these results.
Research and Development Expenses
Research and development expenses were $26.3 million for the year ended December 31, 2016, a decrease of $3.7 million, or 12%, from the year ended December 31, 2015. As a percentage of revenue, research and development expenses remained flat at 14% for both of the years ended December 31, 2016 and 2015. The dollar decrease was primarily due to a reduction in payroll and benefits expense of $2.7 million driven by increased capitalized labor projects primarily associated with new Lexia product offerings and Catalyst and secondarily due to a reduction in headcount. In the near term we will focus our product investment on Lexia and key Enterprise & Education Language initiatives.
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 2016 were $40.5 million, a decrease of $9.6 million, or 19%, from the year ended December 31, 2015. As a percentage of revenue, general and administrative expenses decreased slightly to 21% for the year ended December 31, 2016 compared to 23% for year ended December 31, 2015. The decrease in general and administrative expenses was primarily due to reductions in payroll and benefits, bad debt, and other cost reductions. Payroll and benefits decreased $4.3 million driven by a reduction in headcount, heavier executive restructuring accruals in the prior year related to the 2015 Restructuring Plan, and reductions in stock compensation expense related to the change in CEO in the second quarter of 2015. Bad debt expense decreased by $1.0 million due to reduced sales in the consumer

41


market and improvements in accounts receivable collections. Other costs decreased due to the ongoing cost saving measures. We expect our general and administrative expenses to increase slightly in the near term.
Impairment
Impairment expense for the year ended December 31, 2016 was $3.9 million, a decrease of $2.8 million, from the year ended December 31, 2015. The decrease was due to the 2016 second quarter impairment of the Fit Brains goodwill of $1.7 million, the second quarter impairment of Fit Brains intangible assets of $1.2 million, and the third quarter impairment of $1.0 million associated with a previously capitalized software project that no longer aligned to our strategic direction. These 2016 amounts were partially offset by a $5.6 million goodwill impairment charge related to our Consumer Fit Brains reporting unit and prior year impairment charges related to the abandonment of previously capitalized internal-use software projects.
Lease Abandonment and Termination
Lease abandonment and termination expenses for the year ended December 31, 2016 were $1.6 million, compared to $0.1 million for the year ended December 31, 2015. The increase was attributable to the fourth quarter 2016 lease abandonment charge associated with the planned space consolidation of our former headquarters location in Arlington, VA.
Other Income and (Expense)
 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Interest income
 
$
46

 
$
23

 
$
23

 
100.0
 %
Interest expense
 
(470
)
 
(378
)
 
(92
)
 
24.3
 %
Other income and (expense)
 
2,297

 
(1,469
)
 
3,766

 
(256.4
)%
Total other income and (expense)
 
$
1,873

 
$
(1,824
)
 
$
3,697

 
(202.7
)%
Interest income for the year ended December 31, 2016 was $46 thousand, a slight increase from the year ended December 31, 2015. Interest income represents interest earned on our cash and cash equivalents.
Interest expense for the year ended December 31, 2016 was $0.5 million, an increase of $0.1 million, from the year ended December 31, 2015. This increase was primarily attributable to interest on our capital leases and the recognition of our financing fees associated with our undrawn credit facility.
Other income and (expense) for the year ended December 31, 2016 was income of $2.3 million, an increase of $3.8 million, as compared to expense of $1.5 million for the year ended December 31, 2015. The change was primarily attributable to foreign exchange fluctuations.
Income Tax Expense (Benefit)
 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Income tax expense
 
$
2,503

 
$
1,159

 
$
1,344

 
116.0
%
Our Income tax expense for the year ended December 31, 2016 was $2.5 million, compared to $1.2 million for the year ended December 31, 2015. The increase primarily due to the inability to benefit from Canada losses, higher earnings in U.K. and Germany in 2016, and tax benefit related to Korea withholdings in 2015.

42


Comparison of the Year Ended December 31, 2015 and the Year Ended December 31, 2014
Our total revenue decreased to $217.7 million for the year ended December 31, 2015 from $261.9 million for the year ended December 31, 2014. The change in total revenue was due to a decrease in Consumer revenues of $57.5 million, which was offset by increases in Literacy and Enterprise & Education Language revenue of $12.0 million and $1.3 million.
We reported an operating loss of $43.8 million for the year ended December 31, 2015 compared to an operating loss of $78.9 million for the year ended December 31, 2014. The decrease in operating loss was due to a decrease in operating expenses of $64.7 million, a decrease of $14.5 million in cost of revenue, which was offset by a $44.2 million decrease in revenue.
Revenue by Operating Segment
During 2016, our operating segment structure changed to three operating segments: Enterprise & Education Language, Literacy, and Consumer. Our 2015 and 2014 operating segments were recast under our current operating segment structure and the following table sets forth revenue for our operating segments for the years ended December 31, 2015 and 2014:
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
 
 
2014
 
 
 
Change
 
% Change
 
 
(in thousands, except percentages)
Enterprise & Education Language
 
$
76,129

 
35.0
%
 
$
74,788

 
28.6
%
 
$
1,341

 
1.8
 %
Literacy
 
21,928

 
10.0
%
 
9,912

 
3.8
%
 
$
12,016

 
121.2
 %
Consumer
 
119,613

 
55.0
%
 
177,153

 
67.6
%
 
$
(57,540
)
 
(32.5
)%
Total Revenue
 
$
217,670

 
100.0
%
 
$
261,853

 
100.0
%
 
$
(44,183
)
 
(16.9
)%
Enterprise & Education Language Segment
Total Enterprise & Education revenue increased $1.3 million, or 2%, from $74.8 million for the year ended December 31, 2014 to $76.1 million for the year ended December 31, 2015. The increase in Enterprise & Education Language revenue was comprised primarily of increases of $3.7 million and $0.8 million in our education and non-profit sales channels, respectively, which were partially offset by a decrease of $2.9 million in the corporate sales channel.
Literacy Segment
Literacy revenue increased $12.0 million, or 121%, from $9.9 million for the year ended December 31, 2014 to $21.9 million for the year ended December 31, 2015. Literacy revenue increased, in part, due to the revenue recognition of subscription service contracts recorded as deferred revenue in prior periods. Due to purchase accounting, deferred revenue associated with Lexia was recorded at fair value, which is lower than the book value, and resulted in lower 2014 revenue. As a result, we expect year-over-year revenues to become more comparable as we move beyond the purchase accounting impact, which will result in lower revenue growth rates than what we experienced during 2015.
Consumer Segment
Consumer revenue decreased $57.5 million, or 32%, from the year ended December 31, 2014 to the year ended December 31, 2015. This decrease was largely due to reductions in revenue from our direct-to-consumer, retail, and homeschool sales channels of $48.2 million, $10.4 million, and $1.0 million, respectively, slightly offset by an increase of $1.6 million in revenue related to our Fit Brains offerings. These declines reflect the decision to significantly curtail promotional pricing under our 2015 strategic transformation. In 2014, we focused on driving customers to purchase our direct-to-consumer channel, particularly through our website, by implementing more aggressive discounting and promotional activity to combat the introduction of lower priced competitor products. During 2015, we were more disciplined with discounting and focused on stabilizing prices.
Revenue by Subscription and Service Revenue and Product Revenue
The following table sets forth revenue for subscription and service revenue and product revenue for the years ended December 31, 2015 and 2014:

43


 
 
Year ended December 31,
 
 
 
2015 versus 2014
 
 
2015
 
 
 
2014
 
 
 
Change
 
% Change
 
 
(in thousands, except percentages)
Subscription and service revenue
 
$
151,701

 
69.7
%
 
$
125,602

 
48.0
%
 
$
26,099

 
20.8
 %
Product revenue
 
65,969

 
30.3
%
 
136,251

 
52.0
%
 
(70,282
)
 
(51.6
)%
Total revenue
 
$
217,670

 
100.0
%
 
$
261,853

 
100.0
%
 
$
(44,183
)
 
(16.9
)%
Subscription and Service Revenue
Subscription and service revenue increased $26.1 million, or 21%, to $151.7 million for the year ended December 31, 2015. Within the Enterprise & Education segment, the increase in subscription and service revenue was primarily due to the $12.0 million increase in Enterprise & Education literacy revenue combined with revenue increases within Enterprise & Education language of $3.2 million and $0.9 million in the education and non-profit service sales channels, respectively. These increases were slightly offset by a decrease of $2.1 million in the corporate sales channel within Enterprise & Education language. The Consumer segment realized increases of $10.5 million, $1.6 million, and $0.4 million in direct-to-consumer, Fit Brains, and global retail service sales channels, respectively. Our 2014 subscription and service revenue was lower due to the write-down effects of purchase accounting on the pre-acquisition deferred revenue balances associated with Lexia and Tell Me More. We continue to experience these purchase accounting impacts for Lexia due to the typical subscription length. As a result, we expect the growth rates from our Enterprise & Education segment to mitigate over time. Subscription and services sales volume increased as we continue to carry out our strategy to migrate our Consumer business to subscription-based products. However, it is important to note that these subscribers generally only stay for the duration of the subscription period, which could negatively impact our revenue in the future.
Product Revenue
Product revenue decreased $70.3 million, or 52%, to $66.0 million during the year ended December 31, 2015 from $136.3 million during the year ended December 31, 2014. Product revenue primarily decreased $58.6 million, $9.8 million, and $1.2 million in our direct-to-consumer, global retail, and homeschool sales channels, respectively. Product sales volume decreased as we continue to carry out our strategy to migrate our Consumer business to subscription-based products. Product revenue also decreased due to the year-over-year decline in product unit sales volume as a result of the strategic decision to be more disciplined marketing and advertising expenses and curtail promotional pricing to focus on stabilizing prices.
Cost of Subscription and Service Revenue, Product Revenue Gross Profit
The following table sets forth cost of subscription and service revenue and cost of product revenue, as well as gross profit for the years ended December 31, 2015 and 2014:
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
2014
 
Change
 
% Change
 
 
(in thousands, except percentages)
Revenue:
 
 
 
 
 
 
 
 
Subscription and service
 
$
151,701

 
$
125,602

 
$
26,099

 
20.8
 %
Product
 
65,969

 
136,251

 
(70,282
)
 
(51.6
)%
Total revenue
 
217,670

 
261,853

 
(44,183
)
 
(16.9
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of subscription and service revenue
 
21,629

 
18,862

 
2,767

 
14.7
 %
Cost of product revenue
 
16,898

 
34,192

 
(17,294
)
 
(50.6
)%
Total cost of revenue
 
38,527

 
53,054

 
(14,527
)
 
(27.4
)%
Gross profit
 
$
179,143

 
$
208,799

 
$
(29,656
)
 
(14.2
)%
Gross profit percentages
 
82.3
%
 
79.7
%
 
2.6
%
 
 
Total cost of revenue decreased $14.5 million for the year ended December 31, 2015 from $53.1 million for the year ended December 31, 2014. The change in total cost of revenue was primarily due to decreases in inventory expense, payroll and benefits expense, and freight and payment processing fees. Inventory expense declined $6.3 million primarily due to the decrease in product sales combined with higher first quarter 2014 charges to inventory obsolescence in our Asian operations that did not recur in 2015. Payroll and benefit expenses declined $3.7 million driven by reduced headcount as a result of the

44


2015 Restructuring Plan, the absence of higher severance payments in 2014 related to operations in France and Korea, and lower variable incentive compensation expenses based on reduced funding expectations. Freight and processing fees decreased $3.5 million due to the decrease in sales.
Cost of Subscription and Service Revenue
Cost of subscription and service revenue for the year ended December 31, 2015 was $21.6 million, an increase of $2.8 million, or 15% from the year ended December 31, 2014. As a percentage of subscription and service revenue, cost of subscription and service revenue decreased to 14% from 15% for the year ended December 31, 2015 compared to the prior year period. The dollar increase in cost of subscription and service revenue was primarily due to increases in hosting, amortization of capitalized internal-use software costs, and other allocable costs due to the shift in sales mix to subscription service sales.
Cost of Product Revenue
Cost of product revenue for the year ended December 31, 2015 was $16.9 million, a decrease of $17.3 million or 51% compared to $34.2 million for the year ended December 31, 2014. As a percentage of product revenue, cost of product revenue slightly increased to 26% for the year ended December 31, 2015 from 25% as compared to the prior year period.  The dollar decrease in cost of product revenue is primarily due to decreases of $5.5 million, $4.7 million, $2.2 million, $1.6 million, and $1.2 million in inventory costs, payroll and benefits, freight costs, commission fees, and payment processing fees respectively, due to the shift away from hard product sales to online subscription sales.
Gross Profit
Gross profit decreased $29.7 million to $179.1 million for the year ended December 31, 2015 compared to $208.8 million for the year ended December 31, 2014. Gross profit percentage increased to 82% from 80% for the year ended December 31, 2015 compared to the year ended December 31, 2014. The dollar decrease in gross profit was primarily due to the decrease in revenue. The percentage increase in gross profit percentage was primarily due to the decrease in inventory and freight costs associated with hard product sales as we continue to shift to a SaaS delivery model which attracts higher margins.
Operating Expenses
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
2014
 
Change
 
% Change
 
 
(in thousands, except percentages)
Sales and marketing
 
$
136,084

 
$
173,208

 
$
(37,124
)
 
(21.4
)%
Research and development
 
29,939

 
33,176

 
(3,237
)
 
(9.8
)%
General and administrative
 
50,124

 
57,120

 
(6,996
)
 
(12.2
)%
Impairment
 
6,754

 
20,333

 
(13,579
)
 
(66.8
)%
Lease abandonment and termination
 
55

 
3,812

 
(3,757
)
 
(98.6
)%
Total operating expenses
 
$
222,956

 
$
287,649

 
$
(64,693
)
 
(22.5
)%
In the first quarter of 2015, we announced and initiated actions to reduce headcount and other costs in order to support our 2015 strategic shift in business focus. Included within our operating expenses are restructuring charges related to the 2015 Restructuring Plan which relate to employee severance and related benefits costs incurred in connection with headcount reductions, contract termination costs, and other related costs. As a result of these actions, we realized reductions in our operating expenses, primarily associated with reduced payroll and benefits costs.
The following table presents restructuring costs associated with the 2015 Restructuring Plan included in the related line items of our results from operations:
 
 
Year ended December 31,
 
 
2015
 
2014
 
 
(in thousands)
Cost of revenue
 
$
113

 
$

Sales and marketing
 
4,492

 

Research and development
 
602

 

General and administrative
 
3,584

 

Total
 
$
8,791

 
$


45


Sales and Marketing Expenses
Sales and marketing expenses for the year ended December 31, 2015 were $136.1 million, a decrease of $37.1 million, or 21%, from the year ended December 31, 2014. As a percentage of total revenue, sales and marketing expenses decreased to 63% for the year ended December 31, 2015, from 66% for the year ended December 31, 2014. The dollar and percentage decreases in sales and marketing expenses were primarily due to decreases in media and marketing expenses, payroll and benefit expenses, professional services, and amortization expense, which were partially offset by an increase in commission expense. Media spend decreased $27.1 million due to a decrease of $17.2 million in spend from offline media like TV, radio, and print and a $9.9 million decrease in spend in online and social media expenses. Marketing expenses also decreased by $5.7 million due to decreased spend in creative development and advertising expenses as a result of the strategic shift in focus and the positioning of the Consumer business for profitability. Payroll and benefit expense decreased $4.1 million due to salary savings from the reduced headcount as a result of the 2015 Restructuring Plan, lower variable incentive compensation expenses based on reduced funding expectations, and the absence of Long Term Incentive Plan ("LTIP") expense as the plan ended in 2014. Professional services decreased $2.9 million due to reduced outsourced staffing in the call centers as a result of the strategic shift in the Consumer segment. Amortization expense decreased $1.2 million due to the fully depreciated Tell Me More trade name at the end of 2014. Commission expense increased $4.5 million primarily driven by an increase in Enterprise & Education literacy revenue.
Research and Development Expenses
Research and development expenses were $29.9 million for the year ended December 31, 2015, a decrease of $3.2 million, or 10%, from the year ended December 31, 2014. As a percentage of revenue, research and development expenses increased slightly to 14% from 13% for the years ended December 31, 2015 and 2014, respectively. The dollar decrease was primarily due to a reduction in payroll and benefits expense of $2.3 million due to the headcount reductions from the 2015 Restructuring Plan, coupled with a $1.2 million reduction in costs associated with the Kids Reading and Kids Storytime projects that were released in the second half of 2014 or put on hold in the first half of 2015, respectively.
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 2015 were $50.1 million, a decrease of $7.0 million, or 12%, from the year ended December 31, 2014. As a percentage of revenue, general and administrative expenses increased slightly to 23% for the year ended December 31, 2015 compared to 22% for year ended December 31, 2014. The dollar decrease was primarily due to reductions in payroll and benefits, third party services, bad debt, communications, travel, and other expenses. Payroll and benefits decreased $2.5 million driven by the reduction in headcount related to the 2015 Restructuring Plan, lower variable incentive compensation expense due to the reduction in employees, and the absence of LTIP expense as the plan ended in 2014, partially offset by increases in severance and stock compensation expenses related to the change in CEO effective April 1, 2015. Third party services expense decreased $1.9 million mainly driven by decreased software and hardware maintenance expenses in 2015. Bad debt expense decreased by $0.8 million due to improvements in accounts receivable aging as compared to 2014. Communications expense decreased $0.5 million due to cost savings identified related to hosting, network, and telephone charges. Travel expenses decreased $0.5 million as a result of the international trips in support of acquisition related activities in the first quarter of 2014.
Impairment
Impairment expense for the year ended December 31, 2015 was $6.8 million, a decrease of $13.6 million, from the year ended December 31, 2014. The decrease was primarily attributable to a $20.2 million goodwill impairment charge related to our Consumer business during 2014, partially offset by a $5.6 million goodwill impairment charge related to our Consumer Fit Brains reporting unit and 2015 impairment charges of $1.1 million, primarily related to the abandonment of certain previously capitalized internal-use software projects.
Lease Abandonment and Termination
Lease abandonment and termination expenses for the year ended December 31, 2015 were $0.1 million, compared to $3.8 million for the year ended December 31, 2014. The decrease was attributable to the 2014 lease abandonment of the sixth floor space in the Arlington, VA office of $3.2 million, as well as the closure of the Japan office resulting in lease abandonment costs of $0.4 million.

46


Other Income and (Expense)
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
2014
 
Change
 
% Change
 
 
(in thousands, except percentages)
Interest income
 
$
23

 
$
17

 
$
6

 
35.3
%
Interest expense
 
(378
)
 
(233
)
 
(145
)
 
62.2
%
Other expense
 
(1,469
)
 
(1,129
)
 
(340
)
 
30.1
%
Total other income and (expense)
 
$
(1,824
)
 
$
(1,345
)
 
$
(479
)
 
35.6
%
Interest income for the year ended December 31, 2015 was $23 thousand, a slight increase from the year ended December 31, 2014. Interest income represents interest earned on our cash and cash equivalents.
Interest expense for the year ended December 31, 2015 was $0.4 million, an increase of $0.1 million, from the year ended December 31, 2014. This increase was primarily attributable to interest on our capital leases and the recognition of our financing fees associated with our undrawn credit facility.
Other expense for the year ended December 31, 2015 was $1.5 million, an increase of $0.3 million, as compared to $1.1 million for the year ended December 31, 2014. The fluctuation was primarily attributable to foreign exchange losses, partially offset by the divestiture of our Korea entity of $0.7 million.
Income Tax Expense (Benefit)
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
2014
 
Change
 
% Change
 
 
(in thousands, except percentages)
Income tax expense (benefit)
 
$
1,159

 
$
(6,489
)
 
$
7,648

 
(117.9
)%
Our income tax expense for the year ended December 31, 2015 was $1.2 million, compared to income tax benefit of $6.5 million for the year ended December 31, 2014. The tax expense was due to current year taxable income from our operations in Germany and the UK, the tax impact of the amortization of indefinite lived intangibles, and the inability to recognize tax benefits associated with current year losses of operations in all other foreign jurisdictions and in the U.S. due to the valuation allowance recorded against the deferred tax asset balances of these entities. These tax expenses were partially offset by tax benefits related to current year losses (excluding the Consumer Fit Brains goodwill impairment) in Canada. The goodwill that was impaired in 2015 was not deductible for tax. Additionally, tax benefits were recorded related to the reversal of accrued withholding taxes as a result of an intercompany transaction. For the year ended December 31, 2015, we incurred an income tax expense of $1.2 million based on losses before taxes of $45.6 million resulting in a worldwide effective tax rate of approximately (2.5)%.
Liquidity and Capital Resources
Liquidity
Our principal source of liquidity at December 31, 2016 consisted of $36.2 million in cash and cash equivalents and short-term investments, a decrease of $11.6 million, from $47.8 million as of December 31, 2015. Our primary operating cash requirements include the payment of salaries, employee benefits and other personnel related costs, as well as direct advertising expenses, costs of office facilities, and costs of information technology systems. Historically, we have primarily funded these requirements through cash flow from our operations. For the year ended December 31, 2016, we generated $1.2 million cash flows from operations as reflected in our consolidated statements of cash flows.
As part of our strategic shift, we have begun and continue to reorganize our business around our Enterprise & Education Language and Literacy segments while we optimize our Consumer segment for profitability and cash generation. Our operating segments are affected by different sales-to-cash patterns. Within our Enterprise & Education Language and Literacy segments, revenue in our education, government, and corporate sales channels are seasonally stronger in the second half of the calendar year due to purchasing and budgeting cycles. Our Consumer revenue is affected by seasonal trends associated with the holiday shopping season. Consumer sales typically turn to cash more quickly than Enterprise & Education Language and Literacy sales, which tend to have longer collection cycles. Historically, in the first half of the year we have been a net user of cash and in the second half of the year we have been a net generator of cash. We expect this trend to continue.

47


On October 28, 2014, we entered into a $25.0 million revolving credit Loan and Security Agreement with Silicon Valley Bank, which was amended effective March 31, 2015, May 1, 2015, June 29, 2015, December 29, 2015 and further amended effective March 14, 2016. Under the amended agreement, we may borrow up to $25.0 million including a sub-facility, which reduces available borrowings, for letters of credit in the aggregate availability amount of $4.0 million (the "credit facility"). Borrowings by RSL under the credit facility are guaranteed by us as the ultimate parent. The credit facility has a term that expires on January 1, 2018, during which time RSL may borrow and re-pay loan amounts and re-borrow the loan amounts subject to customary borrowing conditions.
The total obligations under the credit facility cannot exceed the lesser of (i) the total revolving commitment of $25.0 million or (ii) the borrowing base, which is calculated as 80% of eligible accounts receivable. As a result, the borrowing base will fluctuate and we expect it will follow the general seasonality of cash and accounts receivable (lower in the first half of the year and higher in the second half of the year). If the borrowing base less any outstanding amounts, plus the cash held at SVB ("Availability") is greater than $25.0 million, then we may borrow up to an additional $5.0 million, but in no case can borrowings exceed $25.0 million. Interest on borrowings accrue at the Prime Rate provided that we maintain a minimum cash and Availability balance of $17.5 million. If cash and Availability is below $17.5 million, interest will accrue at the Prime Rate plus 1%.
As of the date of this filing, no borrowings have been made under the revolving credit agreement and we were eligible to borrow $20.8 million of available credit less $4.0 million in letters of credit that have been issued by Silicon Valley Bank on our behalf, resulting in a net borrowing availability of $16.8 million. We are subject to certain financial and restrictive covenants under the credit facility, which have been amended to reflect the revised outlook in connection with our 2016 Restructuring Plan. We are required to maintain compliance with a minimum liquidity ratio and maintain a minimum Adjusted EBITDA. As of December 31, 2016, we were in compliance with all of the covenants under the revolving credit agreement. On March 10, 2017, we entered into the sixth amendment to the credit facility, which primarily extended the term to April 1, 2020.
The total amount of cash that was held by foreign subsidiaries as of December 31, 2016 was $6.5 million. As of December 31, 2016, we do not intend to repatriate the cash from our foreign subsidiaries, however, if we were to repatriate this foreign cash, no tax liability would result due to the current period and carryforward net operating losses.
During the last three years, inflation has not had a material effect on our business and we do not expect that inflation or changing prices will materially affect our business in the foreseeable future.
Capital Resources
We believe our current cash and cash equivalents, short-term investments, and funds generated from our sales will be sufficient to meet our cash needs for at least the next twelve months from the date of issuance of this report. We have generated significant operating losses as reflected in our accumulated deficit and stockholders' deficit and we may continue to incur operating losses in the future that may continue to require additional working capital to execute strategic initiatives. Our future capital requirements will depend on many factors, including development of new products, market acceptance of our products, the levels of advertising and promotion required to launch additional products and improve our competitive position in the marketplace, the expansion of our sales, support and marketing organizations, the optimization of office space in the U.S. and worldwide, building the infrastructure necessary to support our growth, the response of competitors to our products and services, and our relationships with suppliers. We extend payments to certain vendors in order to minimize the amount of working capital deployed in the business. In order to maximize our cash position, we will continue to manage our existing inventory, accounts receivable, and accounts payable balances. Borrowings under our credit facility can be utilized to meet working capital requirements, anticipated capital expenditures, and other obligations.
Cash Flow Analysis for the Year ended December 31, 2016 as compared to the year ended December 31, 2015
 
 
Year ended December 31,
 
2016 versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Net cash provided by (used in) operating activities
 
$
1,240

 
$
(5,645
)
 
$
6,885

 
(122.0
)%
Net cash used in investing activities
 
$
(12,476
)
 
$
(9,374
)
 
$
(3,102
)
 
33.1
 %
Net cash used in financing activities
 
$
(658
)
 
$
(727
)
 
$
69

 
(9.5
)%

48


Net Cash Provided By Operating Activities
Net cash provided by operating activities was $1.2 million for the year ended December 31, 2016 compared to net cash used in operating activities of $5.6 million for the year ended December 31, 2015, a favorable change of $6.9 million. The primary factor contributing to the increase in cash provided by operating activities is the improvement in net loss, which reflects our cost reduction initiatives to drive profitable results. For a summary of the factors that led to the net loss for the year ended December 31, 2016 see "Results of Operations" section above. Non-cash items primarily consisted of $13.3 million in depreciation and amortization expense, $4.9 million in stock-based compensation expense, and $3.9 million in impairment loss, which was partially offset by $2.4 million in a gain on foreign currency transactions. The primary drivers of the change in operating assets and liabilities were a decrease in accounts receivable of $14.7 million and an increase in accrued compensation of $2.7 million, partially offset by a decrease in other current liabilities of $13.3 million. The decrease in accounts receivable was primarily related to the lower sales during 2016 as compared to 2015 and faster collections which slightly improved days sales outstanding. The increase in accrued compensation was primarily attributable to an increase in variable compensation related to a higher funding rate in 2016 when compared to 2015. The decrease in other current liabilities reflected our shift in strategy, which resulted in lower operating expenses and fewer obligations due for marketing, advertising, and rebates which included the $4.6 million cash outflow associated with the reduction in suggested retail value initiated in mid-2016
Net Cash Used in Investing Activities
Net cash used in investing activities was $12.5 million for the year ended December 31, 2016, compared to $9.4 million for the year ended December 31, 2015. Net cash used in investing activities increased primarily due to a larger amount of capitalized software costs in 2016 as compared to 2015.
Net Cash Used in Financing Activities
Net cash used in financing activities was flat at $0.7 million for the years ended December 31, 2016 and 2015.
Cash Flow Analysis for the Year ended December 31, 2015 as compared to the year ended December 31, 2014
 
 
Year ended December 31,
 
2015 versus 2014
 
 
2015
 
2014
 
Change
 
% Change
 
 
(in thousands, except percentages)
Net cash (used in) provided by operating activities
 
$
(5,645
)
 
$
6,673

 
$
(12,318
)
 
(184.6
)%
Net cash used in investing activities
 
$
(9,374
)
 
$
(39,109
)
 
$
29,735

 
(76.0
)%
Net cash used in financing activities
 
$
(727
)
 
$
(305
)
 
$
(422
)
 
138.4
 %
Net Cash Used In Operating Activities
Net cash used in operating activities was $5.6 million for the year ended December 31, 2015 compared to net cash provided by operating activities of $6.7 million for the year ended December 31, 2014. The primary factor affecting our net use of cash from operating activities during the year ended December 31, 2015 was our net loss of $46.8 million, which was too large to be offset by the non-cash adjustments totaling $31.1 million and the favorable overall change in operating assets and liabilities of $10.1 million. For a summary of the factors that led to the net loss for the year ended December 31, 2015 see "Results of Operations" section above. Non-cash items primarily consisted of $13.7 million in depreciation and amortization expense, $7.2 million in stock-based compensation expense, $6.8 million in impairment loss, $1.7 million in bad debt expense, and $1.5 million of loss on foreign currency transactions. The primary drivers of the change in operating assets and liabilities were a decrease in other current liabilities of $14.2 million, a decrease of $8.6 million in accounts payable, a decrease in accrued compensation of $5.5 million, an increase in deferred sales commissions of $4.1 million, and an increase of $1.3 million in inventory, partially offset by a decrease in accounts receivable of $26.4 million and an increase of $16.9 million in deferred revenue. The decrease in other current liabilities and accounts payable reflected our shift in strategy, which resulted in fewer obligations due for marketing, advertising, and rebates. The decrease in accrued compensation was primarily attributable to the 2015 Restructuring Plan, which reduced global non-Enterprise & Education headcount approximately 15% and led to a reduction in payroll, benefits, and variable compensation. The increase in deferred sales commission was primarily attributable to the 2014 acquisitions and an increase in Lexia deferred commissions. Inventory increased due to missed forecasts on holiday season sales orders resulting in additional inventory on hand. The decrease in accounts receivable was primarily related to the higher sales during the fourth quarter 2014 holiday season as compared to 2015. The increase in deferred revenue was primarily to a higher mix of Consumer revenue associated with web-based software subscription services and to a lesser extent the purchase accounting impacts related to the 2014 acquisitions.

49


Net cash provided by operating activities for the year ended December 31, 2014 was $6.7 million. The primary factors affecting our operating cash flows during the year were our net loss of $73.7 million, which were offset by non-cash charges totaling $37.1 million, and a favorable overall change in operating assets and liabilities of $43.3 million.  Non-cash items primarily consisted of $20.3 million in impairment loss, $13.9 million in depreciation and amortization expense, $6.8 million in stock-based compensation expense, and $2.4 million in bad debt expense, only slightly offset by a deferred income tax benefit of $7.7 million. The primary drivers of the change in operating assets and liabilities were an increase of $48.9 million in deferred revenue, an increase in other current liabilities of $11.3 million, and an increase of $8.4 million in accounts payable, partially offset by an increase in accounts receivable of $16.5 million, an increase in deferred sales commissions of $7.3 million, and a decrease in accrued compensation of $4.5 million. The increase in deferred revenue was primarily due to the purchase accounting impacts related to the 2014 acquisitions that did not exist in 2013. The increases in other current liabilities and accounts payable were primarily attributable to the timing of our cash payments. The increase in accounts receivable was primarily related to the higher sales during the fourth quarter 2014 holiday season as compared to 2013. The increase in deferred sales commission was primarily attributable to the 2014 acquisitions that did not exist in 2013. The decrease in accrued compensation was primarily due to the reduction of payroll, benefits, and the timing of cash payments.
Net Cash Used in Investing Activities
Net cash used in investing activities was $9.4 million for the year ended December 31, 2015, compared to net cash used of $39.1 million for the year ended December 31, 2014. Net cash used in investing activities decreased primarily due to the 2014 acquisition related cash outflows of $29.4 million pertaining to the acquisitions of Tell Me More and Vivity during the first quarter of 2014. In the first quarter of 2015, we paid the remaining holdback of $1.7 million related to the 2013 acquisition of Lexia. Purchases of property and equipment decreased from $9.7 million for the year ended December 31, 2014 to $8.9 million for the year ended December 31, 2015 primarily due to the reduction of internal-use software capitalization due to the completion and go-live of a major software project in late 2015. Proceeds from the sale of fixed assets totaled $1.6 million during the year ended December 31, 2015 associated with the fourth quarter 2015 sale of an owned office building in Harrisonburg, Virginia, with no comparable activity in 2014.
Net Cash Used in Financing Activities
Net cash used in financing activities was $0.7 million for the year ended December 31, 2015 compared to $0.3 million for the year ended December 31, 2014. The decrease in net cash related to financing activities was primarily due to the decrease in proceeds from the exercise of stock options of $0.6 million due to the decrease in our stock price. Capital lease payments totaled $0.7 million and $0.6 million during the years ended December 31, 2015 and 2014, respectively. Deferred financing costs were larger in 2014 due to the original execution of the revolving credit facility in the fourth quarter of 2014. Deferred financing fees continued to be incurred during 2015 due to the execution of the four amendments discussed above. As mentioned earlier, no borrowings have been made under the revolving credit facility.
Off-Balance Sheet Arrangements
We do not engage in any off-balance sheet financing arrangements. We do not have any material interest in entities referred to as variable interest entities, which include special purpose entities and other structured finance entities.
Contractual Obligations
As discussed in Notes 9 and 16 of Item 8, Financial Statements and Supplementary Data, we lease buildings, parking spaces, equipment, and office space under operating lease agreements. We also lease a building in France, certain equipment, and certain software under capital lease agreements. The following table summarizes our future minimum rent payments under non-cancellable operating and capital lease agreements as of December 31, 2016 and the effect such obligations are expected to have on our liquidity and cash flow in future periods.
 
 
Total
 
Less than
1 Year
 
1-3 Years
 
3-5 Years
 
More than
5 Years
 
 
(in thousands)
Capitalized leases and other financing arrangements
 
$
2,901

 
$
635

 
$
963

 
$
949

 
$
354

Operating leases
 
12,250

 
4,552

 
6,104

 
1,594

 

Total
 
$
15,151

 
$
5,187

 
$
7,067

 
$
2,543

 
$
354


50


Item 7A.    Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Exchange Risk
The functional currency of our foreign subsidiaries is their local currency. Accordingly, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. The volatility of the prices and applicable rates are dependent on many factors that we cannot forecast with reliable accuracy. In the event our foreign sales and expenses increase, our operating results may be more greatly affected by fluctuations in the exchange rates of the currencies in which we do business. At this time we do not, but we may in the future, invest in derivatives or other financial instruments in an attempt to hedge our foreign currency exchange risk.
Interest Rate Sensitivity
Interest income and expense are sensitive to changes in the general level of U.S. interest rates. However, based on the nature and current level of our marketable securities, which are primarily short-term investment grade and government securities and our notes payable, we believe that there is no material risk of exposure.
Credit Risk
Accounts receivable and cash and cash equivalents present the highest potential concentrations of credit risk. We reserve for credit losses and do not require collateral on our trade accounts receivable. In addition, we maintain cash and investment balances in accounts at various banks and brokerage firms. We have not experienced any losses on cash and cash equivalent accounts to date. We sell products to retailers, resellers, government agencies, and individual consumers and extend credit based on an evaluation of the customer's financial condition, without requiring collateral. Exposure to losses on accounts receivable is principally dependent on each customer's financial condition. We monitor exposure for credit losses and maintain allowances for anticipated losses. We maintain trade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers.
Item 8.    Financial Statements and Supplementary Data
Our consolidated financial statements, together with the related notes and the report of independent registered public accounting firm, are set forth on the pages indicated in Item 15.
Item 9.    Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.    Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Management, with the participation of our Interim Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2016. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2016, our Interim Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
Management's annual report on internal control over financial reporting
Management is responsible for establishing and maintaining adequate internal control over our financial reporting. Management has assessed the effectiveness of internal control over financial reporting as of December 31, 2016. Management's assessment was based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, in Internal Control—Integrated Framework (2013).

51


Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:
(1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of our assets;

(2)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of management and Board of Directors; and

(3)
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Based on using the COSO criteria, management believes our internal control over financial reporting as of December 31, 2016 was effective.
Our independent registered public accounting firm, Deloitte & Touche LLP, has audited the financial statements included in this Annual Report on Form 10-K and has issued a report on the effectiveness of our internal control over financial reporting. The attestation report of Deloitte & Touche LLP is included on page F-3 of this Form 10-K.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) or 15d-15(d) of the Exchange Act that occurred during the quarter ended December 31, 2016 that had materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.    Other Information
None.

52


PART III
Certain information required by Part III is omitted from this Annual Report on Form 10-K as we intend to file our definitive Proxy Statement for the 2017 Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 days after the end of the fiscal year covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein by reference.
Item 10.    Directors, Executive Officers and Corporate Governance
The information required by this Item is incorporated herein by reference to the information provided under the headings "Our Board of Directors and Nominees," "Security Ownership of Certain Beneficial Owners and Management—Section 16(A) Beneficial Ownership Reporting Compliance," "Corporate Governance—Code of Ethics," "Corporate Governance—Composition of our Board of Directors; Classified Board," "Corporate Governance—Committees of our Board of Directors," "Corporate Governance—Audit Committee," "Corporate Governance—Compensation Committee," and "Corporate Governance—Corporate Governance and Nominating Committee" in our definitive proxy statement for the 2017 Annual Meeting of Stockholders to be filed with the SEC no later than 120 days after the fiscal year ended December 31, 2016 (the "2017 Proxy Statement").
Code of Ethics and Business Conduct
We have adopted a code of ethics and business conduct ("code of conduct") that applies to all of our employees, officers and directors, including without limitation our principal executive officer, principal financial officer, and principal accounting officer. Copies of both the code of conduct, as well as any waiver of a provision of the code of conduct granted to any senior officer or director or material amendment to the code of conduct, if any, are available, without charge, under the "Corporate Governance" tab of the "Investor Relations" section on our website at www.rosettastone.com. We intend to disclose any amendments or waivers of this code on our website.
Item 11.    Executive Compensation
The information required by this Item is incorporated herein by reference to the information provided under the headings "Compensation Committee Report," "Executive Compensation," "Director Compensation," "Compensation Committee" and "Corporate Governance—Interlocks and Insider Participation" in the 2017 Proxy Statement.
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated herein by reference to the information provided under the headings "Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation" in the 2017 Proxy Statement.
Item 13.    Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated herein by reference to the information provided under the headings "Corporate Governance—Director Independence," and "Transactions with Related Persons" in the 2017 Proxy Statement.
Item 14.    Principal Accounting Fees and Services
The information required by this Item is incorporated herein by reference to the information provided under the heading "Principal Accountant Fees and Services" in the 2017 Proxy Statement.

53


PART IV
Item 15.    Exhibits and Financial Statement Schedules

(a)
Consolidated Financial Statements
1.Consolidated Financial Statements.    The consolidated financial statements as listed in the accompanying "Index to Consolidated Financial Information" are filed as part of this Annual Report.
2.Consolidated Financial Statement Schedules.    Schedules have been omitted because they are not applicable or are not required or the information required to be set forth in those schedules is included in the consolidated financial statements or related notes.
All other schedules not listed in the accompanying index have been omitted as they are either not required or not applicable, or the required information is included in the consolidated financial statements or the notes thereto.
(b)
Exhibits
The exhibits listed in the Index to Exhibits are filed as part of this Annual Report on Form 10-K.

54


SIGNATURES
        Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

ROSETTA STONE INC.
By:
 
/s/ A. JOHN HASS III
 
 
A. John Hass
President, Chief Executive Officer,
and Chairman of the Board
Date: March 14, 2017
        Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
 
Title
Date
 
 
 
 
/s/ A. JOHN HASS III
 
President, Chief Executive Officer and Chairman of the Board
(Principal Executive Officer)
March 14, 2017
A. John Hass III
 
 
 
 
 
 
 
/s/ THOMAS M. PIERNO
 
Chief Financial Officer
(Principal Financial Officer)
March 14, 2017
Thomas M. Pierno
 
 
 
 
 
 
 
/s/ M. SEAN HARTFORD
 
Vice President, Controller and Principal Accounting Officer
(Principal Accounting Officer)
March 14, 2017
M. Sean Hartford
 
 
 
 
 
 
 
/s/ PATRICK W. GROSS
 
Director
March 14, 2017
Patrick W. Gross
 
 
 
 
 
 
 
/s/ LAURENCE FRANKLIN
 
Director
March 14, 2017
Laurence Franklin
 
 
 
 
 
 
 
/s/ DAVID P. NIERENBERG
 
Director
March 14, 2017
David P. Nierenberg
 
 
 
 
 
 
 
/s/ CAROLINE J. TSAY
 
Director
March 14, 2017
Caroline J. Tsay
 
 
 
 
 
 
 
/s/ STEVEN P. YANKOVICH