As filed with the Securities and Exchange Commission on July 26, 2007

Registration No. 333-          

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

 

 

 

 

K12 Inc.
2300 Corporate Park Drive
Herndon, VA 20171
(703) 483-7000

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

 

 

Ronald J. Packard
Chief Executive Officer

K12 Inc.

2300 Corporate Park Drive

Herndon, VA 20171

(703) 483-7000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:   As soon as practicable after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.   o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

 

 

 

 

 

 

[INSIDE FRONT COVER]

 

TABLE OF CONTENTS

 

 

 

You should rely only on the information contained in this prospectus. We and the underwriters have not authorized anyone to provide you with different or additional information. This prospectus is not an offer to sell or a solicitation of an offer to buy our common stock in any jurisdiction where it is unlawful to do so. The information contained in this prospectus is accurate only as of its date, regardless of the date of delivery of this prospectus or of any sale of our common stock.

 

Until and including          , 2007, 25 days after the commencement of this offering, all dealers that affect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

 

PROSPECTUS SUMMARY

	•	According to the National Center for Education Statistics (NCES), a division of the U.S. Department of Education, there were more than 47 million students in K-12 public schools during the 2005-06 school year. In addition, according to National Home Education Research, approximately two million students are home schooled and, according to a March 2006 NCES report, approximately five million students are enrolled in private schools.
	•	According to the NCES, the public school system alone encompassed more than 97,000 schools and 17,000 school districts during the 2005-06 school year.
	•	According to the NCES, total spending in the public K-12 market was $536 billion for the 2004-05 school year.

Certain Risk Factors

 

Investing in our common stock involves substantial risk. You should carefully consider all the information in this prospectus prior to investing in our common stock and review the section entitled “Risk Factors” immediately following this prospectus summary. These risks and uncertainties include, but are not limited to, the following:

 

	•	Most of our revenues depend on adequate funding of the virtual public schools we serve. If our revenues from virtual public schools are reduced, restricted or delayed, our business, financial condition, results of operations and cash flows will be adversely affected.
	•	The poor performance or misconduct of other virtual public school operators could tarnish the reputation of all virtual public school operators, which could have a negative influence on our business.
	•	Opponents of virtual public schools have sought to challenge the establishment and expansion of such schools through the judicial process. If their interests prevail, it could damage our ability to sustain or grow our current business in certain jurisdictions.
	•	We have a limited operating history, and sustained losses of approximately $90 million before only recently achieving profitability. If we fail to remain profitable or achieve further marketplace acceptance for our products and services, our business, financial condition and results of operations will be adversely affected.
	•	Highly qualified teachers are critical to the success of our learning system. If we are not able to continue to recruit, train and retain quality certified teachers, our lessons might not be effectively delivered to students, compromising their academic performance and our reputation with the virtual public schools we serve. As a result, our brand, business and operating results may be adversely affected.

 

Our Corporate Information

 

We were incorporated in Delaware in December 1999. Our principal executive offices are located at 2300 Corporate Park Drive, Herndon, VA 20171. Our telephone number is (703) 483-7000. Our website address is www.K12.com . These are textual references only. We do not incorporate the information on, or accessible through, any of our websites into this prospectus, and you should not consider any information on, or that can be accessed through, our websites as part of this prospectus.

The Offering

Common Stock offered by us				shares
Common Stock offered by selling stockholders				shares
Total				shares
Common Stock outstanding after the offering				shares
Overallotment option				shares

 

Proposed New York Stock Exchange symbol		“LRN”
Use of proceeds from this offering		We estimate that our net proceeds from this offering will be approximately $      million, based on an assumed initial public offering price of $      per share (which is the midpoint of the range on the cover page of this prospectus). We intend to use the net proceeds from this offering for general corporate purposes, including working capital, capital expenditures and the development of new courses and product offerings as well as to repay approximately $6.5 million indebtedness under our revolving credit facility. We will receive no proceeds from the sale of common stock by the selling stockholders. See “Use of Proceeds.”

	•	gives effect to the automatic conversion of all of the outstanding shares of our preferred stock into 101,386,536 shares of our common stock immediately prior to the completion of this offering; and
	•	excludes 18,450,344 shares of common stock issuable upon the exercise of options outstanding as of March 31, 2007 at a weighted average exercise price of $1.41 per share, 2,328,358 shares of preferred stock (or upon the consummation of the offering an equivalent amount of common stock) that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are currently exercisable at a purchase price of $1.34 per share, and 108,649 shares of common stock that may be issued upon the exercise of warrants outstanding as of March 31, 2007, all of which are exercisable at a purchase price of $1.60 per share.

	•	a           for           stock split of our common stock to be effected prior to completion of this offering;
	•	an initial offering price of $      per share (which is the midpoint of the range on the cover page of this prospectus); and
	•	the underwriters’ option to purchase up to           additional shares of common stock is not exercised.

														Nine Months Ended
		Year Ended June 30,												March 31,
		2004				2005				2006				2006				2007
		(dollars in thousands, except per share data)
Consolidated Statement of Operations Data:
Revenues		$	71,434			$	85,310			$	116,902			$	90,088			$	104,930
Cost and expenses:
Instructional costs and services			39,943				49,130				64,828				48,473				55,103
Selling, administrative, and other operating expenses			25,656				30,031				41,660				28,403				35,059
Product development expenses			12,750				9,410				8,568				5,587				5,855
Total costs and expenses			78,349				88,571				115,056				82,463				96,017
Income (loss) from operations			(6,915	)			(3,261	)			1,846				7,625				8,913
Interest expense, net			(516	)			(279	)			(488	)			(394	)			(474	)
Net income (loss) before income taxes			(7,431	)			(3,540	)			1,358				7,231				8,439
Income tax expense			—				—				—				—				(227	)
Net income (loss)			(7,431	)			(3,540	)			1,358				7,231				8,212
Dividends on preferred stock			(2,667	)			(5,261	)			(5,851	)			(4,333	)			(4,707	)
Preferred stock accretion			(15,768	)			(15,947	)			(18,697	)			(13,880	)			(16,544	)
Net loss attributable to common stockholders		$	(25,866	)		$	(24,748	)		$	(23,190	)		$	(10,982	)		$	(13,039	)
Net loss attributable to common stockholders per share:
Basic and diluted		$	(2.58	)		$	(2.46	)		$	(2.30	)		$	(1.09	)		$	(1.28	)
Basic and diluted (pro forma) (1)			n/a				n/a			$	0.01				n/a			$	0.07
Weighted average shares used in computing per share amounts:
Basic and diluted			10,017,162				10,062,587				10,083,721				10,081,180				10,195,440
Basic (pro forma) (1)			n/a				n/a				106,937,388				n/a				111,581,976
Diluted (pro forma) (1)			n/a				n/a				107,055,314				n/a				111,621,446

														Nine Months Ended
		Year Ended June 30,												March 31,
		2004				2005				2006				2006				2007
		(dollars in thousands)
Other Data:
Net cash provided by (used in) operating activities		$	(8,020	)		$	9,697			$	3,625			$	1,137			$	7,324
Depreciation and amortization		$	4,922			$	5,509			$	4,986			$	3,574			$	4,618
Capital expenditures (2)		$	4,643			$	5,133			$	10,842			$	6,509			$	10,350
EBITDA (3)		$	(1,993	)		$	2,248			$	6,832			$	11,199			$	13,531
Average enrollments (4)			11,158				15,097				20,220				20,183				27,297

 

														As of
		As of June 30,												March 31,
		2004				2005				2006				2007
		(dollars in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	15,881			$	19,953			$	9,475			$	5,147
Total assets			42,714				41,968				48,485				64,001
Total short-term debt			—				—				—				1,500
Total long-term obligations			3,432				4,466				4,025				6,112
Convertible redeemable preferred stock			155,069				176,277				200,825				222,076
Total stockholders’ deficit			(125,621	)			(150,299	)			(173,451	)			(186,390	)
Working capital			24,130				22,953				15,421				14,617

(1)		Pro forma net income per common share gives effect to the automatic conversion of all of our outstanding shares of preferred stock into common stock immediately prior to the completion to this offering. Assuming the completion of this offering on March 31, 2007 and June 30, 2006, all of our outstanding shares of preferred stock would convert into 101,386,536 and 96,853,667 shares of common stock respectively.
(2)		Capital expenditures consist of the purchase of property and equipment and new capital lease obligations.
(3)		EBITDA consists of net income (loss) minus interest income, plus interest expense, plus income tax expense and plus depreciation and amortization. Interest income consists primarily of interest earned on short-term investments or cash deposits. Interest expense primarily consists of interest expense for capital leases, long-term and short-term borrowings. We use EBITDA as a measure of operating performance. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles, or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, net income (loss) as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management’s discretionary use, as it does not consider certain cash requirements such as tax payments.
		We believe EBITDA is useful to an investor in evaluating our operating performance because it is widely used to measure a company’s operating performance without regard to items such as depreciation and amortization, which can vary depending upon accounting methods and the book value of assets, and to present a meaningful measure of corporate performance exclusive of our capital structure and the method by which assets were acquired.

	•	as a measurement of operating performance, because it assists us in comparing our performance on a consistent basis, as it removes depreciation, amortization, interest and taxes; and

	•	in presentations to the members of our board of directors to enable our board to have the same measurement basis of operating performance as is used by management to compare our current operating results with corresponding prior periods and with the results of other companies in our industry.

														Nine Months Ended
		Year Ended June 30,												March 31,
		2004				2005				2006				2006				2007
		(dollars in thousands)
Net income (loss)		$	(7,431	)		$	(3,540	)		$	1,358			$	7,231			$	8,212
Interest expense, net			516				279				488				394				474
Income tax expense			—				—				—				—				227
Depreciation and amortization			4,922				5,509				4,986				3,574				4,618
EBITDA		$	(1,993	)		$	2,248			$	6,832			$	11,199			$	13,531

(4)		To ensure that all schools are reflected in our measure of enrollments, we consider our enrollments as of the end of September to be our opening enrollment level, and the number of students enrolled at the end of May to be our ending enrollment level. To provide comparability, we do not consider enrollment levels for June, July and August as all schools are not open during these months. For each period, average enrollments represent the average of the month end enrollment levels for each month that has transpired between September and the end of the period, up to and including the month of May.

 

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus, including our consolidated financial statements and the related notes, before investing in our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, also may become important factors that affect us. If any of the following risks materialize, our business, financial condition or results of operations could be materially harmed. In that case, the trading price of our common stock could decline, and you may lose some or all of your investment.

 

Risks Related to Government Funding and Regulation of Public Education

 

Most of our revenues depend on adequate funding of the virtual public schools we serve. If these schools do not receive adequate funding, our revenues could be reduced, restricted or delayed and our business, financial condition, results of operations and cash flows would be adversely affected.

 

The public schools we contract with are financed with government funding from federal, state and local taxpayers. Our business is primarily dependent upon those funds. Budget appropriations for education at all levels of government are determined through the political process and, as a result, funding for virtual public schools may fluctuate. This political process creates a number of risks that could have an adverse affect on our business including the following:

 

 

The poor performance or misconduct of other virtual public school operators could tarnish the reputation of all virtual public school operators, which could have a negative impact on our business.

 

As a relatively new form of public education, virtual school operators will be subject to scrutiny, perhaps even greater than that applied to traditional public schools or charter schools. Not all virtual public school operators will have successful academic programs or operate efficiently, and new entrants may not perform well either. Such underperforming operators could create the impression that virtual schooling is not an effective way to educate students, whether or not our learning system achieves solid performance. Moreover, some virtual school operators have been subject to governmental investigations alleging the misuse of public funds or financial irregularities. These allegations have attracted significant adverse media coverage and have prompted legislative hearings and regulatory responses. Although these investigations have focused on specific companies and individuals, they may negatively impact public perceptions of virtual public school providers generally, including us. If these few situations cause all virtual public school providers to be viewed by the public and/or policymakers unfavorably, we

may find it difficult to enter into or renew contracts to operate virtual schools. In addition, this perception could serve as the impetus for more restrictive legislation, which could limit our future business opportunities.

 

Opponents of virtual public schools have sought to challenge the establishment and expansion of such schools through the judicial process. If these interests prevail, it could damage our ability to sustain or grow our current business or expand in certain jurisdictions.

 

We have been, and will likely continue to be, subject to lawsuits filed against virtual public schools by those who do not share our belief in the value of this form of public education. Legal claims have involved challenges to the constitutionality of authorizing statutes, methods of instructional delivery, funding provisions and the respective roles of parents and teachers. We currently face two such lawsuits pertaining to the Wisconsin Virtual Academy and the Chicago Virtual Charter School. See “Business — Legal Proceedings”. An adverse judgment in these cases could serve as a negative precedent in other jurisdictions where we do business, and new lawsuits could result in unexpected liabilities and limit our ability to grow.

 

The failure of the virtual public schools we serve to comply with applicable government regulations could result in a loss of funding and an obligation to repay funds previously received, which could adversely affect our business, financial condition and results of operations.

 

Once authorized by law, virtual public schools are generally subject to extensive regulation. These regulations cover specific program standards and financial requirements including, but not limited to: (i) student eligibility standards; (ii) numeric and geographic limitations on enrollments; (iii) prescribed teacher funding allocations from per pupil revenue; (iv) state-specific curriculum requirements; and (v) restrictions on open-enrollment policies by and among districts. State and federal funding authorities conduct regular program and financial audits of virtual public schools, including the virtual public schools we serve, to ensure compliance with applicable regulations. Two virtual public schools we serve are currently undergoing such audits. If a virtual public school we serve is found to be noncompliant, it can be barred from receiving additional funds and could be required to repay funds received during the period of non-compliance, which could impair that school’s ability to pay us for services in a timely manner, if at all. Additionally, the indemnity provisions in our standard service agreements with virtual public schools may require us to return any contested funds on behalf of the school. For a more detailed discussion of the regulations affecting our business, see “Regulation.”

 

Virtual public schools are relatively new, and enabling legislation therefore is often ambiguous and subject to discrepancies in interpretation by regulatory authorities, which may lead to disputes over our ability to invoice and receive payments for services rendered.

 

Statutory language providing for virtual public schools is sometimes interpreted by regulatory authorities in ways that may vary from year to year, making compliance subject to uncertainty. For example, in Colorado, the regulators’ approach to determining the eligibility of virtual school students for funding purposes, which is based on a student’s substantial completion of a semester in a public school, has undergone varying interpretations. These regulatory uncertainties may lead to disputes over our ability to invoice and receive payments for services rendered, which could adversely affect our business, financial condition and results of operations.

 

The operation of virtual public schools depends on the maintenance of the authorizing charter and compliance with applicable laws. If these charters are not renewed, our contracts with these schools would be terminated.

 

In some cases, virtual public schools operate under a charter that is granted by a state or local authority to the charter holder, such as a community group or an established not-for-profit corporation, which typically is required by state law to qualify for student funding. The service agreement for these schools is with the charter holder or the charter board. For example, non-profit charter schools qualifying for exemption from federal taxation under Internal Revenue Code Section 501(c)(3) as charitable organizations must also operate in accordance with Internal Revenue Service rules and policies to maintain that status and their funding eligibility. In addition, all state charter school statutes require periodic reauthorization. If a virtual public school fails to maintain its tax-exempt status and funding eligibility, or if its charter is revoked for non-performance or other reasons that may be due to actions of the independent charter board completely outside of our control, our contract with that school would be terminated.

Actual or alleged misconduct by our senior management and directors would make it more difficult for us to enter into new contracts or renew existing contracts.

 

If any of our directors, officers or key employees are accused or found to be guilty of serious crimes, including the mismanagement of public funds, the schools we serve could be barred from entering into or renewing service agreements with us or otherwise discouraged from contracting with us and, as a result, our business and revenues would be adversely affected.

 

Risks Related to Our Business and Our Industry

 

We have a limited operating history, and sustained losses of approximately $90 million before only recently achieving profitability. If we fail to remain profitable or achieve further marketplace acceptance for our products and services, our business, financial condition and results of operations will be adversely affected.

 

The virtual public schools we serve began enrolling students in the 2002-03 school year. As a result, we have only a limited operating history upon which you can evaluate our business and prospects. Since our inception, we have recorded net losses totaling approximately $90 million until we recently achieved profitability. We recorded our first profit in the fiscal year ended June 30, 2006. There can be no assurance that we will remain profitable, or that our products and services will achieve further marketplace acceptance. Our marketing efforts may not generate a sufficient number of student enrollments to sustain our business plan; our capital and operating costs may exceed planned levels; and we may be unable to develop and enhance our service offerings to meet the demands of virtual public schools and students to the extent that such demands and preferences change. If we are not successful in managing our business and operations, our financial condition and results of operations will be adversely affected.

 

Highly qualified teachers are critical to the success of our learning system. If we are not able to continue to recruit, train and retain quality certified teachers, our curriculum might not be effectively delivered to students, compromising their academic performance and our reputation with the virtual public schools we serve. As a result, our brand, business and operating results may be adversely affected.

 

Effective teachers are critical to maintaining the quality of our learning system and assisting students with their daily lessons. Teachers in virtual public schools must be state certified and have strong interpersonal communications skills to be able to effectively instruct students in a virtual school setting. They must also possess the technical skills to use our technology-based learning system. There is a limited pool of teachers with these specialized attributes and the virtual public schools we serve must provide competitive compensation packages to attract and retain such qualified teachers.

 

The teachers in most virtual public schools we serve are not our employees and the ultimate authority relating to those teachers resides with the governing body overseeing the schools. However, under many of our service agreements with virtual public schools, we have responsibility to recruit, train and manage these teachers. We must also provide continuous training to virtual public school teachers so that they can stay abreast of changes in student demands, academic standards and other key trends necessary to teach online effectively. We may not be able to recruit, train and retain enough qualified teachers to keep pace with our growth while maintaining consistent teaching quality in the various virtual public schools we serve. Shortages of qualified teachers or decreases in the quality of our instruction, whether actual or perceived, would have an adverse effect on our business.

 

The schools we contract with and serve are governed by independent governing bodies who may shift their priorities or change objectives in ways adverse to us.

 

We contract with and provide a majority of our products and services to virtual public schools governed by independent boards or similar governing bodies. While we typically share a common objective at the outset of our business relationship, over time our interests could diverge. If these independent boards of the schools we serve subsequently shift their priorities or change objectives, and as a result reduce the scope or terminate their relationship with us, our ability to generate revenues would be adversely affected.

Our contracts with the virtual public schools we serve are subject to periodic renewal, and each year several of these agreements are set to expire. If we are unable to renew several such contracts or if a single significant contract expires during a given year, our business, financial condition, results of operations and cash flow could be adversely affected.

 

For the 2007-08 school year, we have contracts to provide our full range of products and services to virtual public schools in 16 states and the District of Columbia. Several of these contracts are scheduled to expire in any given year. For example, five such contracts are scheduled to expire in 2008, and we usually begin to engage in renewal negotiations during the final year of these contracts. In order to renew these contracts, we have to enter into negotiations with the independent boards of these virtual public schools. If we are unable to renew several such contracts or one significant contract expiring during a given year, our business, financial condition, results of operations and cash flow could be adversely affected.

 

We generate significant revenues from four virtual public schools, and the termination, revocation, expiration or modification of our contracts with these virtual public schools could adversely affect our business, financial condition and results of operation.

 

During the nine months ended March 31, 2007, sales of our products and services to four virtual public schools accounted for approximately 17%, 12%, 11% and 10% of our revenues. If our contracts with any of these virtual public schools are terminated, the charters to operate any of these schools are not renewed or are revoked, enrollments decline substantially, funding is reduced, or more restrictive legislation is enacted, our business, financial condition and results of operations could be adversely affected.

 

We may not be able to effectively address the execution risks associated with our expansion into the virtual high school market. Our failure to do so could substantially harm our growth strategy.

 

The virtual high school market presents us with a number of challenges, including timely deployment of new courses in the 2007-08 school year, and the planned launch of 11th and 12th grade offerings. We are currently using third-party platforms and some third-party curriculum in our high school offering. If the quality of the third-party curriculum or platforms is unsatisfactory, student enrollments could decline. Furthermore, the subject matter expertise and skills necessary to teach in high school are fundamentally different than those necessary to teach kindergarten through 8th grade. If the high school instructional experience does not meet the expectations of students previously enrolled in our kindergarten through 8th grade programs, or new enrollees experience performance issues with our high school program delivery, the virtual public schools we serve may decline to offer our high school program and our business, financial condition and results of operations may be adversely affected.

 

Our growth strategy anticipates that we will create new products and distribution channels and expand existing distribution channels. If we are unable to effectively manage these initiatives, our business, financial condition, results of operations and cash flows would be adversely affected.

 

As we create new products and distribution channels and expand our existing distribution channels, we expect to face challenges distinct from those we currently encounter, including:

 

 

Our failure to manage these new distribution channels, or any new distribution channels we pursue, may have an adverse effect on our business, financial condition, results of operations and cash flows.

 

Increasing competition in the market segments that we serve could lead to pricing pressures, reduced operating margins, loss of market share and increased capital expenditures.

 

We face varying degrees of competition from several discrete education providers because our learning system integrates all the elements of the education development and delivery process, including curriculum development, textbook publishing, teacher training and support, lesson planning, testing and assessment, and school performance and compliance management. We compete most directly with companies that provide online curriculum and support services to K-12 virtual public schools. Additionally, we expect increased competition from for-profit post-secondary and supplementary education providers that have begun to offer virtual high school curriculum and services. In certain jurisdictions and states where we currently serve virtual public schools, we expect intense competition from existing providers and new entrants. Our competitors may adopt similar curriculum delivery, school support and marketing approaches, with different pricing and service packages that may have greater appeal in the market. If we are unable to successfully compete for new business, win and renew contracts or maintain current levels of academic achievement, our revenue growth and operating margins may decline. Price competition from our current and future competitors could also result in reduced revenues, reduced margins or the failure of our product and service offerings to achieve or maintain more widespread market acceptance.

 

We may also face direct competition from publishers of traditional educational materials that are substantially larger than we are and have significantly greater financial, technical and marketing resources. As a result, they may be able to devote more resources to develop products and services that are superior to our platform and technologies. We may not have the resources necessary to acquire or compete with technologies being developed by our competitors, which may render our online delivery format less competitive or obsolete.

 

Our future success will depend in large part on our ability to maintain a competitive position with our curriculum and our technology, as well as our ability to increase capital expenditures to sustain the competitive position of our product. We cannot assure you that we will have the financial resources, technical expertise, marketing, distribution or support capabilities to compete effectively.

 

If demand for increased options in public schooling does not continue or if additional jurisdictions do not authorize or adequately fund virtual public schools, our business, financial condition and results of operations could be adversely affected.

 

According to the Center for Education Reform, as of January 2007 there were 173 virtual schools with total enrollments exceeding 92,000 students, operating in 18 states. However, if the demand for virtual public schools does not increase, if additional jurisdictions do not authorize new virtual schools or if the funding of such schools is inadequate, our business, financial condition and results of operations could be adversely affected.

 

Our business is subject to seasonal fluctuations, which may cause our operating results to fluctuate from quarter-to-quarter and adversely impact the market price of our common stock.

 

Our revenues and operating results normally fluctuate as a result of seasonal variations in our business, principally due to the number of months in a fiscal quarter that our virtual public schools are fully operational and serving students. In the typical academic year, our first and fourth fiscal quarters may have fewer than three full months of operations, whereas our second and third fiscal quarters will have three complete months of operations. We ship offline learning kits to students in the beginning of the school year, our first fiscal quarter, generally resulting in higher offline learning kit revenues and margins in the first fiscal quarter relative to the other quarters. In aggregate, the seasonality of our revenues has generally produced higher revenues in the first fiscal quarter and lower revenues in the fourth fiscal quarter.

 

Our operating expenses are also seasonal. Instructional costs and services increase in the first fiscal quarter primarily due to the costs incurred to ship offline learning kits at the beginning of the school year. These instructional costs may increase significantly quarter-to-quarter as school operating expenses increase. The majority of our selling and marketing expenses are incurred in the first and fourth fiscal quarters, as our primary enrollment season is July through September.

We expect quarterly fluctuations in our revenues and operating results to continue. These fluctuations could result in volatility and adversely affect our cash flow. As our business grows, these seasonal fluctuations may become more pronounced. As a result, we believe that quarterly comparisons of our financial results may not be reliable as an indication of future performance.

 

Our revenues for a fiscal year are based in part on our estimate of the total funds each school will receive in a particular school year and our estimate of the full year deficits to be incurred by each school. As a result, differences between our estimates and the actual funds received and deficits incurred could have an adverse impact on our results of operations and cash flows.

 

We recognize revenues from certain of our fees ratably over the course of our fiscal year. To determine the amount of revenues to recognize, we estimate the total funds each school will receive in a particular school year. Additionally, we take responsibility for any operating deficits at most of the virtual schools we serve. Because these operating deficits may impair our ability to collect the full amount invoiced in a period and collection cannot reasonably be assured, we reduce revenues by the estimated amount of these deficits. We review our estimates of total funds and operating deficits periodically, and we revise as necessary, amortizing any adjustments over the remaining portion of the fiscal year. Actual funding received and operating deficits incurred may vary from our estimates or revisions and could adversely impact our results of operation and cash flows.

 

The continued development of our brand identity is important to our business. If we are not able to maintain and enhance our brand, our business and operating results may suffer.

 

Expanding brand awareness is critical to attracting and retaining students, and for serving additional virtual public schools. In order to expand brand awareness, we intend to spend significant resources on a brand-enhancement strategy, which includes sales and marketing efforts directed to targeted locations as well as the national marketplace, the educational community at large, key political groups, image-makers and the media. We believe that the quality of our curriculum and management services has contributed significantly to the success of our brand. As we continue to increase enrollments and extend our geographic reach, maintaining quality and consistency across all of our services and products may become more difficult to achieve, and any significant and well-publicized failure to maintain this quality and consistency will have a detrimental effect on our brand. We cannot provide assurances that our new sales and marketing efforts will be successful in further promoting our brand in a competitive and cost effective manner. If we are unable to further enhance our brand recognition and increase awareness of our products and services, or if we incur excessive sales and marketing expenses, our business and results of operations could be adversely affected.

 

Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.

 

Our patent, trademarks, trade secrets, copyrights and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights could harm our business or our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results.

 

Although we seek to obtain patent protection for our innovations, it is possible that we may not be able to protect some of these innovations. In addition, given the costs of obtaining patent protection, we may choose not to protect certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable.

 

We also seek to maintain certain intellectual property as trade secrets. This secrecy could be compromised by outside parties, or by our employees intentionally or accidentally, which would cause us to lose the competitive advantage resulting from these trade secrets.

We must monitor and protect our Internet domain names to preserve their value.

 

We own the domain names K12 (.com and .org) and K-12 (.com, .net, and .org) as well as the service mark K ¹² . Third parties may acquire substantially similar domain names that decrease the value of our domain names and trademarks and other proprietary rights which may hurt our business. The regulation of domain names in the United States and foreign countries is subject to change. Governing bodies could appoint additional domain name registrars or modify the requirements for holding domain names. Governing bodies could also establish additional “top-level” domains, which are the portion of the Web address that appears to the right of the “dot,” such as “com,” “gov,” or “org.” As a result, we may not maintain exclusive rights to all potentially relevant domain names in the United States or in other countries in which we conduct business.

 

We may be sued for infringing the intellectual property rights of others and such actions would be costly to defend, could require us to pay damages and could limit our ability or increase our costs to use certain technologies in the future.

 

Companies in the Internet, technology, education, curriculum and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. As we grow, the likelihood that we may be subject to such claims also increases. Regardless of the merits, intellectual property claims are often time-consuming and expensive to litigate or settle. In addition, to the extent claims against us are successful, we may have to pay substantial monetary damages or discontinue any of our products, services or practices that are found to be in violation of another party’s rights. We also may have to seek a license and make royalty payments to continue offering our products and services or following such practices, which may significantly increase our operating expenses.

 

We may be subject to legal liability resulting from the actions of third parties, including independent contractors and teachers, which could cause us to incur substantial costs and damage our reputation.

 

We may be subject, directly or indirectly, to legal claims associated with the actions of our independent contractors and teachers. In the event of accidents or injuries or other harm to students, we could face claims alleging that we were negligent, provided inadequate supervision or were otherwise liable for their injuries. Additionally, we could face claims alleging that our independent curriculum contractors or teachers infringed the intellectual property rights of third parties. A liability claim against us or any of our independent contractors or teachers could adversely affect our reputation, enrollment and revenues. Even if unsuccessful, such a claim could create unfavorable publicity, cause us to incur substantial expenses and divert the time and attention of management.

 

Unauthorized disclosure or manipulation of student, teacher and other sensitive data, whether through breach of our network security or otherwise, could expose us to costly litigation or could jeopardize our contracts with virtual public schools.

 

Maintaining our network security is of critical importance because our Student Administration Management System (SAMS) stores proprietary and confidential student and teacher information, such as names, addresses, and other personal information. Individuals and groups may develop and deploy viruses, worms and other malicious software programs that attack or attempt to infiltrate SAMS. If our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise, third parties may be able to access student records and we could be subject to liability or our business could be interrupted. Penetration of our network security could have a negative impact on our reputation and could lead virtual public schools and parents to choose competitive offerings. As a result, we may be required to expend significant resources to provide additional protection from the threat of these security breaches or to alleviate problems caused by these breaches.

We rely on the Internet to enroll students and to deliver our products and services to children, which exposes us to a growing number of legal risks and increasing regulation.

 

We collect information regarding students during the online enrollment process, and a significant amount of our curriculum content is delivered over the Internet. As a result, specific federal and state laws that could have an impact on our business include the following:

 

 

In addition, the laws applicable to the Internet are still developing. These laws impact pricing, advertising, taxation, consumer protection, quality of products and services, and are in a state of change. New laws may also be enacted, which could increase the costs of regulatory compliance for us or force us to change our business practices. As a result, we may be exposed to substantial liability, including significant expenses necessary to comply with such laws and regulations.

 

System disruptions and vulnerability from security risks to our online computer networks could impact our ability to generate revenues and damage our reputation, limiting our ability to attract and retain students.

 

The performance and reliability of our technology infrastructure is critical to our reputation and ability to attract and retain virtual public schools, parents and students. Any sustained system error or failure, or a sudden and significant increase in bandwidth usage, could limit access to our learning system, and therefore, damage our ability to generate revenues. Our technology infrastructure could be vulnerable to interruption or malfunction due to events beyond our control, including natural disasters, terrorist activities and telecommunications failures.

 

Substantially all of the inventory for our offline learning kits is located in one warehouse facility. Any damage or disruption at this facility would have an adverse effect on our business, financial condition and results of operations.

 

Substantially all of the inventory for our offline learning kits is located in one warehouse facility operated by a third-party. A natural disaster, fire, power interruption, work stoppage or other unanticipated catastrophic event, especially during the period from May through September when we have received most of the curriculum materials for the school year and have not yet shipped such materials to students, could significantly disrupt our ability to deliver our products and operate our business. If any of our material inventory were to experience any significant damage, we would be unable to meet our contractual obligations and our business would suffer.

 

Any significant interruption in the operations of our data center could cause a loss of data and disrupt our ability to manage our network hardware and software and technological infrastructure.

 

We host our products and serve all of our students from a third-party data center facility. While we are developing a risk mitigation plan, such a plan may not be able to prevent a significant interruption in the operation of this facility or the loss of school and operational data due to a natural disaster, fire, power interruption, act of terrorism or other unanticipated catastrophic event. Any significant interruption in the operation of this facility, including an interruption caused by our failure to successfully expand or upgrade our systems or manage our transition to utilizing the expansions or upgrades, could reduce our ability to manage our network and technological infrastructure, which could result in lost sales, enrollment terminations and impact our brand reputation.

 

Additionally, we do not control the operation of this facility and must rely on a third-party to provide the physical security, facilities management and communications infrastructure services related to our data center. Although we believe we would be able to enter into a similar relationship with another third-party should this relationship fail or terminate for any reason, our reliance on a third-party vendor exposes us to risks outside of our control. If this third-party vendor encounters financial difficulty such as bankruptcy or other events beyond our control that causes it to fail to secure adequately and maintain its hosting facilities or provide the required data

communications capacity, students of the virtual public schools we serve may experience interruptions in our service or the loss or theft of important customer data.

 

Any significant interruption in the operations of our call center could disrupt our ability to respond to service requests and process orders and to deliver our products in a timely manner.

 

Our call center is housed in a single facility. We do not currently have a fully functional back-up system in place for this facility. While we are developing a risk mitigation plan, such a plan may not be able to prevent a significant interruption in the operation of this facility due to natural disasters, accidents, failures of the inventory locator or automated packing and shipping systems we use or other events. Any significant interruption in the operation of this facility, including an interruption caused by our failure to successfully expand or upgrade our systems or to manage these expansions or upgrades, could reduce our ability to respond to service requests, receive and process orders and provide products and services, which could result in lost and cancelled sales, and damage to our brand reputation.

 

Capacity limits on some of our technology, transaction processing systems and network hardware and software may be difficult to project and we may not be able to expand and upgrade our systems in a timely manner to meet significant unexpected increased demand.

 

As the number of virtual public schools we serve increases and our student base grows, the traffic on our transaction processing systems and network hardware and software will rise. We may be unable to accurately project the rate of increase in the use of our transaction processing systems and network hardware and software. In addition, we may not be able to expand and upgrade our systems and network hardware and software capabilities to accommodate significant unexpected increased use. If we are unable to appropriately upgrade our systems and network hardware and software in a timely manner, our operations and processes may be temporarily disrupted.

 

We may be unable to manage and adapt to changes in technology.

 

We will need to respond to technological advances and emerging industry standards in a cost-effective and timely manner in order to remain competitive. The need to respond to technological changes may require us to make substantial, unanticipated expenditures. There can be no assurance that we will be able to respond successfully to technological change.

 

We may be unable to attract and retain skilled employees.

 

Our success depends in large part on continued employment of senior management and key personnel who can effectively operate our business. If any of these employees leave us and we fail to effectively manage a transition to new personnel, or if we fail to attract and retain qualified and experienced professionals on acceptable terms, our business, financial conditions and results of operations could be adversely affected.

 

Our success also depends on our having highly trained financial, technical, recruiting, sales and marketing personnel. We will need to continue to hire additional personnel as our business grows. A shortage in the number of people with these skills or our failure to attract them to our Company could impede our ability to increase revenues from our existing products and services and to launch new product offerings, and would have an adverse effect on our business and financial results.

 

We may not be able to effectively manage our growth, which could impair our ability to operate profitably.

 

We have experienced significant expansion since our inception, which has sometimes strained our managerial, operational, financial and other resources. A substantial increase in our enrollment or the addition of new schools in a short period of time could strain our current resources and increase capital expenditures, without an immediate increase in revenues. Our failure to successfully manage our growth in a cost efficient manner and add and retain personnel to adequately support our growth could disrupt our business and decrease profitability.

 

We may need additional capital in the future, but there is no assurance that funds will be available on acceptable terms.

 

We may need to raise additional funds in order to achieve growth or fund other business initiatives. This financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing

stockholders. Additionally, any securities issued to raise funds may have rights, preferences or privileges senior to those of existing stockholders. If adequate funds are not available or are not available on acceptable terms, our ability to expand, develop or enhance services or products, or respond to competitive pressures will be limited.

 

Our curriculum and approach to instruction may not achieve widespread acceptance, which would limit our growth and profitability.

 

Our curriculum and approach to instruction are based on the structured delivery, clarification, verification and practice of lesson subject matter. The goal of this approach is to make students proficient at the fundamentals and to instill confidence in a subject prior to confronting new and complex concepts. This approach, however, is not accepted by all academics and educators, who may favor less formalistic methods. Accordingly, some academics and educators are opposed to the principles and methodologies associated with our approach to learning, and have the ability to negatively influence the market for our products and services.

 

If student performance falls or parent and student satisfaction declines, a significant number of students may not remain enrolled in a virtual public school that we serve, and our business, financial condition and results of operations will be adversely affected.

 

The success of our business depends on a family’s decision to have their child continue his or her education in a virtual public school that we serve. This decision is based on many factors, including student achievement and parent and student satisfaction. Students may perform significantly below state averages or the virtual school may fail to meet the standards of the No Child Left Behind Act. For instance, in the 2005-06 school year, an increase in certain enrollments in two of the virtual schools we served created the need to monitor two subgroups that did not meet Adequate Yearly Progress requirements of NCLB, causing those schools not to meet the Adequate Yearly Progress requirements for that year. We expect that, as our enrollments increase and the portion of students that have not used our learning system for multiple years increases, the average performance of all students using our learning system may decrease, even if the individual performance of other students improves over time. Additionally, parent and student satisfaction may decline as not all parents and students are able to devote the substantial time and energy necessary to complete our curriculum. A student’s satisfaction may also suffer if his or her relationship with the virtual school teacher does not meet expectations. If a student’s performance or satisfaction declines, students may decide not to remain enrolled in a virtual public school that we serve and our business, financial condition and results of operations will be adversely affected.

 

Although we do not currently transact business in a foreign country, we intend to expand into international markets, which will subject us to additional economic, operational and political risks that could increase our costs and make it difficult for us to continue to operate profitably.

 

One of our growth strategies is to pursue international opportunities that leverage our current product and service offerings. The addition of international operations may require significant expenditure of financial and management resources and result in increased administrative and compliance costs. As a result of such expansion, we will be increasingly subject to the risks inherent in conducting business internationally, including:

 

 

 

Risks Related to this Offering

 

The price of our common stock may be subject to wide fluctuations and may trade below the initial public offering price.

 

Before this offering, there has not been a public market for our common stock. The initial public offering price of our common stock will be determined by negotiations between us and representatives of the underwriters based on numerous factors, including those that we discuss under “Underwriting.” This price may not be indicative of the market price of our common stock after this offering. We cannot assure you that an active public market for our common stock will develop or be sustained after this offering. The market price of our common stock also could be subject to significant fluctuations. As a result, you may not be able to sell your shares of our common stock quickly or at prices equal to or greater than the price you paid in this offering.

 

Among the factors that could affect our common stock price are the risks described in this section and other factors, including:

 

 

Stock markets in general have experienced extreme volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations could adversely affect the trading price of our common stock, regardless of our operating performance.

 

Sales of substantial amounts of our common stock in the public markets, or the perception that they might occur, could reduce the price of our common stock and may dilute your voting power and your ownership interest in us.

 

After the completion of this offering, we will have           shares of common stock outstanding (           shares of common stock outstanding if the underwriters exercise their overallotment option in full). This number is comprised of all the shares of our common stock that we and the selling stockholders are selling in this offering (including           shares that we expect to be issued upon exercise of stock options by certain of the selling stockholders and resold in this offering), which may be resold immediately in the public market. Subject to certain exceptions described under the caption “Underwriting,” we and all of our directors and executive officers and all of our stockholders and optionholders have agreed not to offer, sell or agree to sell, directly or indirectly, any shares of common stock without the permission of the underwriters for a period of 180 days from the date of this prospectus. When this period expires we and our locked-up stockholders will be able to sell our shares in the public market. Sales of a substantial number of such shares upon expiration, or early release, of the lock-up (or the perception that such sales may occur) could cause our share price to fall.

 

We cannot predict what effect, if any, future sales of our common stock, or the availability of common stock for future sale, will have on the market price of our common stock. Sales of substantial amounts of our common stock in the public market following our initial public offering, including a secondary offering by the Company, or the perception that such sales could occur, could adversely affect the market price of our common stock and may make it more difficult for you to sell your common stock at a time and price that you deem appropriate.

We also may issue our shares of common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we may issue may in turn be significant. In addition, we may also grant registration rights covering those shares in connection with any such acquisitions and investments.

 

Upon completion of this offering,           of our shares of common stock will be restricted or control securities within the meaning of Rule 144 under the Securities Act of 1933, as amended, (           shares of common stock if the underwriters’ overallotment option is exercised in full). The rules affecting the sale of these securities are summarized under “Shares Eligible for Future Sale.”

 

Our principal stockholders hold (and following completion of this offering will continue to hold) shares of our common stock in which they have a large unrealized gain, and these stockholders may wish, to the extent they may permissibly do so, to realize some or all of that gain relatively quickly by selling some or all of their shares.

 

Investors purchasing common stock in this offering will experience immediate and substantial dilution.

 

The assumed initial public offering price of our common stock is substantially higher than the net tangible book value per outstanding share of our common stock immediately after this offering. As a result, you will pay a price per share that substantially exceeds the book value of our assets after subtracting our liabilities. Purchasers of our common stock in this offering will incur immediate and substantial dilution of $      per share in the net tangible book value of our common stock from the assumed initial public offering price of $      per share, which is the mid-point of the estimated range set forth on the cover of this prospectus. If the underwriters exercise their over-allotment option in full, there will be an additional dilution of $      per share in the net tangible book value of our common stock, assuming the same public offering price. See “Dilution.” In addition, if outstanding options to purchase shares of common stock are exercised, there could be substantial additional dilution.

 

Antitakeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.

 

Provisions in our amended and restated certificate of incorporation and amended and restated bylaws to be effective upon the consummation of this offering may delay or prevent an acquisition of us or a change in our management. These provisions will include a classified board of directors, prohibition on actions by written consent of our stockholders, and the ability of our board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirers to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.

 

As a result of becoming a public company, we will be obligated to develop and maintain proper and effective internal control over financial reporting and will be subject to other requirements that will be burdensome and costly. We may not timely complete our analysis of our internal control over financial reporting, or these internal controls may not be determined to be effective, which could adversely affect investor confidence in our company and, as a result, the value of our common stock.

 

We will be required, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404), to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting for the first fiscal year beginning after the effective date of this offering. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. In addition, our auditors will issue an attestation report on our internal control over financial reporting.

 

We are just beginning the costly and challenging process of compiling the system and processing documentation before we perform the evaluation needed to comply with Section 404. We may not be able to complete our

evaluation, testing and any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control is effective. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to issue an unqualified opinion that we maintained, in all material respects, effective internal control over financial reporting, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our common stock. Failure to comply with the new rules might make it more difficult for us to obtain certain types of insurance, including director and officer liability insurance, and we might be forced to accept reduced policy limits and coverage and/or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on committees of our board of directors, or as executive officers.

 

In addition, as a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company, and our administrative staff will be required to perform additional tasks. For example, in anticipation of becoming a public company, we will need to create or revise the roles and duties of our board committees, adopt disclosure controls and procedures, retain a transfer agent, adopt an insider trading policy and bear all of the internal and external costs of preparing and distributing periodic public reports in compliance with our obligations under federal securities laws. In addition, changing laws, regulations and standards relating to corporate governance and public disclosure, and related regulations implemented by the SEC and the New York Stock Exchange, are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and our business may be harmed.

 

Our largest stockholders will continue to have significant control over us after this offering, and they may make decisions with which you disagree.

 

Following the offering, assuming no exercise of the underwriters’ overallotment option, our current stockholders will beneficially own approximately     % of the outstanding shares of common stock (or approximately     % of the shares of common stock on a fully diluted basis, after giving effect to the exercise of all outstanding options and other rights to acquire common stock). As a result, such current stockholders may have the ability to control the election of our directors and the outcome of corporate actions requiring stockholder approval. This concentration of ownership could have the effect of discouraging potential take-over attempts and may make attempts by stockholders to change our management more difficult.

 

We have not paid and do not expect to pay dividends, and any return on your investment will likely be limited to the appreciation of our common stock.

 

We have never paid dividends on our common stock and do not anticipate paying dividends on our common stock in the foreseeable future. If, however, we decide to pay dividends on our common stock in the future, the payment of dividends will depend on our earnings, financial condition and other business and economic factors affecting us at such time as our board of directors may consider relevant. In addition, our credit facility with PNC Bank, N.A. (PNC Bank) contains covenants prohibiting the payment of cash dividends without their consent. Accordingly, for the foreseeable future, any return on your investment will be related to the appreciation of our stock price.

 

We have broad discretion in the use of the net proceeds from this offering and may not use them effectively.

 

We cannot specify with certainty the particular uses of the net proceeds we will receive from this offering. Our management will have broad discretion in the application of the net proceeds, including for any of the purposes described in “Use of Proceeds.” The failure by our management to apply these funds effectively could harm our

business. Pending their use, we may invest the net proceeds from this offering in a manner that does not produce income or that loses value.

 

If equity research analysts do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our common stock, the price of our common stock could decline.

 

The trading market for our common stock will rely in part on the research and reports that equity research analysts publish about us and our business. The price of our stock could decline if one or more securities analysts downgrade our stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.

 

The Securities and Exchange Commission, or SEC, encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. This prospectus contains such “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.

 

All statements other than statements of historical facts contained in this prospectus, including our disclosure and analysis concerning our operations, cash flows and financial position, business strategy and plans and objectives, including, in particular, the likelihood of our success developing and expanding our business, are forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. All forward-looking statements are management’s present expectations of future events and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. These risks include, but are not limited to, the risks and uncertainties set forth in “Risk Factors,” beginning on page 10 of this prospectus.

 

In light of these assumptions, risks and uncertainties, the results and events discussed in the forward-looking statements contained in this prospectus might not occur. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this prospectus. We are not under any obligation, and we expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. All subsequent forward-looking statements attributable to us or to any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.

 

This prospectus also contains estimates and other statistical data made by independent parties and by us relating to market size and growth and other industry data. These data involves a number of assumptions and limitations, and you are cautioned not to give undue weight to such estimates. We have not independently verified the statistical and other industry data generated by independent parties and contained in this prospectus and, accordingly, we cannot guarantee their accuracy or completeness. In addition, projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this prospectus. These and other factors could cause results to differ materially from those expressed in the estimates made by the independent parties and by us.

USE OF PROCEEDS

 

Assuming an initial public offering price of $      per share, we estimate that we will receive net proceeds from this offering of approximately $      million, after deducting underwriting discounts and commissions and other estimated expenses of $      million payable by us. If the underwriters exercise their overallotment option in full, we estimate that our net proceeds from this offering will be approximately $      million. We will not receive any of the proceeds from the sale of shares by the selling stockholders. A $1.00 increase (decrease) in the assumed initial public offering price of $      per share would increase (decrease) the net proceeds to us from this offering by approximately $      million, assuming the number of shares offered, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

We intend to use the net proceeds from this offering for general corporate purposes, including working capital, capital expenditures and the development of new courses and product offerings. In addition, we intend to repay approximately $6.5 million of borrowings under our revolving credit facility, which bears interest at rates of approximately 6.6%, with various maturity dates on or before October 1, 2007 that may be renewed at the then current interest rate. Management will have broad discretion in the allocation of the net proceeds of this offering. Depending upon future events, we may determine at a later time to use the net proceeds for different purposes. Pending their use, we plan to invest the net proceeds in short-term, investment grade, interest-bearing securities.

DIVIDEND POLICY

 

We have never paid or declared a dividend on our common stock, and we intend to retain all future earnings, if any, for use in the operation of our business and to fund future growth. We do not anticipate paying any dividends for the indefinite future, and our credit facility with PNC Bank, N.A. limits our ability to pay dividends or other distributions on our common stock. The decision whether to pay dividends will be made by our board of directors in light of conditions then existing, including factors such as our results of operations, financial condition and requirements, business conditions, and covenants under any applicable contractual arrangements.

 

The following table sets forth our capitalization as of March 31, 2007:

 

 

You should read this table in conjunction with the consolidated financial statements and the related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Use of Proceeds” included elsewhere in this prospectus.

 

 

 

 

Dilution is the amount by which the offering price paid by the purchasers of the common stock to be sold in the offering exceeds the net tangible book value per share of common stock after the offering. Net tangible book value per share is determined at any date by subtracting our total liabilities from the total book value of our tangible assets and dividing the difference by the number of shares of common stock deemed to be outstanding at that date.

 

Our pro forma net tangible book value as of March 31, 2007 was $35.7 million, or $0.32 per share after giving effect to the automatic conversion of all of our preferred stock into shares of common stock in accordance with their terms immediately prior to the consummation of the offering. After giving effect to our receipt of the estimated net proceeds from the sale of shares of common stock offered by us in this offering, assuming an initial public offering price of $     , the midpoint of the estimated price range shown on the cover page of this prospectus, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of March 31, 2007 would have been approximately $      million, or $      per share. This represents an immediate increase in pro forma net tangible book value of $      per share to existing stockholders and an immediate dilution of $      per share to new investors purchasing shares of common stock in the offering. The following table illustrates this substantial and immediate per share dilution to new investors:

 

 

A $1.00 increase (decrease) in the assumed initial public offering price of $      per share would increase (decrease), the as adjusted pro forma net tangible book value per share after this offering by $      and the dilution per share to new investors in this offering by $     , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

The following table summarizes on a pro forma as adjusted basis as of March 31, 2007, giving effect to the automatic conversion of all of our shares of preferred stock into shares of common stock in connection with the offering and for a           for           stock split which will occur prior to the completion of this offering:

 

 

The tables and calculations above assume no exercise of:

 

 

To the extent any of these options are exercised, there will be further dilution to new investors.

 

The following table sets forth our selected consolidated statement of operations, balance sheet and other data for the periods indicated. We have derived our selected consolidated statement of operations data for the years ended June 30, 2004, 2005 and 2006 and our balance sheet data as of June 30, 2005 and 2006, from our audited consolidated financial statements that are included elsewhere in this prospectus. We have derived our selected consolidated statement of operations data for the years ended June 30, 2002 and 2003, and our balance sheet data as of June 30, 2002, 2003 and 2004, from our audited consolidated financial statements that are not included in this prospectus. We have derived our selected consolidated statement of operations data for the nine months ended March 31, 2006 and 2007 and consolidated balance sheet data as of March 31, 2007 from our unaudited consolidated financial statements. Our historical results are not necessarily indicative of future operating results. You should read the information set forth below in conjunction with “Selected Consolidated Financial and Operating Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and their related notes included elsewhere in this prospectus.

 

 

 

 

 

 

The following table provides a reconciliation of net income (loss) to EBITDA:

 

 

 

You should read the following discussion together with our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of the factors we describe under “Risk Factors” and elsewhere in this prospectus.

 

Our Company

 

We are a technology-based education company. We offer proprietary curriculum, software and educational services created for online delivery to students in kindergarten through 12th grade, or K-12. Our mission is to maximize a child’s potential by providing access to an engaging and effective education, regardless of geographic location or socio-economic background. Since our inception, we have invested more than $95 million to develop curriculum and an online learning platform that promotes mastery of core concepts and skills for students of all abilities. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for a virtual school and other educational applications. From fiscal year 2004 to fiscal year 2007, we increased average enrollments in the virtual public schools we serve from approximately 11,000 students to 27,000 students, representing a compound annual growth rate of approximately 35%. From fiscal year 2004 to fiscal year 2006, we increased revenues from $71.4 million to $116.9 million, representing a compound annual growth rate of approximately 28%.

 

We deliver our learning system to students primarily through virtual public schools. Many states have embraced virtual public schools as a means to provide families with a publicly funded alternative to a traditional classroom-based education. We offer virtual schools our proprietary curriculum, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions, under long-term contracts. These contracts provide the basis for a recurring revenue stream as students progress through successive grades. Additionally, without the requirement of a physical classroom, virtual schools can be scaled quickly to accommodate a large dispersed student population, and allow more capital resources to be allocated towards teaching, curriculum and technology rather than towards a physical infrastructure.

 

Our proprietary curriculum is currently used by public school students in 16 states and the District of Columbia. Parents can also purchase our curriculum and online learning platform directly to facilitate or supplement their children’s education. Additionally, we have piloted our curriculum in brick and mortar classrooms with promising academic results. We also believe there is additional widespread applicability for our learning system internationally.

 

Our History

 

We were founded in 2000 to utilize the advances in technology to provide children access to a high-quality public school education regardless of their geographic location or socio-economic background. Given the geographic flexibility of technology-based education, we believed that the pursuit of this mission could help address the growing concerns regarding the regionalized disparity in the quality of public school education, both in the United States and abroad. These concerns were reflected in the passage of the No Child Left Behind (NCLB) Act in 2000, which implemented new standards and accountability requirements for public K-12 education. The convergence of these concerns and rapid advances in Internet technology created the opportunity to make a significant impact by deploying a high quality learning system on a flexible, online platform.

 

In September 2001, after 18 months of research and development on our curriculum, we launched our kindergarten through 2nd grade offering. We initially launched our learning system in virtual public schools in Pennsylvania and Colorado, serving approximately 900 students in the two states combined. During the 2002-03 school year, we added our 3rd through 5th grade offering and entered into contracts to operate virtual public schools in California, Idaho, Ohio, Minnesota and Arkansas, increasing our average enrollment to approximately 5,900 students during the 2002-03 school year. During the 2003-04 and 2004-05 school years, we added 7th and 8th grades, respectively, and added contracts with virtual public schools in Wisconsin, Arizona and Florida. By the end of the 2004-05 school year, we had increased enrollment to approximately 15,100 students. In the 2005-06

school year, we added contracts to operate virtual public schools in Washington, Illinois and Texas. Additionally during the 2006-07 school year, we implemented a hybrid school offering in Chicago that combines face-to-face time in the classroom with online instruction. We recently entered the virtual high school market, enrolling 9th and 10th grade students at the start of the 2005-06 and 2006-07 school years, respectively, and we plan to offer 11th and 12th grades at the start of the 2007-08 school year.

 

We believe we have significant growth potential. Therefore over the last three years, we have put a great deal of effort into developing the infrastructure necessary to scale our business. We further developed our logistics and technological infrastructure and implemented sophisticated financial systems to allow us to more effectively operate a large and growing company.

 

Key Aspects and Trends of Our Operations

 

Revenues

 

We generate a significant portion of our revenues from enrollments in virtual public schools. Revenues consist principally of product and service revenues derived through our contracts with these schools. These contracts provide the channels through which we can enroll students into the school, and we execute marketing and recruiting programs designed to create awareness and generate enrollments for these schools. We generate our revenues by providing each student with access to our online lessons and offline learning kits, including a personal computer. In addition, we provide a variety of management and academic support services to virtual public schools, ranging from turnkey end-to-end management solutions to a single service to meet a school’s specific needs. We also generate revenues from sales of our curriculum and offline learning kits through other channels, including directly to consumers and pilots in a traditional classroom environment.

 

Factors affecting our revenues include: (i) the number of enrollments; (ii) the nature and extent of the management services provided to the schools and school districts; (iii) state or district per student funding levels; and (iv) prices for our products and services.

 

We define an enrollment as a full-time student using our provided courses as their primary curriculum. We consider full-time students to be those utilizing our curriculum regardless of the nature and extent of the management services we provide to the virtual public school. Generally, a full-time student will take five or six courses, except for kindergarten students who participate in half-day programs. We count each half-day kindergarten student as an enrollment.

 

School sessions generally begin in August or September and end in May or June. We consider the duration of a school year to be 10 months. To ensure that all schools are reflected in our measure of enrollments, we consider the number of students on the last day of September to be our opening enrollment level, and the number of students enrolled on the last day of May to be our ending enrollment level. To provide comparability, we do not consider enrollment levels for June, July and August as most schools are not open during these months. For each period, average enrollments represent the average of the month-end enrollment levels for each month that has transpired between September and the end of the period, up to and including the month of May. We continually evaluate our enrollment levels by state, by school and by grade. We track new student enrollments and withdrawals throughout the year.

 

We believe that the number of enrollments depends upon the following:

 

 

We continually evaluate our trends in revenues by monitoring the number of enrollments in total, by state, by school and by grade, assessing the impact of changes in funding levels and our product pricing. We track

enrollments throughout the year, as students enroll and withdraw. We also provide our courses for use in a traditional classroom setting and we sell our courses directly to consumers. Our classroom course revenues are generally for single courses. Consumers typically purchase from one to six courses in a year, however, we do not monitor the progress of these students. Therefore, we do not include classroom or consumer students in our enrollment totals.

 

We closely monitor the financial performance of the virtual public schools to which we provide turnkey management services. Under the contracts with these schools, we take responsibility for any operating deficits that they may incur in a given school year. These operating deficits may result from a combination of cost increases or funding reductions attributable to the following: 1) costs associated with new schools including the initial hiring of teachers and the establishment of school infrastructure; 2) school requirements to establish contingency reserves; 3) one-time costs such as a legal claim; 4) funding reductions due to the inability to qualify specific students for funding; and 5) regulatory or academic performance thresholds which may initially restrict the ability of a school to fund all expenses. In these cases, because a deficit may impair our ability to collect our invoices in full, we reduce revenues by the sum of these deficits. Over the past three years, these deficits and the related reduction to revenues have grown substantially faster than overall revenue growth reflecting a significant number of new school start-ups, the time required to meet performance thresholds in certain states and funding adjustments in two states related to the disqualification of certain past enrollments. We expect these deficits to continue to grow faster than overall revenue growth as we expand into new states, continue investment in educational programs, and incur the higher costs associated with our high school offering.

 

Our annual growth in revenues may be materially affected by changes in the level of management services we provide to certain schools. Currently a significant portion of our enrollments are associated with virtual public schools to which we provide turnkey management services. We are responsible for the complete management of these schools and therefore, we recognize as revenues the funds received by the schools, up to the level of costs incurred. These costs are substantial, as they include the cost of teacher compensation and other ancillary school expenses. Accordingly, enrollments in these schools generate substantially more revenues than enrollments in other schools where we provide limited or no management services. In these situations, our revenues are limited to direct invoices and are independent of the total funds received by the school from a state or district. As a result, changes in the number of enrollments associated with schools operating under turnkey arrangements relative to total enrollments may have a disproportionate impact on growth in revenues relative to the growth in enrollments.

 

Our annual growth in revenues will also be impacted by changes in state or district per enrollment funding levels. These funding levels are typically established on an annual basis and generally increase at modest levels from year to year. We expect this trend to continue. Finally, we may generate modest growth in revenues from increases in the prices of our products. We evaluate our product pricing annually against market benchmarks and conditions and raise them as we deem appropriate. We do not expect our price increases to have a significant incremental impact as they are encompassed within increases in per enrollment funding levels.

 

Instructional Costs and Services Expenses

 

Instructional costs and services expenses include expenses directly attributable to the educational products and services we provide. The virtual public schools we manage are the primary drivers of these costs, including teacher and administrator salaries and benefits and expenses of related support services. Instructional costs also include fulfillment costs of student textbooks and materials, and the cost of any third-party online courses. In addition, we include in instructional costs the amortization of capitalized curriculum and related systems. We measure, track and manage instructional costs and services as a percentage of revenues and on a per enrollment basis as these are key indicators of performance and operating efficiency. As a percentage of revenues, instructional costs and services expenses decreased slightly for the nine months ended March 31, 2007, as compared to the nine months ended March 31, 2006 primarily due to lower costs associated with a renewed virtual school contract that no longer includes turnkey management services. This was partially offset by higher school operating costs and the start-up costs of new schools. We expect instructional costs and services expenses as a percentage of revenues to increase as we expand our high school enrollments, develop new delivery models, and incur start-up costs for new schools.

 

Over time, we expect high school enrollments to grow as a percentage of total enrollments. Our high school offering requires increased instructional costs as a percentage of revenues compared to our kindergarten to 8th grade

offering. This is due to the following: (i) demand for numerous electives which requires licensing of third-party courses to augment our proprietary curriculum; (ii) generally lower student-to-teacher ratios; (iii) higher compensation costs for teachers due to the need for subject-matter expertise; and (iv) ancillary costs for required student support services including college placement, SAT preparation and guidance counseling.

 

We are developing new delivery models, such as the hybrid model, where students receive both face-to-face and online instruction. Development costs may include instructional research and curriculum development. These models necessitate additional costs including facilities related costs and additional administrative support, which are generally not required to operate typical virtual public schools. As a result, instructional costs as a percentage of revenues may be higher than our typical offering. In addition, we are pursuing expansion into new states. If we are successful, we will incur start-up costs and other expenses associated with the initial launch of a virtual public school, which may result in increased instructional costs as a percentage of revenues.

 

distributing periodic public reports in compliance with our obligations under the federal securities laws. In addition, as a public company, it will make it more expensive for us to obtain directors and officers liability insurance.

 

Stock Option Expense.   The adoption of Statement of Financial Accounting Standard No. 123R, “Share Based Payments” (SFAS No. 123R), requires that we recognize an expense for stock options granted beginning July 1, 2006. We incurred approximately $0.1 million in stock compensation expense for the nine months ended March 31, 2007. We expect stock option expense to increase in the future as we grant additional stock options.

 

Income Tax Benefits Resulting from Decrease of Valuation Allowance.   In the period from our inception through fiscal year 2005, we incurred significant operating losses that resulted in a net operating loss carryforward for tax purposes and net deferred tax assets. Through March 31, 2007, we provided a 100% valuation allowance for all net deferred tax assets based on our limited history of generating taxable income. Our provision for income taxes for the nine months ended March 31, 2007 was $0.2 million, compared to no provision for the nine months ended March 31, 2006. Our tax expense for the nine months ended March 31, 2007 is primarily related to alternative minimum tax liabilities. Effectively, no tax expense was recorded in the nine months ending March 31, 2006 as we were able to utilize net operating loss carryforwards that were fully reserved for in prior periods. We do not expect to record any income tax expense in the next few years other than alternative minimum tax, unless we decrease the valuation allowance on net deferred tax assets of $28.5 million as of March 31, 2007.

 

Public Funding and Regulation.   Our public school customers are financed with federal, state and local government funding. Budget appropriations for education at all levels of government are determined through a political process and, as a result, our revenues may be affected by changes in appropriations. Decreases in funding could result in an adverse affect on our financial condition, results of operations and cash flows.

 

Competition.   The market for providing online education for grades K-12 is becoming increasingly competitive and attracting significant new entrants. If we are unable to successfully compete for new business and contract renewals, our growth in revenues and operating margins may decline. With the introduction of new technologies and market entrants, we expect this competition to intensify.

 

Critical Accounting Policies and Estimates

 

The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. In the preparation of our consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The results of our analysis form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated financial statements. Our critical accounting policies have been discussed with the audit committee of our board of directors.

 

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

 

Revenue Recognition

 

In accordance with SEC Staff Accounting Bulletin No. 104 (SAB No. 104), we recognize revenues when each of the following conditions is met: (1) persuasive evidence of an arrangement exists; (2) delivery of physical goods or rendering of services is complete; (3) the seller’s price to the buyer is fixed or determinable; and (4) collection is reasonably assured. Once these conditions are satisfied, the amount of revenues we record is determined in accordance with Emerging Issues Task Force (EITF 99-19), “ Reporting Revenue Gross as a Principal versus Net as an Agent .”

 

We generate almost all of our revenues through long-term contracts with virtual public schools. These schools are generally funded by state or local governments on a per student basis. Under these contracts, we are responsible for providing each enrolled student with access to our OLS, our online lessons, offline learning kits and student

support services required for their complete education. In most cases, we are also responsible for providing complete management and technology services required for the operation of the school. The revenues derived from these long-term agreements is primarily dependent upon the number of students enrolled, the extent of the management services contracted for by the school, and the level of funding provided to the school for each student.

 

We invoice virtual public schools in accordance with the established contractual terms. Generally, this means that we invoice each school for the following items: (1) access to our online school and online lessons; (2) offline learning kits; (3) student personal computers; and (4) management and technology services. We apply SAB No. 104 to each of these items as follows:

 

 

The majority of our enrollments occur at the beginning of the school year in August or September, depending upon the state. Because upfront fees are generally charged at the beginning of the school year, the balance in our deferred revenue account tends to be at its highest point at the end of the first quarter. Generally, the balance will decline over the course of the year and all deferred revenue related to virtual public schools will be fully recognized by the end of our fiscal year on June 30.

 

 

We recognize the revenues from turnkey management and technology fees ratably over the course of our fiscal year. We use 12 months as a basis for recognition because administrative offices of the school remain open for the entire year. To determine the amount of revenues to recognize in our fiscal year, we estimate the total funds that each school will receive in a particular school year, and our related fees associated with the estimated funding. We review our estimates of funding periodically, and revise as necessary, amortizing any adjustments over the remaining portion of the fiscal year. Actual school funding may vary from these estimates or revisions, and the impact of these differences could have a material impact on our results of operations.

 

Under most contracts, we provide the virtual schools we manage with turnkey management services and take responsibility for any operating deficits that the schools may incur in a given school year. Such deficits may arise from school start-up costs, from funding shortfalls, from temporary or long-term incremental cost requirements for a particular school, or due to specific one-time expenses that a school may incur. These operating deficits may impair our ability to collect the full amount invoiced in a period. In these cases, since collection cannot be reasonably assured, we reduce revenues by the amount of these deficits. We recognize the impact of these operating deficits by estimating the full year revenues and full year deficits of schools at the beginning of the fiscal year. We amortize the estimated deficits against recognized revenues based upon the percentage of actual revenues in the period to total estimated revenues for the fiscal year. We periodically review our estimates of full year school revenues and full year operating deficits and amortize the impact of any changes to these estimates over the remainder of our fiscal year. Actual school operating deficits may vary from these estimates or revisions, and the impact of these differences could have a material impact on our results of operations. The amount of revenues we record is determined in accordance with Emerging Issues Task Force Reporting Revenue Gross as a Principal versus Net as an Agent, EITF 99-19. For these schools, we have determined that we are the primary obligor for substantially all expenses of the school. Accordingly, we report revenues on a gross basis by recording the associated per student revenues received by the school from its funding state or school district up to the expenses incurred by the school. Revenues are recognized when the underlying expenses are incurred by the school. For the small percentage of contracts where we provide individually selected services for the school, we invoice on a per student or per service basis and recognize revenues in accordance with SAB No. 104. Under these contracts, where we do not assume responsibility for operating deficits, we record revenues on a net basis.

 

We also generate a small percentage of our revenues through the sale of our online courses and offline learning kits directly to consumers. Online course sales are generally subscriptions for periods of 12 to 24 months and customers have the option of paying a discounted amount in full upfront or paying in monthly installments. Payments are generally made with charge cards. For those customers electing to pay these subscription fees in their entirety upfront, we record the payment as deferred revenue and amortize the revenues over the life of the subscription. For customers paying monthly, we recognize these payments as revenues in the month earned. Revenues for offline learning kits are recognized when shipped. Within 30 days of enrollment, customers can receive a full refund, however customers terminating after 30 days will receive a pro rata refund for the unused portion of their subscription less a termination fee. Historically, the impact of refunds has been immaterial.

 

Capitalized Curriculum Development Costs

 

Our curriculum is primarily developed by our employees and to a lesser extent, by independent contractors. Generally, our courses cover traditional subjects and utilize examples and references designed to remain relevant for long periods of time. The online nature of our curriculum allows us to incorporate user feedback rapidly and make ongoing corrections and improvements. For these reasons, we believe that our courses, once developed, have an extended useful life, similar to computer software.

 

We capitalize curriculum development costs incurred during the application development stage in accordance with Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 provides guidance for the treatment of costs associated with computer software

development and defines those costs to be capitalized and those to be expensed. Costs that qualify for capitalization are external direct costs, payroll, payroll-related costs, and interest costs. Costs related to general and administrative functions are not capitalizable and are expensed as incurred. We capitalize curriculum development costs when the projects under development reach technological feasibility. Many of our new courses leverage off of proven delivery platforms and are primarily content, which has no technological hurdles. As a result, a significant portion of our courseware development costs qualify for capitalization due to the concentration of our development efforts on the content of the courseware. Technological feasibility is established when we have completed all planning, designing, coding, and testing activities necessary to establish that a course can be produced to meet its design specifications. Capitalization ends when a course is available for general release to our customers, at which time amortization of the capitalized costs begins. The period of time over which these development costs will be amortized is generally five years. This is consistent with the capitalization period used by others in our industry and corresponds with our product development lifecycle.

 

Software Developed or Obtained for Internal Use

 

We develop our own proprietary computer software programs to provide specific functionality to support both our unique education offering and the student and school management services. These programs enable us to develop courses, process student enrollments, meet state documentation requirements, track student academic progress, deliver online courses to students, coordinate and track the delivery of course-specific materials to students and provide teacher support and training. These applications are integral to our learning system and we continue to enhance existing applications and create new applications.

 

We capitalize software development costs incurred during the development stage of these applications in accordance with SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use . These development costs are generally amortized over three years.

 

Impairment of Long-lived Assets

 

Long-lived assets include property, equipment, capitalized curriculum and software developed or obtained for internal use. In accordance with Statement of Financial Accounting Standards No. 144 (SFAS No. 144), Accounting for the Impairment or Disposal of Long-Lived Assets , we review our recorded long-lived assets for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. We determine the extent to which an asset may be impaired based upon our expectation of the asset’s future usability as well as on a reasonable assurance that the future cash flows associated with the asset will be in excess of its carrying amount. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between fair value and the carrying value of the asset.

 

Accounting for Stock-based Compensation

 

Prior to July 1, 2006, we accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees , or APB No. 25 and related interpretations. Accordingly, compensation cost for stock options generally was measured as the excess, if any, of the estimated fair value of our common stock over the amount an employee must pay to acquire the common stock on the date that both the exercise price and the number of shares to be acquired pursuant to the option are fixed. We had adopted the disclosure-only provisions of SFAS No. 123 which was released in May 1995, and used the minimum value method of valuing stock options as allowed for non-public companies.

 

In December 2004, SFAS No. 123R revised SFAS No. 123 and superseded APB No. 25. SFAS No. 123R requires the measurement of the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the measurement date of grant, with the cost being recognized over the applicable requisite service period. In addition, SFAS No. 123R requires an entity to provide certain disclosures in order to assist in understanding the nature of share-based payment transactions and the effects of those transactions on the financial statements. The provisions of SFAS No. 123R are required to be applied as of the beginning of the first interim or annual reporting period of the entity’s first fiscal year that begins after December 15, 2005.

Effective July 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R using the prospective transition method, which requires the Company to apply the provisions of SFAS No. 123R only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock- based compensation expense recognized beginning July 1, 2006 is based on the fair value of stock awards as of the grant date. As the Company had used the minimum value method for valuing its stock options under the disclosure requirements of SFAS No. 123, all options granted prior to July 1, 2006 continue to be accounted for under APB No. 25.

 

The Company accounts for equity instruments issued to nonemployees in accordance with the provisions of SFAS No. 123 and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services .

 

Deferred Tax Asset Valuation Allowance

 

We account for income taxes as prescribed by Statement of Financial Accounting Standards No. 109 (SFAS No. 109), Accounting for Income Taxes . SFAS No. 109 prescribes the use of the asset and liability method to compute the differences between the tax bases of assets and liabilities and the related financial amounts, using currently enacted tax laws. If necessary, a valuation allowance is established to reduce deferred tax assets to the amount that is more likely than not to be realized. Realization of the deferred tax assets, net of deferred tax liabilities, is principally dependent upon achievement of projected future taxable income offset by deferred tax liabilities. We exercise significant judgment in determining our provisions for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefit from our deferred tax assets. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to examination by tax authorities in the ordinary course of business. We periodically assess the likelihood of adverse outcomes resulting from these examinations to determine the impact on our deferred taxes and income tax liabilities and the adequacy of our provision for income taxes. Changes in income tax legislation, statutory income tax rates, or future taxable income levels, among other things, could materially impact our valuation of income tax assets and liabilities and could cause our income tax provision to vary significantly among financial reporting periods.

 

As of March 31, 2007, we had net operating loss carry-forwards of $57.5 million that expire between 2020 and 2027 if unused. We recorded a full valuation allowance against net deferred tax assets, including deferred tax assets generated by net operating loss carry-forwards. The valuation allowance on net deferred tax assets was $29.0 million as of March 31, 2007.

 

Comparison of Nine Months Ended March 31, 2007 to Nine Months Ended March 31, 2006

 

Revenues.   Our revenues for the nine months ended March 31, 2007 were $104.9 million, representing an increase of $14.8 million, or 16.4%, as compared to revenues of $90.1 million for the nine months ended March 31, 2006. Average enrollments increased 35.3% to 27,297 for the nine months ended March 31, 2007 from 20,183 average enrollments for the nine months ended March 31, 2006. Primarily offsetting the increased revenues related to enrollment growth, was a decline in management services revenues resulting from the impact of a substantial reduction in the percentage of enrollments associated with schools to which we provide turnkey management services. For the nine months ended June 30, 2007, 76.2% of our enrollments were associated with these schools, down from 91.7% for the corresponding period in 2006. The increase in average enrollments was primarily attributable to new school openings in Washington, California, and Chicago, where we opened our first hybrid school. In addition, we launched 10th grade in August 2006 attracting new students as well as prior year 9th grade students. Price increases of approximately 2% also generated additional revenues. Finally, increased operating deficits at certain schools partially offset the growth in revenues. These deficits were attributable to greater school operating expenses to support increased enrollment and high school services as well as school funding adjustments stemming from enrollment audits in California and Colorado.

 

Instructional Costs and Services Expenses.   Instructional costs and services for the nine months ended March 31, 2007 were $55.1 million, representing an increase of $6.6 million, or 13.6%, as compared to instructional costs and services of $48.5 million for the nine months ended March 31, 2006. This increase was primarily attributable to increased costs to supply books and materials as well as increased school operating expenses, both primarily a result of the increase in enrollments. As a percentage of revenues, instructional costs and services decreased by 1.3% to 52.5% for the nine months ended March 31, 2007, as compared to 53.8% for the nine months ended March 31, 2006. The decrease in instructional costs and services expenses as a percentage of revenues is primarily due to lower costs associated with a renegotiated management and services agreement, partially offset by a shift in mix of enrollments to schools with higher operating costs and the start-up costs of new schools.

 

Selling, Administrative, and Other Operating Expenses.   Selling, administrative, and other operating expenses for the nine months ended March 31, 2007 were $35.1 million, representing an increase of $6.7 million, or 23.4%, as compared to selling, administrative and other operating expenses of $28.4 million for the nine months ended March 31, 2006. This increase is primarily attributable to increases in marketing staff as well as increased spending on advertising and other marketing tactics. In addition, expenses increased in finance, legal and school services as the Company increased its capabilities in these areas. As a percentage of revenues, selling,

administrative, and other operating expenses increased to 33.4% for the nine months ended March 31, 2007 compared to 31.5% for the nine months ended March 31, 2006.

 

Product Development Expenses.   Product development expenses for the nine months ended March 31, 2007 were $5.9 million, representing an increase of $0.3 million, or 5.4%, as compared to product development expenses of $5.6 million for the nine months ended March 31, 2006. Contributing to this increase are increases in employee headcount and contract labor offset by greater utilization of these resources for capitalized curriculum. As a percentage of revenues, product development expenses were relatively stable at 5.6% for the nine months ended March 31, 2007 compared to 6.2% for the nine months ended March 31, 2006.

 

Net Interest Expense.   Net interest expense for the nine months ended March 31, 2007 was $0.5 million, an increase of $0.1 million, or 25.0%, from $0.4 million for the nine months ended March 31, 2006. The increase in net interest expense is primarily due to interest charges on increased capital lease obligations.

 

Income Taxes.   Our provision for income taxes for the nine months ended March 31, 2007 was $0.2 million, compared to no provision for the nine months ended March 31, 2006. Our tax expense for the nine months ended March 31, 2007 is primarily related to alternative minimum tax liabilities. Effectively no tax expense was recorded in the nine months ending March 31, 2006 as we were able to utilize net operating loss carry-forwards that were fully reserved for in prior periods.

 

Net Income.   Net income for the nine months ended March 31, 2007 was $8.2 million, representing an increase of $1.0 million, or 13.9%, as compared to net income of $7.2 million for the nine months ended March 31, 2006. Net income as a percentage of revenues was relatively stable at to 7.8% for the nine months ended March 31, 2007, as compared to 8.0% for the nine months ended March 31, 2006, as a result of the factors discussed above.

 

Comparison of Years Ended June 30, 2006 and 2005

 

Revenues.   Our revenues for the year ended June 30, 2006 were $116.9 million, representing an increase of $31.6 million, or 37.0%, as compared to revenues of $85.3 million for the year ended June 30, 2005. Average enrollments increased 33.9% to 20,220 for the year ended June 30, 2006 from 15,097 average enrollments for the year ended June 30, 2005. Our enrollment growth was driven by the addition of the 9th grade which attracted new students in addition to students enrolled in 8th grade in the prior year. Also, average price increases of approximately 4% were implemented in July 2005. Partially offsetting growth in revenues as compared to enrollment growth was growth in the percentage of enrollments attributable to schools where we earn limited or no services revenues. Enrollments associated with schools to which we provide turnkey management services declined from 92.3% for the year ended June 30, 2006 from 94.3% for the corresponding period in 2005. Finally, increased operating deficits at certain schools partially offset the growth in revenues. These deficits were primarily attributable to greater school operating expenses to support increased enrollment and high school services.

 

Instructional Costs and Services Expenses.   Instructional costs and services expenses for the year ended June 30, 2006 were $64.8 million, representing an increase of $15.7 million, or 31.9%, as compared to instructional costs and services of $49.1 million for the year ended June 30, 2005. This increase was primarily attributable to increased costs to supply books, educational materials and computers to students and school operating expenses as a result of the increase in enrollments. As a percentage of revenues, instructional costs and services decreased to 55.5% for the year ended June 30, 2006, as compared to 57.6% for the year ended June 30, 2005. The decrease in instructional costs and services as a percentage of revenues is primarily due to economies in scale in the operation of the virtual public schools partially offset by higher costs for books and materials.

 

Selling, Administrative, and Other Operating Expenses.   Selling, administrative, and other operating expenses for the year ended June 30, 2006 were $41.7 million, representing an increase of $11.7 million, or 38.7%, as compared to selling, administrative and other operating expenses of $30.0 million for the year ended June 30, 2005. This increase is primarily attributable to increases in employee headcount in sales and marketing staff as well as increased spending on advertising and other marketing tactics. In addition, contract labor increased in information technology and employee headcount increased in finance and human resources as the company increased its capabilities in these areas. As a percentage of revenues, selling, administrative, and other operating expenses remained relatively stable at 35.6% for the year ended June 30, 2006 compared to 35.2% for the year ended June 30, 2005.

Product Development Expenses.   Product development expenses for the year ended June 30, 2006 were $8.6 million, representing a decrease of $0.8 million, or 8.9%, as compared to product development expenses of $9.4 million for the year ended June 30, 2005. This decrease is primarily attributable to a year over year decrease of $2.9 million in impairment charges. Offsetting this decrease is an increase in personnel and contract labor. As a percentage of revenues, product development expenses decreased to 7.3% for the year ended June 30, 2006 compared to 11.0% for the year ended June 30, 2005. This decrease is primarily attributable to the factors described above and our ability to leverage these costs over an increasing number of enrollments.

 

Net Interest Expense.   Net interest expense for the year ended June 30, 2006 was $0.5 million, an increase of $0.2 million, or 66.7%, from $0.3 million for the year ended June 30, 2005. The increase in interest expense is primarily due to debt of $4.0 million borrowed in June 2005.

 

Income Taxes.   Our provision for income taxes for the year ended June 30, 2006 was zero as we were able to utilize net operating loss carry-forwards that were fully reserved for in prior periods. We also recorded no income tax expense for the year ended June 30, 2005 as the Company had a net loss.

 

Net Income (Loss).   Net income for the year ended June 30, 2006 was $1.4 million, representing an increase of $4.9 million as compared to a net loss of $3.5 million for the year ended June 30, 2005. Net income as a percentage of revenues was 1.2% for the year ended June 30, 2006, as compared to a net loss of 4.1% for the year ended June 30, 2005, as a result of the factors discussed above.

 

Comparison of Years Ended June 30, 2005 and 2004

 

Revenues.   Our revenues for the year ended June 30, 2005 were $85.3 million, representing an increase of $13.9 million, or 19.4%, as compared to revenues of $71.4 million for the year ended June 30, 2004. Average enrollments increased 35.3% to 15,097 for the year ended June 30, 2006 from 11,158 average enrollments for the year ended June 30, 2004. Partially offsetting growth in revenues as compared to growth in enrollments was growth in enrollments at schools where we earn limited or no services revenues. In 2004, all of our enrollments were associated with schools where we provided complete turnkey services. In 2005, we began to offer schools the opportunity to use our curriculum without purchasing any services. In fiscal year 2005, 5.7% of enrollments were associated with schools to which we provided limited or no management services. Fiscal year 2005 was the first year in which we offered limited services. Our enrollment growth benefited from the addition of the 8th grade in September 2004 which attracted new students in addition to students enrolled in 7th grade in the prior year. Average price increases of 7% were implemented in July 2004. In addition, increased operating deficits partially offset the growth in revenues. These increased deficits were primarily attributable to a higher percentage of enrollments associated with schools in the early stages of development.

 

Instructional Costs and Services Expenses.   Instructional costs and services expenses for the year ended June 30, 2005 were $49.1 million, representing an increase of $9.2 million, or 23.0%, as compared to instructional costs and services expenses of $39.9 million for the year ended June 30, 2004. This increase was primarily attributable to increased expenses incurred to operate the schools. Also contributing to the increase were increased costs to supply computers to students as a result of the increase in enrollments. As a percentage of revenues, instructional costs and services expenses increased to 57.6% for the year ended June 30, 2005, as compared to 55.9% for the year ended June 30, 2004. The increase in instruction costs and services expenses as a percentage of revenues is primarily due to increased costs to provide computers to students partially offset by a reduction in fulfillment costs for materials to students.

 

Selling, Administrative, and Other Operating Expenses.   Selling, administrative, and other operating expenses for the year ended June 30, 2005 were $30.0 million, representing an increase of $4.3 million, or 17.1%, as compared to selling, administrative and other operating expenses of $25.7 million for the year ended June 30, 2004. This increase is primarily attributable to increases in employee headcount in operations and marketing as well as increased spending on advertising and other marketing tactics. These increases are partially offset by a decrease in information technology operating expenses. As a percentage of revenues, selling, administrative, and other operating expenses remained relatively stable at 35.2% for the year ended June 30, 2005 compared to 35.9% for the year ended June 30, 2004.

Product Development Expenses.   Product development expenses for the year ended June 30, 2005 were $9.4 million, representing a decrease of $3.4 million, or 26.6%, as compared to product development expenses of $12.8 million for the year ended June 30, 2004. The decrease is primarily attributable to a year over year decrease of $1.7 million in impairment charges, a decrease in employee headcount and an increase in the utilization of labor for capitalized curriculum. As a percentage of revenues, product development expenses decreased to 11.0% for the year ended June 30, 2005 compared to 17.8% for the year ended June 30, 2004. This decrease is primarily attributable to the factors described above and our ability to leverage these costs over an increasing number of enrollments.

 

Net Interest Expense.   Net interest expense for the year ended June 30, 2005 was $0.3 million, a decrease of $0.2 million, or 40.0%, from $0.5 million for the year ended June 30, 2004. The decrease is primarily attributable to lower interest charges from lower outstanding balances of capital lease obligations.

 

Income Taxes.   We also recorded no income tax expense for the years ended June 30, 2005 and 2004 as the company had a net loss.

 

Net Loss.   Net loss for the year ended June 30, 2005 was $3.5 million as compared to a net loss of $7.4 million for the year ended June 30, 2004. Net loss as a percentage of revenues was 4.1% for the year ended June 30, 2005, as compared to 10.4% for the year ended June 30, 2004, as a result of the factors discussed above.

 

Quarterly Results of Operations

 

The following tables set forth selected unaudited quarterly consolidated statement of operations data for the seven most recent quarters, as well as each line item expressed as a percentage of total revenues. The information for each of these quarters has been prepared on the same basis as the audited consolidated financial statements included in this prospectus and, in the opinion of management, includes all adjustments necessary for the fair presentation of the results of operations for such periods. This data should be read in conjunction with the audited consolidated financial statements and the related notes included in this prospectus. These quarterly operating results are not necessarily indicative of our operating results for any future period

 

The following table sets forth statements of operations data as a percentage of revenues for each of the periods indicated: