MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

      You should read the following discussion together with the financial statements and the related notes included elsewhere in the prospectus. This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business and operations. The cautionary statements made in this prospectus should be read as applying to all related forward-looking statements wherever they appear in this prospectus. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including those we discuss under “Risk Factors” and elsewhere in this prospectus. You should read “Risk Factors” and “Forward-Looking Statements.”

Overview

      We are an exclusively online post-secondary education services company. Our wholly owned subsidiary, Capella University, is a regionally accredited university that offers a variety of undergraduate and graduate degree programs primarily targeted to working adults. As of December 31, 2004, we offered more than 675 courses and 13 degree programs with 68 specializations at the graduate and undergraduate levels to more than 12,000 learners.

      We were founded in 1991, and in 1993, we established our wholly owned university subsidiary, The Graduate School of America, to offer doctoral and master’s degrees through distance learning programs in management, education, human services and interdisciplinary studies. In 1995, we launched our online format for delivery of our doctoral and master’s degree programs. In 1997, our university subsidiary received accreditation from the North Central Association of Colleges and Schools (later renamed The Higher Learning Commission of the North Central Association). In 1998, we began the expansion of our original portfolio of academic programs by introducing doctoral and master’s degrees in psychology and a master of business administration degree. In 1999, to expand the reach of our brand in anticipation of moving into the bachelor’s degree market, we changed our name to Capella Education Company and the name of our university to Capella University. In 2000, we introduced our bachelor’s degree completion program in information technology, which provided instruction for the last two years of a four-year bachelor’s degree. In 2004, we believe we expanded our addressable market through the introduction of our four-year bachelor’s degree programs in business administration and information technology as well as the introduction of three master’s level specializations in education targeted at K-12 teachers.

      Revenues. Revenues consist principally of tuition, application and graduation fees, and commissions we earn from bookstore and publication sales. During each of 2002, 2003 and 2004, tuition represented approximately 99% of our revenues. Factors affecting our revenues include: (i) the number of enrollments; (ii) the number of courses per learner; (iii) our degree and program mix; (iv) the number of programs and specializations we offer; and (v) annual tuition adjustments.

      Enrollments for a particular time period are defined as the number of learners registered in a course on the last day of classes within that period. We offer monthly start options for newly enrolled learners. Learners who start their program in the second or third month of a quarter transition to a quarterly schedule beginning in their second quarter. Enrollments are a function of the number of continuing learners at the beginning of each period and new enrollments during the period, which are offset by graduations, withdrawals and inactive learners during the period. Inactive learners for a particular period include learners who are not registered in a class, and, therefore, are not generating revenues for that period, but who have not withdrawn from Capella University. We believe that our enrollments are influenced by the attractiveness of our program offerings, the effectiveness of our marketing and recruiting efforts, the quality of our instructors, the number of programs and specializations we offer, the availability

of federal and other funding, the length of our educational programs, the seasonality of our enrollments and general economic conditions.

      Our enrollments by degree level for the periods ended December 31, 2002, 2003 and 2004, were as follows:

      Our tuition rates vary by type and length of the programs and the degree level, such as doctoral, master’s or bachelor’s. For all master’s and bachelor’s programs and for selected doctoral programs, tuition is determined by the number of courses taken by each learner. For the 2004 – 2005 academic year (the academic year that began in July 2004), prices per course generally range from $1,350 to $1,825. The price of the course depends on the number of credit hours, the degree level of the program and the discipline. For the 2004 – 2005 academic year, the majority of doctoral programs are priced at a fixed quarterly amount of $3,750 per learner, regardless of the number of courses in which the learner is registered. Based on these prices, we estimate that full tuition is approximately $49,000 for a four-year bachelor’s program, ranges from approximately $16,000 to $26,000 for a master’s program, and ranges from approximately $48,000 to $67,000 for a doctoral program. These amounts and ranges assume no reductions for transfer credits. Many of our learners reduce their total program costs at Capella University by transferring credits earned at other institutions.

      Tuition increases ranged from 3% to 7% in the 2004 – 2005 academic year as compared to the prior academic year. Tuition increases have not historically been, and may not in the future be, consistent across our programs and specializations due to market conditions or changes in operating costs that have an impact on price adjustments of individual programs or specializations.

      A large portion of our learners rely on funds received under various government-sponsored student financial aid programs, predominantly Title IV programs, to pay a substantial portion of their tuition and other education-related expenses. In the years ended December 31, 2002, 2003 and 2004, approximately 51%, 61% and 69%, respectively, of our revenues were attributable to funds derived from Title IV programs. In addition to Title IV funding, our learners receive financial aid from other governmental sources or finance their education through private financing institutions or with their own funds.

      Other income, net. Other income, net consists primarily of interest income earned on short-term investments net of any interest expense for capital leases.

      Costs and expenses. We categorize our costs and expenses as (i) instructional costs and services expenses, (ii) selling and promotional expenses, and (iii) general and administrative expenses.

      Instructional costs and services expenses are items of expense directly attributable to the educational services we provide our learners. This expense category includes salaries and benefits of full-time faculty, administrators and academic advisors and costs associated with adjunct faculty. Instructional pay for adjunct faculty varies across programs and is primarily dependent on the number of learners taught. Instructional costs and services expenses also include costs of educational supplies, costs associated with admissions and other university services, and an allocation of facility costs, depreciation and amortization and information technology costs that are attributable to providing educational services to our learners.

      Selling and promotional expenses include salaries and benefits of personnel engaged in recruitment and promotion, as well as costs associated with advertising and the production of marketing materials. Selling and promotional expenses also include an allocation of facility costs, depreciation and amortization,

and information technology costs that are attributable to the marketing of Capella University and recruitment of new learners. Our selling and promotional expenses are generally affected by the cost of advertising media, the efficiency of our selling efforts, salaries and benefits for our sales personnel and the number of advertising initiatives for new and existing academic programs.

      General and administrative expenses include salaries and benefits of employees engaged in management, finance, human resources, compliance and other corporate functions, together with an allocation of facility costs, depreciation and amortization and information technology costs attributable to such functions. General and administrative expenses also include bad debt expense and any charges associated with asset impairments.

      We set forth below selected factors that we believe have had, or are expected to have, a significant effect on the comparability of recent or future results of operations:

      Introduction of new programs and specializations. At December 31, 2002, learners seeking doctoral degrees represented approximately 50% of our enrollment, while learners seeking master’s and bachelor’s degrees represented approximately 41% and 9%, respectively. The higher concentration of learners in doctoral programs reflects our early emphasis on these programs. In 2004, we believe we expanded our addressable market through the introduction of our four-year bachelor’s degree programs in business administration and information technology as well as the introduction of three master’s level specializations in education targeted at K-12 teachers. These additions are consistent with our continuing migration from a concentration of doctoral enrollment to an enrollment that includes more master’s and bachelor’s learners. At December 31, 2004, learners seeking doctoral, master’s and bachelor’s degrees represented 47%, 38% and 15%, respectively, of our enrollment. We expect to introduce additional master’s and bachelor’s programs and specializations in the future.

      We make significant investments in program and specialization development, support infrastructure and marketing and selling when introducing new programs and specializations. Relative to our doctoral programs, our master’s and bachelor’s programs have tended to have lower revenue per learner and higher selling and promotional, learner recruitment and support costs. In the year ended December 31, 2004, doctoral programs accounted for a majority of our revenues and all of our operating profit. In contrast, our bachelor’s and master’s programs were not profitable in 2004. During the period of new program introduction and development, the rate of growth of revenues and income from operations has been, and may be, adversely affected in part due to these factors. Our strategy is to operate these newer programs at profit levels approaching those of our doctoral program. As our newer programs develop, we anticipate increases in enrollment, higher revenue per learner, more cost-effective delivery of instructional and support services and more efficient selling and promotional processes.

      Income tax benefits resulting from reversal of valuation allowance. In the period from our inception through 2002, we incurred significant operating losses that resulted in a net operating loss carryforward for tax purposes and net deferred tax assets. Until 2004, we provided a 100% valuation allowance for all net deferred tax assets. Because we achieved three years of cumulative taxable income in 2004 and we expect to be profitable in future years, we have concluded that it is more likely than not that substantially all of our net deferred tax assets will be realized. As a result, in accordance with SFAS No. 109, Accounting for Income Taxes , all of the valuation allowance applied to net deferred tax assets was reversed during the year ended December 31, 2004. Reversal of the valuation allowance resulted in a non-cash income tax benefit totaling $12.9 million, which accounted for 68% of our net income of $18.8 million in the year ended December 31, 2004. We expect that our effective tax rate for 2005 will be in the range of 39% to 41%.

      Stock option expense. In December 2004, the FASB issued to SFAS No. 123 (revised), Share-Based Payment (SFAS No. 123R). The Securities and Exchange Commission amended the compliance date on April 14, 2005, to require public companies to adopt the standard as of the beginning of the first annual period that begins after June 15, 2005. We are therefore required to implement this standard on

January 1, 2006. SFAS 123R eliminates the ability to account for share-based compensation transactions using the footnote disclosure-only provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees , and instead requires that such transactions be recognized and reflected in our financial statements using a fair-value-based method. Companies are required to recognize an expense for compensation costs related to share-based payment arrangements including stock options and employee stock purchase plans. Under SFAS 123R, the amount of compensation expense recognized will vary depending on numerous factors, including the option valuation methodology adopted, the number and vesting period of option grants, the publicly traded stock price of the underlying option security and the volatility of that stock price. The cumulative effect of adoption, if any, would be measured and recognized in the period of adoption. We are evaluating SFAS 123R, the factors referred to above and the resulting impact of adoption of SFAS 123R. We expect that we will record in our statement of operations substantial noncash compensation expense in 2006 and thereafter. In accordance with SFAS No. 123, we provide in Note 2 to our consolidated financial statements, included elsewhere in this prospectus, an estimate of the effect, on a pro forma basis, of recognizing as compensation expense option grants on a fair value basis using the Black-Scholes option valuation model and other assumptions. However, had we adopted SFAS 123R using the Black-Scholes option valuation model in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income (loss) and pro forma net income (loss) per common share in Note 2 to our consolidated financial statements. Estimates of option values using the Black-Scholes method and these other assumptions may not be indicative of results from valuation methodologies and assumptions ultimately adopted by us for purposes of SFAS 123R. The adoption of SFAS 123R is not expected to have a significant adverse effect on our cash flows, but is expected to have a significant adverse effect on our results of operations.

      Public company expense. Upon consummation of our initial public offering, we will become a public company, and our shares of common stock will be publicly traded on The Nasdaq National Market. As a result, we will need to comply with new laws, regulations and requirements that we did not need to comply with as a private company, including certain provisions of the Sarbanes-Oxley Act of 2002, related SEC regulations and the requirements of The Nasdaq National Market. Compliance with the requirements of being a public company will require us to increase our general and administrative expenses in order to pay our employees, legal counsel and accountants to assist us in, among other things, instituting and monitoring a more comprehensive compliance and board governance function, establishing and maintaining internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 and preparing and distributing periodic public reports in compliance with our obligations under the federal securities laws. In addition, being a public company will make it more expensive for us to obtain director and officer liability insurance. We estimate that incremental annual public company costs will be between $1.5 million and $2.5 million. During 2004, we incurred approximately $0.5 million of such general and administrative expenses in anticipation of our becoming a public company in 2005.

      401(k) company contributions. In April 2005, we instituted, for the first time, a program under which we match employee contributions to our 401(k) program up to a specified level. We estimate that this program will result in additional expenses in 2005 of between $0.5 million and $1.0 million.

Critical Accounting Policies and Use of Estimates

      The discussion of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. During the preparation of these financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions, including those related to revenue recognition, allowance for doubtful accounts, impairment of long-lived assets, stock-based compensation expense and income taxes. We base our estimates on historical experience and on various other assumptions that we believe are 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.

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

      Revenue recognition. Tuition revenue represented approximately 99% of our revenues recognized for each of the years ended December 31, 2002, 2003 and 2004. Course tuition revenue is deferred and recognized as revenue ratably over the period of instruction, which is generally from one and a half to three months. Seminar tuition revenue is recognized over the length of the seminar, which ranges from two days to two weeks. Deferred revenue in any period represents the excess of tuition and fees received as compared to tuition and fees recognized in revenue on the consolidated statement of operations and is reflected as a current liability on our consolidated balance sheet.

      Allowance for doubtful accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability, failure or refusal of our learners to make required payments. We determine the allowance for doubtful accounts amount based on an analysis of the aging of the accounts receivable and historical write-off experience.

      In establishing our credit practices, we seek to strike an appropriate balance between prudent learner credit policies and learner retention. Accordingly, we periodically review and alter learner credit policies to achieve that objective by restricting or expanding the availability of credit we extend. Changes to credit practices may impact enrollments, revenues, accounts receivables, our allowance for doubtful accounts and bad debt expense. For example, in the second quarter of 2005, we arranged to offer learners new, third-party private loan programs. The third party loans were not available at the beginning of classes and, as a result, we permitted some learners, who previously may have been placed on inactive, non-revenue-generating status, to remain enrolled and in their classes. Because a majority of these learners received federal financial aid and were eligible for the third party private loan programs, we were able to effect this change with a relatively small increase in our accounts receivable during this enrollment period. If changes in credit practices result in higher receivable balances, if the financial condition of our learners deteriorates resulting in an impairment of their ability to pay, or if we underestimate the allowances required, additions to our allowance for doubtful accounts may be necessary, which will result in increased general and administrative expenses in the period such determination is made.

      As of December 31, 2002, 2003 and 2004, the allowance for doubtful accounts was approximately $1.2 million, $0.7 million and $1.1 million, respectively. During 2002, 2003 and 2004, we recognized bad debt expense of $3.0 million, $0.6 million and $1.4 million, respectively. The lower bad debt expense as a percentage of revenue in 2003 and 2004 as compared to 2002 resulted from a tightening of our credit policies during 2002.

      Impairment of long-lived assets. We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We measure the recoverability of an asset by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the asset. If the asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. If we determine that an asset’s carrying value is impaired, we will record a write-down of the carrying value of the identified asset and charge the impairment as an operating expense in the period in which the determination is made. During the years ended December 31, 2002, 2003 and 2004, we recorded impairment charges of $0.2 million, $0.4 million and $1.0 million, respectively. The impairment charge recorded in 2004 consisted primarily of the write-off of previously capitalized software development costs for software projects that were abandoned due to our decision to implement an enterprise resource planning system. Capitalized software costs represent our long-lived assets that are most subject to the risk of impairment from changes in our business strategy and ongoing technological developments. We recorded capitalized software costs with a net book value of $5.8 million as of December 31, 2004. Our impairment loss calculation is subject to uncertainties because management

must use judgment to forecast estimated fair values and to determine the useful lives of the assets. If actual results are not consistent with our assumptions and estimates regarding these factors, we may be exposed to losses that could be material. Changes in strategy or market conditions, or significant technological developments, could significantly impact these judgments and require adjustments to recorded asset balances.

      Stock-based compensation. We account for stock-based employee compensation arrangements in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation. We currently are not required to record stock-based compensation charges if the employee stock option exercise price or restricted stock purchase price equals or exceeds the deemed fair value of our common stock at the grant date. Because no market for our common stock existed prior to this offering, our board of directors determined the fair value of our common stock based upon several factors, including our operating performance, forecasted future operating results, the terms of preferred stock issued by us, including the liquidation value and other preferences of our preferred shareholders, recent sales of our stock by investors, recent transactions involving our investors and our expected valuation in an initial public offering.

      For purposes of pro forma disclosures, the estimated fair value of the option is expensed over the option’s vesting period. The compensation expense determined under the fair-value-based method does not include assumed tax benefits related to non-qualified stock options until the fourth quarter of 2004, which is the first period in which we have not fully reserved for our net deferred tax assets with a valuation allowance.

      If we had estimated the fair value of the options on the date of grant using a Black-Scholes option valuation model and then amortized this estimated fair value over the vesting period of the options, our net income (loss) would have been adversely affected, as shown in the table below:

      As our stock has not been publicly traded, the pro forma compensation expense determined under the fair-value-based method is based on a stock price volatility assumption that reflects the average of our peer group of public post-secondary education companies. Our calculation of pro forma compensation expense also reflects estimates of forfeitures which are adjusted in subsequent periods as actual forfeitures differ from the original estimates.

      The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because our employee stock options have characteristics significantly different than those of traded options, and

because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a single measure of the fair value of our employee stock options.

      Effective for annual periods beginning after June 15, 2005, public companies are required to implement SFAS 123R, an amendment to SFAS No. 123. We are required to implement this standard on January 1, 2006. SFAS 123R eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25 and generally instead requires that such transactions be recognized and recorded using a fair-value-based method. SFAS 123R will continue to require significant management judgment and assumptions concerning such factors as the option methodology adopted and the volatility of the underlying stock price. We are currently evaluating SFAS No. 123R, these factors and the resulting impact of adoption of SFAS 123R. For more information concerning the adoption of SFAS 123R and the possible effects on our results of operations, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting Comparability – Stock Option Expense; – Recent Accounting Pronouncements” and Note 2 to our consolidated financial statements.

      Accounting for income taxes. We account for income taxes as prescribed by 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. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount that more likely than not will 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.

      At December 31, 2004, a significant portion of our net deferred tax assets consisted of net operating loss carryforwards approximating $22.1 million that are available to offset future taxable income. The net operating loss carryforwards expire at various dates through 2022. During 2004, we experienced an ownership change as defined under Section 382 of the Internal Revenue Code. As a result, the utilization of the net operating loss carryforwards will be subject to an annual limitation imposed by Section 382. While based on our estimates we do not believe the limitation will adversely impact our ability to utilize the net operating loss carryforwards before they expire, changes in future taxable income levels could significantly impact our ability to realize the entire benefit of this deferred tax asset.

      Prior to 2004, we had provided a valuation allowance for all net deferred tax assets. Because we achieved three years of cumulative taxable income in 2004 and expect to be profitable in future years, we concluded that it is more likely than not that all of our net deferred tax assets will be realized. As a result, in accordance with SFAS No. 109, the valuation allowance applied to such net deferred tax assets of $12.9 million at December 31, 2003, was reversed during the year ended December 31, 2004. We will require approximately $22.0 million of future taxable income to realize the $8.6 million of net deferred tax assets that existed as of December 31, 2004.

Results of Operations

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

      Revenues. Our revenues for the year ended December 31, 2004, were $117.7 million, representing an increase of $35.9 million, or 43.9%, as compared to revenues of $81.8 million for the year ended December 31, 2003. This increase was primarily due to an increase in enrollments as well as increases in tuition in 2004 as compared to 2003, partially offset by a larger proportion of bachelor’s learners, who generated less revenue per learner than our doctoral learners. Tuition increases ranged from 3% to 7% and were implemented during July 2004.

      Instructional costs and services expenses. Our instructional costs and services expenses for the year ended December 31, 2004, were $57.5 million, representing an increase of $15.1 million, or 35.6%, as compared to instructional costs and services expenses of $42.4 million for the year ended December 31, 2003. This increase was primarily due to increases in instructional pay due to the increase in enrollments. Our instructional costs and services expenses as a percentage of revenues decreased by 2.9 percentage points to 48.9% for the year ended December 31, 2004, as compared to 51.8% for the year ended December 31, 2003. This improvement in 2004 was driven by our tuition increases, the centralization of academic services, and slower growth of information technology and depreciation and amortization expenses relative to revenue growth.

      Selling and promotional expenses. Our selling and promotional expenses for the year ended December 31, 2004, were $34.0 million, representing an increase of $12.8 million, or 60.6%, as compared to selling and promotional expenses of $21.2 million for the year ended December 31, 2003. This increase was primarily attributable to an increase in recruitment personnel, an increase in marketing and advertising expenses to attract more learners to our existing programs, and an increase in the cost of online advertising. This increase in selling and promotional expenses was also attributable to an increase in marketing and advertising expenses and enrollment expenses to support the introduction of our four-year bachelor’s degree program in January 2004, and to develop and launch our new brand strategy during 2004. Our selling and promotional expenses as a percentage of revenues increased by 3.0 percentage points to 28.9% for the year ended December 31, 2004, from 25.9% for the year ended December 31, 2003, as a result of the same factors described above.

      General and administrative expenses. Our general and administrative expenses for the year ended December 31, 2004, were $16.3 million, representing an increase of $2.1 million, or 15.3%, as compared to

general and administrative expenses of $14.2 million for the year ended December 31, 2003. This increase was primarily attributable to an increase in administrative costs resulting from investments to further develop our corporate infrastructure, an increase in internally developed software impairment charges, and an increase in bad debt expense. In 2004, we made further investments in corporate infrastructure through additions of personnel and systems to accommodate current and expected future growth. A $0.7 million increase in asset impairment charge was the result of our decision to abandon some internally developed software projects in light of a decision to implement a new enterprise resource planning system that will be phased in starting in 2006. A $0.8 million increase in bad debt expense was primarily due to an increase in revenues and an increase in our write off experience. Our general and administrative expenses as a percentage of revenues decreased by 3.4 percentage points to 13.9% for the year ended December 31, 2004, from 17.3% for the year ended December 31, 2003, as a significant portion of our general and administrative expenses do not vary with fluctuations in revenues.

      Other income, net. Other income, net increased by $0.3 million, or 69.6%, to $0.7 million for the year ended December 31, 2004, from $0.4 million for the year ended December 31, 2003. The increase was principally due to higher average cash and short-term investment balances throughout 2004, which was partially offset by lower interest rates.

      Income tax expense (benefit). We recognized a net tax benefit for the year ended December 31, 2004, of $8.2 million. The tax benefit recorded in 2004 included a tax benefit for the complete reversal of our valuation allowance on our net deferred tax assets of $12.9 million, offset by tax expense of $4.3 million on 2004 pretax earnings and $0.4 million relating to a change in our estimate of the income tax rates applied to our net deferred tax assets. During 2003, we had $0.1 million of income tax expense related to alternative minimum tax liabilities. No additional tax expense was recorded in 2003 as we were able to utilize net operating loss carryforwards that were fully reserved for in prior periods. We expect that our effective tax rate for 2005 will be in the range of 39% to 41%.

      Net income. Net income was $18.8 million for the year ended December 31, 2004, compared to net income of $4.4 million for the year ended December 31, 2003, an increase of $14.4 million, because of the factors discussed above.

      Revenues. Our revenues for the year ended December 31, 2003, were $81.8 million, representing an increase of $32.2 million, or 65.0%, as compared to revenues of $49.6 million for the year ended December 31, 2002. This increase was primarily due to an increase in enrollments and in tuition rates in 2003 compared to 2002. We implemented an average tuition increase of approximately 5% in July 2003 for almost all our courses. These increases were partially offset by a slight decline in the number of courses taken per learner due to the introduction of our FirstCourse initiative, which encourages learners to only take one course in their first quarter with us.

      Instructional costs and services expenses. Our instructional costs and services expenses for the year ended December 31, 2003, were $42.4 million, representing an increase of $15.2 million, or 55.6%, as compared to instructional costs and services expenses of $27.2 million for the year ended December 31, 2002. This increase was primarily due to increases in instructional pay due to the increase in enrollments in 2003 compared to 2002, investments in the development of the bachelor’s programs that were subsequently launched in January 2004, investments to build infrastructure needed to support corporate alliance programs, and an increase in academic advising to support growth in our doctoral program. Our instructional costs and services expenses as a percentage of revenues decreased by 3.2 percentage points to 51.8% for the year ended December 31, 2003, as compared to 55.0% for the year ended December 31, 2002. This improvement in 2003 was driven by tuition increases, the centralization of academic services, and slower growth of information technology and depreciation and amortization expenses relative to revenue growth.

      Selling and promotional expenses. Our selling and promotional expenses for the year ended December 31, 2003, were $21.2 million, representing an increase of $5.6 million, or 36.0%, as compared to

selling and promotional expenses of $15.6 million for the year ended December 31, 2002. This increase was primarily attributable to increased recruitment personnel, increased marketing and advertising expenses to attract more learners to our programs and an incremental increase in advertising expenses and enrollment expenses to support the introduction of our four-year bachelor’s programs in January 2004. Selling and promotional expenses as a percentage of revenues decreased by 5.5 percentage points to 25.9% for the year ended December 31, 2003, as compared to 31.4% in the year ended December 31, 2002, primarily driven by improved efficiency of advertising and recruitment functions and tuition increases.

      General and administrative expenses. Our general and administrative expenses for the year ended December 31, 2003, were $14.2 million, representing an increase of $1.4 million, or 11.1%, as compared to general and administrative expenses of $12.7 million for the year ended December 31, 2002. This increase is primarily attributable to further investments in our corporate infrastructure consisting primarily of personnel and management to accommodate current and expected growth and additional compensation expense. This increase was partially offset by a decrease in bad debt expense, primarily attributable to a tightening of our credit policies during 2002. Our general and administrative expenses as a percentage of revenues decreased by 8.4 percentage points to 17.3% of revenues for the year ended December 31, 2003, from 25.7% for the year ended December 31, 2002, due to the fact that a significant portion of our general and administrative expenses does not vary with fluctuations in revenues and reduced bad debt expense.

      Other income, net. Other income, net increased $0.1 million, or 30.5%, to $0.4 million for the year ended December 31, 2003, from $0.3 million for the year ended December 31, 2002. The increase was principally due to a higher average cash and short-term investment balances throughout 2003, partially offset by lower interest rates.

      Income tax expense (benefit). We were able to utilize existing net operating loss carryforwards to offset all taxable income in 2003. As these net operating loss carryforwards were fully reserved for in prior periods, no income tax expense was recognized in 2003, except for $0.1 million of alternative minimum tax liabilities, which were paid during 2003.

      Net income (loss). Net income was $4.4 million for the year ended December 31, 2003, as compared to a net loss of $5.7 million for the year ended December 31, 2002, an increase of $10.1 million, because of the factors discussed above.

      The following table sets forth certain unaudited financial and operating data in each quarter during the years ended December 31, 2003 and 2004. The unaudited information reflects all adjustments, which include only normal and recurring adjustments, necessary to present fairly the information shown.

      Our revenues and operating results normally fluctuate as a result of seasonal variations in our business, principally due to changes in enrollment. Learner population varies as a result of new enrollments, graduations and learner attrition. While the number of enrollments has grown in each sequential quarter over these periods, the sequential quarterly increase in enrollments has been the greatest in the fourth quarter of each respective year, which corresponds with a traditional Fall school start. The larger relative increases in enrollments in the fourth quarter have resulted in larger sequential increases in revenue during the fourth quarter than in other quarters. A significant portion of our general and administrative expenses do not vary proportionately with fluctuations in revenues, resulting in larger relative increases in operating income in the fourth quarter relative to increases between other quarters. We expect quarterly fluctuations in operating results to continue as a result of seasonal enrollment patterns.

      In addition to our recurring seasonal patterns described above, our quarterly revenue may be impacted by the timing of our seminar tuition revenue resulting from week-long gatherings of our doctoral learners for in-depth, face-to-face instruction. We typically have three to six seminars per year. For example, revenue declined slightly from the second quarter of 2004 as compared to the third quarter of 2004 because two seminars totaling $2.7 million in revenue occurred in the second quarter of 2004 and no seminars occurred in the third quarter of 2004. Our quarterly operating results may fluctuate in the future based on the timing and number of our seminars.

      Our fourth quarter results in each of 2003 and 2004 were affected particularly by impairment charges and income tax expense (benefit). During the fourth quarter of 2003 and 2004, we recorded impairment charges of $0.4 and $1.0 million, respectively, related to previously capitalized software development costs for software projects that were abandoned. The fourth quarter of 2003 included tax expense of $0.1 million related to alternative minimum taxes, while the first three quarters in 2003 and in 2004 included zero tax expense primarily because we utilized net operating loss carryforwards that were fully reserved for in prior periods. Additionally, in the fourth quarter of 2004, in accordance with SFAS No. 109, the remaining valuation allowance applied to net deferred tax assets of $10.6 million was reversed, resulting in a corresponding favorable impact on net income.

Liquidity and Capital Resources

      We financed our operating activities and capital expenditures during the year ended December 31, 2004, through cash provided by operating activities. During the years ended December 31, 2002 and 2003, we financed our operating activities and capital expenditures through a combination of cash provided by operating activities and sales of equity to private investors. Our cash, cash equivalents and short-term investments were $41.2 million and $50.0 million at 2003 and 2004, respectively.

      In August 2004, we entered into an unsecured $10.0 million line of credit with Wells Fargo Bank. The line of credit has an expiration date of June 30, 2005. There have been no borrowings to date under

this line of credit. Any borrowings would bear interest at a rate of either LIBOR plus 2.5% or the bank’s prime rate, at our discretion on the borrowing date.

      A majority of our revenues are derived from Title IV programs. Federal regulations dictate the timing of disbursements under Title IV programs. Learners must apply for new loans and grants each academic year, which starts July 1. Loan funds are generally provided by lenders in multiple disbursements for each academic year. The disbursements are usually received by the start of the second week of the term, except that borrowers in the first year of their bachelor’s program are subject to a 30-day delivery delay on the first disbursement. Certain types of grants and other funding are not subject to a 30-day delay and are delivered after enrollment has been verified. These factors, together with the timing of our learners beginning their programs, affect our operating cash flow.

      Based on our current level of operations and anticipated growth, we believe that our cash flow from operations and other sources of liquidity, including cash, cash equivalents and short-term investments, will provide adequate funds for ongoing operations and planned capital expenditures for at least the 12 months immediately following the consummation of this offering.

      Net cash provided by operating activities during the year ended December 31, 2004, was $17.5 million, an increase of $1.5 million, or 9.1%, from $16.0 million during the year ended December 31, 2003. The increase was primarily due to a $14.4 million increase in net income, a $3.3 million increase in non-cash related expenses for the provision for bad debts, depreciation and amortization, asset impairments, and equity related expense, and a $2.1 million increase in deferred revenue, partially offset by a $8.4 million increase in deferred tax assets primarily as a result of the non-cash reversal of the valuation allowance, a $5.6 million increase in accounts receivable and prepaid expenses and a $4.4 million decrease in accounts payable and accrued liabilities due to the timing of vendor payments.

      Net cash provided by operating activities during the year ended December 31, 2003, was $16.0 million, an increase of approximately $15.9 million, from $0.2 million during the year ended December 31, 2002. This increase was primarily due to a $10.1 million increase in net income in the 2003 period, a $1.9 million increase in accounts payable and a $5.3 million increase in accrued liabilities related to an increase in accrued salaries and related benefits, partially offset by a $1.8 million decrease in accounts receivable.

      Our cash used in investing activities is primarily related to the purchase of property and equipment and short-term investment activity. Net cash used in investing activities was $15.8 million, $26.7 million and $13.6 million for the years ended December 31, 2002, 2003 and 2004, respectively. Short-term investment activity consists of purchases and sales of auction rate securities. Net purchases of these securities were $12.0 million, $22.4 million and $4.7 million during the year ended December 31, 2002, 2003 and 2004, respectively. Our capital expenditures primarily result from the expansion of our existing corporate facilities, classroom technology and other systems and equipment that support our program offerings and our learner management and reporting system. Capital expenditures were $3.9 million, $4.3 million and $9.0 million for the year ended December 31, 2002, 2003 and 2004, respectively. The increase in 2004 was due to the investment in a new courseroom learning platform and furniture and fixtures in our new corporate headquarters. Capital expenditures are expected to continue to increase in the next several years as we invest in integrating most of our business systems with an enterprise resource planning system. We expect that once implemented, this integration of our systems and processes will reduce some of our instructional costs and services, selling and promotional and general and administrative expenses. We expect that our capital expenditures in 2005 will be approximately $13 million to $15 million. We expect to be able to fund these capital expenditures with cash generated from operations.

      We lease all of our facilities. We expect to make future payments on existing leases from cash generated from operations.

      Net cash provided by financing activities was $15.1 million, $7.4 million and $0.3 million, for the years ended December 31, 2002, 2003 and 2004, respectively. The financing activities during these periods were primarily related to private placements of our stock in 2002 and 2003 and stock option exercises in 2004.

      In February 2002, we entered into an agreement with investors pursuant to which we issued and sold 1,425,457 shares of our Class F redeemable convertible preferred stock, or Class F preferred stock, at a price per share of $11.71. We received proceeds, less offering costs of $1.3 million, totaling $15.4 million from this sale. In January 2003, we entered into another agreement with the purchasers of the Class F preferred stock as well as new investors, pursuant to which we issued and sold 2,184,540 shares of our Class G redeemable convertible preferred stock, or Class G preferred stock, at a price per share of $11.12. Of the 2,184,540 shares of Class G preferred stock issued, 1,501,088 shares were issued in exchange for all of the outstanding shares of Class F preferred stock. We received no proceeds from this exchange. As consideration for the remaining 683,452 shares of Class G preferred stock sold, we received proceeds, less offering costs of $0.4 million, totaling $7.2 million.

      We received proceeds from the exercise of stock options of $0.04 million, $0.8 million and $0.9 million in 2002, 2003 and 2004, respectively.

Contractual Obligations

      The following table sets forth, as of December 31, 2004, the aggregate amounts of our significant contractual obligations and commitments with definitive payment terms due in each of the periods presented:

Impact of Inflation

      We believe that inflation has not had a material impact on our results of operations for any of the years in the three year period ended December 31, 2004. We cannot assure you that future inflation will not have an adverse impact on our operating results and financial condition.

Quantitative and Qualitative Disclosures About Risk

      We have no derivative financial instruments or derivative commodity instruments. We believe that the risk related to short-term investments is limited due to the adherence to our investment policy that requires investments to have a minimum Standard & Poor’s rating of A (or equivalent), and limits investments in any one issuer to the greater of 10% of the short-term portfolio at the time of purchase or $2,500,000. All of our investments as of December 31, 2003 and 2004, consisted of cash, cash equivalents, and short-term investments rated AA or higher, further limiting our credit and market risk related to investments.

      We manage interest rate risk by investing excess funds in cash equivalents and short-term investments bearing variable interest rates, which are tied to various market indices. Consequently, the fair value of our cash and cash equivalents would not be significantly impacted by either a 100 basis point increase or decrease in interest rates. However, a 100 basis point change in interest rates for 2004 would have changed our interest income from cash equivalents and short-term investments by approximately $0.5 million based on the average amount of our cash, cash equivalents and short-term investments during the year ended December 31, 2004.

Recent Accounting Pronouncements

      In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how a company classifies and measures certain financial instruments and specifies that some financing arrangements with characteristics of both liabilities and equity must be classified as liabilities. Among the requirements of SFAS No. 150 is that all “mandatorily redeemable” securities be classified as liabilities. SFAS No. 150 was effective for us beginning in 2004. None of our current classes of redeemable preferred stock is considered “mandatorily redeemable” as defined by SFAS No. 150 because these securities are also convertible into common stock and therefore are not required to be classified as liabilities. Our adoption of SFAS No. 150 did not have a material effect on our financial condition or results of operations.

      In December 2004, the FASB issued SFAS No. 123 (revised), Share-Based Payment (SFAS 123R). We are required to adopt SFAS 123R on January 1, 2006. The cumulative effect of adoption, if any, would be measured and recognized in the period of adoption. SFAS 123R addresses the accounting for transactions in which an enterprise receives employee services in exchange for equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25 and generally would require instead that such transactions be accounted for using a fair-value-based method. Companies are required to recognize an expense for compensation cost related to share-based payment arrangements, including stock options and employee stock purchase plans. We currently account for share-based payments to our employees using APB Opinion No. 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair-value-based method will have a significant adverse impact on our results of operations, although it will have no impact on our overall cash position. We are currently evaluating option valuation methodologies and assumptions. The impact of adoption of SFAS 123R cannot be predicted with more specificity at this time because it will depend on the option methodology adopted, the assumptions utilized and the levels of share-based payments granted in the future. However, had we adopted SFAS 123R using the Black-Scholes option valuation model in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income (loss) and pro forma net income (loss) per share of common stock in Note 2 to our consolidated financial statements included elsewhere in this prospectus.