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FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

For the fiscal year ended December 31, 2001

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to                     

Commission File Number 000-24289

CLICK2LEARN, INC.

110-110th Avenue NE, Bellevue, Washington 98004

(425) 462-0501

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

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

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

      The aggregate market value of common stock held by non-affiliates of the registrant as of March 1, 2002 was $54,964,496.

      The number of shares outstanding of the registrant’s common stock as of March 1, 2002 was 24,250,697.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 29, 2002 are incorporated by reference into Part III.

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CLICK2LEARN, INC.

FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2001

INDEX

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PART I

      This Annual Report and the documents incorporated herein by reference include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact we make in this Annual Report or in any document incorporated by reference are forward-looking. Such forward-looking statements involve risks and uncertainties, including, among other things, statements regarding our anticipated costs and expenses and revenue mix. Such forward-looking statements include, among others, those statements including the words “expect”, “anticipate”, “intend”, “believe” and similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to those discussed in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Factors That May Affect Future Results of Operations.” You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

Item 1.     Business

Overview and History

      We are a leading developer and provider of enterprise e-Learning solutions for businesses, government agencies and educational institutions. We design, develop, market, license and support an integrated suite of e-Learning software products and related services that allow our customers to cost-effectively create, personalize and manage the delivery of educational content across their extended enterprise of employees, suppliers, distributors and customers. We recently introduced our new Aspen Enterprise Learning Platform (“Aspen”), a suite of software products that unifies collaborative content development, personalized content delivery and comprehensive learning management in an integrated system designed to be open, flexible and scalable. We also offer a range of professional services to support our e-Learning software products.

      Our e-Learning solutions focus on the needs of organizations that realize the ability to provide relevant and up-to-date knowledge when and where it is needed throughout the extended enterprise is critical to their overall success. We provide our e-Learning solutions to customers across a broad range of industries including financial services, accounting, healthcare, insurance, technology, manufacturing, telecommunications, transportation, utilities, government and education.

      We were originally incorporated as Asymetrix Corporation in the State of Washington in 1984 and developed and marketed a wide range of software products. In 1995, we focused our business on the e-Learning market and we released our first authoring tool focused specifically on the creation of e-Learning content. We created our first learning management system in 1997 and our first web-based collaborative content development system in 1999. As a result of our decision to focus on e-Learning, we divested several product lines and made a number of acquisitions to strengthen our position in this market, and we changed our name to Asymetrix Learning Systems, Inc. In connection with our initial public offering in June 1998, we reincorporated as a Delaware corporation and in 2001, we changed our name to Click2learn, Inc.

      In 2001, as part of our ongoing focus on the Aspen platform, we acquired IntelliPrep Technologies, Incorporated (“IntelliPrep”) and made the decision to discontinue investing in our e-Learning Network, our hosted application service platform. We intend to migrate our e-Learning Network customers to Aspen as their existing contracts expire. We also decided to limit our services offerings to those directly related to the Aspen platform and our ToolBook II product line. As a result, in January 2002 we sold the majority of

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Products and Services

      We offer the following products and services:

      Aspen Enterprise Learning Platform. Aspen is a suite of three software products, each of which can be implemented on a stand-alone basis or in any combination. The Aspen product suite unifies collaborative content development, personalized content delivery and comprehensive learning management in an integrated system designed to be open, flexible, modular, and scalable. Each product in the Aspen suite is designed to offer comprehensive support for industry standards such as SCORM, AICC, and IMS Packaging specifications, and to work together with other standards-compliant e-Learning products. The open architecture of Aspen and a well-defined software development kit make it possible for developers to integrate Aspen with other enterprise applications such as systems for enterprise resource planning, supply chain and customer relationship management, human resources, e-commerce and financial management. We offer Aspen as a behind-the-firewall solution for implementation on our customers’ information systems or hosted at our data center. Aspen can be licensed on a perpetual or subscription basis.

      The Aspen suite includes the following three products, which are generally licensed based on the number of individual users of the particular product:

	•	Aspen Content Development Server (“Aspen CDS”). Aspen CDS enables customers to collaboratively create standards-compliant learning content in the form of reusable learning objects. Aspen CDS is designed to provide the instructional design, workflow, collaboration and management capabilities that enable a distributed team of subject matter experts, instructional designers and software developers to rapidly and cost-effectively develop engaging and flexible e-Learning courses. Courses created with Aspen CDS are designed to integrate with other standards-compliant learning management systems.
	•	Aspen Learning Experience Server (“Aspen LXS”). Aspen LXS is designed to provide an individual learner with a personalized learning experience that promotes rapid learning and knowledge exchange through adaptive delivery, collaboration tools, guided study paths, knowledge exchange tools and personalized feedback options. For example, Aspen LXS can adapt courses to the needs of individual learners by providing a guided path through the learning objects within a course. Aspen LXS includes features designed to increase learning effectiveness by annotating and highlighting relevant content, allowing the learner to access communities of experts for assistance with difficult subject matter and share knowledge, insights and experience with other learners.
	•	Aspen Learning Management Server (“Aspen LMS”). Aspen LMS is designed to allow organizations to manage learning resources from a central location and provide managers throughout the organization with access to those resources. Aspen LMS manages e-Learning, instructor-led training and other types of learning through a single interface, enabling organizations to efficiently use learning resources from a variety of sources, including custom content created with Aspen CDS and other standards-compliant content authoring programs, as well as commercially available content offerings. Aspen LMS also includes tools to analyze learning performance and capture data about the learning process at the learning-object level, providing organizations with the ability to quickly increase the effectiveness of their learning resources.

      ToolBook II Products. In addition to Aspen CDS, we offer our ToolBook II Instructor and ToolBook II Assistant e-Learning content creation products targeted at small teams or individual authors that do not require the collaborative capabilities and learning object functionality of Aspen CDS. These products enable our customers to create their own media-rich interactive e-Learning content for deployment on the Aspen platform, other standards-compliant e-Learning delivery systems or CD-ROM. ToolBook II Instructor is a multimedia development system for creating sophisticated e-Learning applications that is targeted at professional software developers. ToolBook II Assistant is designed to be an

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      Professional Services. We complement our Aspen and ToolBook II product offerings with a range of professional services to enable our customers to develop, implement, evaluate and maintain their e-Learning solutions. Our professional services offerings include:

	•	Strategic Consulting. We assist our customers in evaluating their e-Learning needs, using e-Learning to increase effectiveness or add value to current offerings, developing e-Learning business models, defining a solution that best meets their e-Learning needs and providing on-going consulting on the effectiveness of their solution and return on investment.
	•	Systems Integration. We provide the services necessary to implement and customize our customers’ e-Learning solutions and to integrate Aspen with our customers’ content, information systems and enterprise applications.
	•	Training and Technical Support. We offer training that helps organizations become more self-reliant in the use of our products and in e-Learning generally, and we offer technical support and maintenance packages for our products.

      A significant portion of our professional services business in 2001 consisted of developing custom e-Learning content. Although we sold the majority of our custom content development business to NIIT in January 2002, we will continue to provide custom content development services to the Washington National Guard at least through 2002.

Customers

      We provide our e-Learning products and services to customers across a broad range of industries including financial services, accounting, health care, insurance, computer hardware and software, manufacturing, networking, telecommunications, government and education. The following is a partial list of our significant customers in 2001:

      The Washington National Guard accounted for 17.5% of our total consolidated revenues and 38.6% of our Content Services revenues during 2001. See Management’s Discussion and Analysis at page 12 for a description of Content Services revenues and our other revenue categories. Although the Washington National Guard will continue to be a significant customer in 2002, we anticipate it will account for a smaller percentage of our total consolidated revenues for 2002. However, with the sale of the custom

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Competition

      The e-Learning market is a new market that is quickly evolving and subject to rapid technological change. The market is also highly fragmented, with no single competitor holding a dominant market position. Because there are no significant barriers to entry in this market, we expect a number of new competitors to enter this market in the future. We face competition from a variety of companies in different segments of the e-Learning market. The Aspen platform faces competition from vendors of other learning or content management systems, such as Saba and Docent, and other companies, including existing enterprise software vendors, may enter the e-Learning market in the future. Our ToolBook II products face competition from other web authoring products.

      The principal competitive factors affecting the market for e-Learning include:

	•	the features and functionality of e-Learning solutions;
	•	scalability and the ability to integrate with a variety of content and other e-Learning and enterprise software products;
	•	the scope and quality of professional services offered;
	•	pricing;
	•	customer service and support;
	•	reputation and financial position of the provider; and
	•	the effectiveness of sales and marketing efforts.

      Although we believe our solutions compete favorably with respect to all these factors, we may not be able to maintain a competitive position against current and potential competitors.

Sales and Marketing

      As of December 31, 2001, our combined sales and marketing organization consisted of 98 employees based at our corporate headquarters in Bellevue, Washington and at other locations throughout the United States, Canada and the United Kingdom. We sell our solutions primarily through a direct sales force consisting of field sales representatives focused on selling larger Aspen implementations and related services. We also have inside sales representatives focused on selling the ToolBook II authoring products and smaller Aspen licenses. Our sales organization also includes sales engineers who provide technical expertise, architect the technical aspects of our e-Learning solutions, assist in proposal preparation and provide ongoing sales support. We expect to add to our direct sales force in the future.

      Although in the past we have not used resellers significantly in marketing our e-Learning solutions other than the ToolBook II products, during 2001 we expanded our distribution through key strategic partnerships. We signed an agreement with Accenture LLP to enable them to market Aspen to their clients and we have established several new reseller relationships to bring the Aspen platform to a number of additional markets in Europe, Asia and the Pacific Rim. Sales to resellers accounted for 7% of total revenues in 2001, and may increase in future years. We expect to appoint additional resellers for the Aspen platform and ToolBook II products in the future.

      International revenue, based on the origin of the customer, accounted for 16%, 6% and 13% of our total revenue for 1999, 2000 and 2001, respectively. We believe that the e-Learning market is still in the early stages of development outside the United States, but that businesses in many other regions of the world are beginning to undertake e-Learning initiatives. We intend to continue to expand internationally by

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      We conduct a variety of marketing programs to promote our e-Learning solutions, including advertising in national business and technology magazines and trade publications, major trade shows, direct mail and e-mail campaigns, public seminars, web-based seminars, and public relations activities focused on company news and successful applications of our e-Learning solutions. In cooperation with the publisher of Training and Online Learning magazines, we are founding sponsors of the largest e-Learning conference in the industry. The next conference will be held in September 2002 in Anaheim, California. We also participate as an exhibitor and speaker at numerous training and e-Learning trade shows and we maintain an area on our web site where potential customers can obtain information about e-Learning and our solutions.

Research and Development

      We believe our long-standing focus on technology has attracted qualified engineering and other technical personnel and has contributed to our core technology capabilities. In May 2001, we significantly enhanced our engineering team with the acquisition of IntelliPrep, which brought a number of engineers who had previously held senior positions within Microsoft Corporation’s engineering organization. Our principal research and development groups are located in Bellevue, Washington and Rochester, New York. Research and development expenses were $7.4 million, $9.5 million and $8.9 million in 1999, 2000 and 2001, respectively and represented 21%, 22% and 20% of total revenue in those periods.

      We believe our future success will depend on our ability to continue to enhance our e-Learning solutions to keep pace with competitive product and service offerings, new technologies and industry standards, and diverse and changing customer requirements. As a result, we actively participate in a number of standards bodies and are taking an active role in defining standards for the e-Learning industry. We expect to continue to commit significant resources to research and development of our e-Learning solutions in the future.

Proprietary Rights

      Our e-Learning solutions are based on technology that is primarily internally developed, although some portions are licensed from third parties. We rely on a combination of copyrights, trademarks, trade secret laws, restrictions on disclosure and other methods to protect our intellectual property. We also enter confidentiality agreements with our employees and consultants, and control access to our proprietary information. Despite our precautions, however, unauthorized parties may copy or otherwise obtain or use our intellectual property and other companies may independently develop equivalent technology or intellectual property.

      We use the following trademarks in the conduct of our business: CLICK2LEARN, ASPEN, TOOLBOOK II ASSISTANT and TOOLBOOK II INSTRUCTOR.

Employees

      As of December 31, 2001, we had 356 full-time employees, including 73 in research and development, 98 in sales and marketing and technical support, 138 in professional services and 47 in operations and administration. None of our employees are represented by a labor union. We have not experienced any work stoppages and we consider our relations with our employees to be good. In connection with the sale of the majority of our custom content development business to NIIT in January 2002, 52 of our employees became employees of NIIT or were terminated.

Item 2.     Properties

      Our corporate headquarters and executive offices are located in Bellevue, Washington in approximately 35,293 square feet of leased office space, with the lease term expiring in October 2003. We also

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Item 3.     Legal Proceedings

      From time to time, we are involved in legal proceedings and litigation arising in the ordinary course of business. We are not a party to any litigation or other legal proceeding that, in the opinion of management, could have a material adverse effect on our business, operating results and financial condition, except as described below.

      ComVest Venture Partners, L.P. v. Click2learn, Inc., Supreme Court of the State of New York, County of New York, No. 01604817. On October 10, 2001, ComVest Venture Partners, L.P. (“ComVest”) filed suit against us alleging that we breached our obligations under a term sheet to allow them to purchase shares of our common stock and warrants for the purchase of additional shares. On November 12, 2001, the parties executed a settlement agreement and the suit was formally discontinued by stipulation on December 20, 2001.

      Richard B. Grant v. Asymetrix Corporation, No. CV-96-3635 HLH, Central District of California. On May 21, 1996, Richard B. Grant filed a complaint alleging that our ToolBook and Multimedia ToolBook products infringe a patent owned by him and seeking unspecified damages. We have received an opinion from patent counsel that the products do not infringe this patent and that the patent is invalid. This action is still in the discovery stage, and it is not yet possible to assess the likelihood of its outcome. Currently discovery in the case has been stayed pending the court’s ruling on the interpretation of the patent claims. Although we believe that we do not infringe this patent and that the patent is invalid, and although we intend to defend this action vigorously, the results of litigation can never be predicted with certainty. An adverse outcome in this litigation could have a material adverse effect on our business, operating results and financial condition. Moreover, the costs of defending the action, regardless of outcome, could be time-consuming, distract management personnel and have a negative effect on our business.

Item 4.     Submission of Matters to a Vote of Securities Holders

      Not applicable.

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PART II

Item 5.     Market for Registrant’s Common Stock and Related Stockholder Matters

      Since the initial public offering, our common stock has been listed on the Nasdaq National Market, originally under the symbol ASYM and currently under the symbol CLKS. The following table sets forth the high and low sales prices per share for each fiscal quarter during 2000 and 2001.

      As of March 1, 2002, there were 219 holders of record of our common stock. Because brokers and other institutions hold many of the shares on behalf of stockholders, we are unable to estimate the actual number of stockholders represented by these record holders. We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings to finance growth and, thus, we do not anticipate paying any cash dividends in the foreseeable future.

      The stock market from time to time has experienced significant price and volume fluctuations. In addition, the market price of our common stock has been highly volatile since our initial public offering. Factors such as fluctuations in our operating results, announcements of technological innovations or introductions of new products by us or our competitors, analysts’ reports and projections and general market conditions may have a significant effect on the market price of our common stock. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against such a company. The institution of such litigation against us could result in substantial costs and a diversion of management’s attention and resources, which could have a material adverse effect on our business.

Recent Sales of Unregistered Securities

      In a private placement transaction closing on November 20, 2001 and December 10, 2001, we sold 3,680,000 shares of our common stock to several accredited investors for an aggregate purchase price of $9.2 million in cash. In connection with the purchase of the common stock, we issued the investors warrants for the purchase of an additional 1,840,000 shares of common stock at an exercise price of $4.00 per share.

      Jefferies & Company, Inc. (“Jefferies”) acted as placement agent in connection with a portion of the private placement closings on November 20, 2001 and December 10, 2001 and was paid commissions of $456,750. Jefferies was also issued warrants for the purchase of 64,200 common shares on November 20, 2001 and for the purchase of 28,200 common shares on December 10, 2001, both at an exercise price of $2.50 per share.

      ComVest acted as placement agent in connection with a portion of the private placement closing on November 20, 2001 and was paid commissions of $70,000. ComVest was also issued warrants for the purchase of 12,000 common shares on November 20, 2001, at an exercise price of $2.50 per share. ComVest was also an investor in the November 20, 2001 private placement closing and purchased stock

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      Commonwealth Associates, L.P. (“Commonwealth”) acted as placement agent in connection with a portion of the private placement closing on November 20, 2001 and was paid commissions of $105,000. Commonwealth was also issued warrants for the purchase of 18,000 common shares on December 10, 2001, at an exercise price of $2.50 per share.

      The sale of shares and warrants was made only to accredited investors pursuant to Rule 506 of Regulation D under the Securities Act of 1933 as amended (“the Act”) and was therefore exempt under the Act. The shares sold in the private placement and issuable upon exercise of the warrants were subsequently registered for resale pursuant to a Registration Statement on Form S-3. The proceeds have and will be used for working capital requirements.

      The warrants are exercisable at any time prior to their expiration dates in whole or in part upon the payment of the exercise price for the number of shares with respect to which the warrants are being exercised. In addition, the warrants may be exercised on a net exercise basis, pursuant to which the exercise price for an exercise of warrants is paid by the cancellation of a portion of the shares being exercised having a fair market value equal to the exercise price for all the shares being exercised. However, a net exercise may only be made if there is not an effective registration statement in place on the date of such exercise covering the resale of the warrant shares. The terms of the warrants are summarized in the following table:

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(a)	Historical information was restated to reflect the combination of Click2learn and Meliora in 1998, accounted for as a pooling-of-interests.
(b)	Historical results of operations are not necessarily indicative of future results. Refer to the “Factors that May Affect Future Results of Operations” under Item 7: “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the discussion of factors which may impact future results.

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      The following discussion of our financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and our Consolidated Financial Statements and related Notes thereto included elsewhere in this Report.

Overview

      We are a leading developer and provider of enterprise e-Learning software products and services for companies, government agencies and educational institutions. We design, develop, market, license and support an integrated suite of e-Learning software products and related services that allow our customers to cost-effectively create, personalize and manage the delivery of educational content. In the third quarter of 2001, we introduced our new Aspen platform that unifies collaborative content development, personalized content delivery and comprehensive learning management in an integrated system designed to be open, flexible and scalable. We provide our e-Learning products and services to customers across a broad range of industries including financial services, accounting, healthcare, insurance, technology, manufacturing, telecommunications, transportation, utilities, government and education.

      We group revenues around the primary components of our solutions: Platforms, Content Services and Tools.

      Platforms revenues include software licenses, subscription and hosting fees, implementation, customization, training and support related to the Aspen platform, our Ingenium learning management system, the precursor product to the Aspen Learning Management Server, and our e-Learning Network, an Internet e-Learning ASP offering that is not material to our current business.

      Content Services revenues are derived from the creation of custom e-Learning courses, consulting, fees for licensing, implementing and hosting our Rapid e-Learning Development System (“ReDS”) and sales of third party off-the-shelf content. ReDS is a collaborative development system that was licensed in connection with custom content development engagements and is no longer offered.

      Tools revenues primarily include software licenses, technical support and training related to our ToolBook II line of products.

      We recognize revenues for software licenses upon shipment; for technical support, subscription licenses and hosting evenly over the life of the contract; and for services such as content development and implementation based on the percentage of completion method or on a time and materials basis. We recognize non-refundable royalty advances paid by resellers or distributors upon execution of the agreement and shipment of the master copy of the software. To the extent royalties exceed the advances they are recognized as earned based on regular reports from such resellers or distributors.

      Costs related to revenues consist of media, manuals, royalties, packaging and distribution for software licenses and primarily salaries and overhead for service related offerings. Costs of revenues for the Platforms and Tools categories are similar due to a relatively high mix of software licenses versus services with costs averaging 15% to 25% of related revenue. Contrasting the mix for Platforms and Tools, Content Services consist primarily of relatively high personnel costs associated with providing professional services compared to the lower materials, packaging and other costs of software.

Critical Accounting Policies and Estimates

      Our critical accounting policies and estimates are as follows:

	•	Revenue recognition
	•	Estimating allowances for sales returns and the allowance for doubtful accounts
	•	Valuation of long-lived assets and goodwill

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      Revenue recognition. We report our revenue in three categories Tools, Content Services, and Platforms. Tools include software licenses and technical support and training for ToolBook II and other products. Content Services includes custom development of e-Learning courses, consulting, licensing and fees for ReDS, and royalties from resale of third party content. Platforms includes software licenses, subscription and hosting fees, implementation, and training and support for the Aspen platform as well as Ingenium and the e-Learning Network.

      We recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software.

      For all sales, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. Sales through our reseller are evidenced by a master agreement governing the relationship.

      For software license fees in single element arrangements and multiple element arrangements which do not include customization or consulting services, delivery typically occurs when the product is shipped to customers.

      At the time of each transaction, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account for the fee as not being fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.

      We assess the probability of collection based on a number of factors, including past transaction history with the customer and the current financial condition of the customer. We do not request collateral from our customers. If we determine that collection of a fee is not reasonably assured, we defer revenue until the time collection becomes reasonably assured.

      For multiple element arrangements, when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, Company specific objective evidence is established for support and maintenance arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive.

      Professional services revenue is recognized from fixed price contracts as services are provided or by using the percentage-of-completion method of accounting, based on the ratio of costs incurred to the total estimated project cost, for individual fixed-price contracts. Provisions for any estimated losses on uncompleted contracts are made in the period in which such losses become evident. Professional services revenue from time and materials contracts and training services is recognized as revenue as services are performed.

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      We recognize revenue from non-refundable minimum royalty agreements from distributors or resellers upon delivery of product to the distributor or reseller, provided no significant obligations remain outstanding and the conditions of SOP 97-2 have been met. Additional royalties are recognized as revenue to the extent the minimums are exceeded when earned, based on the distributor’s or reseller’s contractual reporting obligations.

      Revenue from subscription licenses, hosting agreements and support agreements is recognized on a straight-line basis over the life of the contract. Revenues from the e-Learning Network include site fees, hosting, royalties, and content sales. The revenues are determined by individual contracts, one to three years in length, which specify functionality of the site and the commerce conducted on the site. The e-Learning Network fees are recognized ratably over the life of the contract. Content revenue is either recognized evenly over the life of the contract for course usage on bundled curriculum courses or recognized at the time of the purchase of individual e-Learning courses. Revenues from tangible goods, including books, videotapes and CD-ROMs are recognized at the time of shipment.

      Allowances for Sales returns and doubtful accounts. The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, we must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing reserves for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

      Valuation of long-lived assets and goodwill. We assess the impairment of long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include poor economic performance relative to expected historical or projected future operating results, significant negative industry, economic or company specific trends, significant declines in valuations of similar businesses in comparison with the market valuations at the time the Company invested in the acquired businesses and changes in the manner of our use of the assets or the plans for our business. If we were to determine that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure impairment based on a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. As a result of our analysis, we recorded an impairment charge for goodwill related to our custom e-Learning content development business of $7.6 million in 2001.

      In 2002, Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” became effective and as a result, we will cease to amortize goodwill. In lieu of amortization, we are required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter. We currently do not expect to record an impairment charge upon completion of the initial impairment review. However, there can be no assurance that at the time the review is completed a material impairment charge will not be recorded.

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Results of Operations

      The following table presents Click2learn’s results of operations as a percentage of total revenue for the periods indicated.

Year Ended December 31, 2001 Compared To Year Ended December 31, 2000

      Revenue. Our total revenue increased 6% from $42.6 million in 2000 to $45.1 million in 2001. Growth was attributable to our focus on the Platforms portion of our business and new customers choosing these systems to address their e-Learning technology requirements.

      The following table sets forth for the periods indicated the year over year revenue growth or decline for each category of revenue:

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      Platforms revenue includes revenue from software licenses and services associated with our new Aspen platform. The Aspen platform is the evolution of our strategy to provide an integrated e-Learning platform to address the need to manage individual users and multiple types of content, personalize the learning experience, and manage the creation of content. The Aspen platform was officially launched in the third quarter of 2001 by integrating the latest release of our Ingenium Learning Management System, now known as Aspen Learning Management Server (LMS), with two new server products, the Aspen Learning Experience Server (LXS) and the Aspen Content Development Server (CDS). We experienced higher overall Platforms revenue in the last two quarters of 2001 as a result of the release of the Aspen product suite. We experienced full year Platforms revenue growth of 68% from $12.5 million in 2000 to $21.0 million in 2001. For overall revenue growth to continue, sales growth of the Aspen platform must continue to trend upwards.

Offsetting the growth of our Platforms business in 2001 were declines in the Tools and Content Services revenue categories.

      The Tools category is comprised primarily of revenue from the sale of software licenses and services related to our Toolbook II line of products. In 1998, we made the decision to focus our primary research and development (R&D) and sales and marketing efforts on the platform technology area of e-Learning. As a result, Tools has declined as a percentage of our total revenue and in absolute revenue dollars. Tools revenue declined 19% from $8.6 million in 2000 to $7.0 million in 2001. We do not anticipate increasing our Tools related R&D or sales and marketing investments from their current levels in the near term. As a result we do not expect Tools related revenues to increase and they are likely to continue to decline.

      The Content Services category of revenue consists of custom content development, consulting services and to a lesser extent the sale of third party content. The demand for the services portion of this category grew significantly in 2000 as new customers adopted e-Learning and contracted for the creation of custom content. In 2001, the general economic decline resulted in an overall decrease in budgets for these services. Customers reduced their spending and sought the lowest cost alternatives, resulting in a large portion of the custom content development market moving outside of the United States. As a result, we significantly reduced our capacity and Content Services revenue declined 21% from $21.5 million in 2000 to $17.1 million in 2001. During January of 2002, we sold most of this business to NIIT (U.S.A.), Inc. In the future, we will only offer custom content development services to a limited part of the government market, in particular the Washington National Guard, which will result in a significant reduction of Content Services revenue in coming years.

      Cost of Revenue. Though revenue increased in 2001, total cost of revenue decreased from $22.2 million in 2000 to $21.5 million in 2001. The reduction was due primarily to a change in the mix of our revenues and the related costs of each revenue category. Platforms and Tools revenues carry a much lower cost as a percent of revenue than does Content Services. The overall mix of Platforms and Tools revenue grew from 50% of total revenue in 2000 to 62% in 2001. As a result, total gross margin improved from 48% in 2000 to 52% in 2001. With the sale of our commercial Content Development business, we anticipate gross margins to continue to increase as Platforms and Tools becomes a larger portion of total revenue.

      The following table sets forth for the periods indicated, our Tools, Content Services and Platforms revenues as a percent of net revenue:

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      The following table sets forth for the periods indicated, the costs as a percent of associated revenue for each category of revenue reported.

      Offsetting the improved gross margins in 2001 resulting from revenue mix changes was an increase in cost of revenues from our Content Services category. In response to the decline in demand for these services, we reduced costs 11% from $18.5 million in 2000 to $16.4 million in 2001, however due to lower billable utilization rates, employee severance payments and fixed facility costs we were not able to maintain our gross margins as a percentage of content services revenue as compared to 2000. Gross margins as a percentage of revenue declined from 14% in 2000 to 4% in 2001. In response to this environment, we sold the commercial portion of this business in January of 2002, and anticipate that we will take a charge of $2.5 million during the quarter ending March 31, 2002 to cover the costs associated with employee severance and excess office facilities. By eliminating these expenses, costs for Content Services revenue will decrease significantly in the future.

      Tools costs of revenue are primarily labor associated with training customers on the use of Toolbook and to a lesser extent packaging, royalties and CD replication costs associated with software license sales. Tools costs declined 15% from $1.8 million in 2000 to $1.5 million in 2001. The primary reason for the decline was the decrease in revenue.

      Platforms costs of revenue are primarily labor costs associated with software implementations and to a lesser extent packaging and CD replication costs associated with software license sales. Costs of revenue increased 86% from $1.9 million in 2000 to $3.5 million in 2001. The increase in costs was attributed to demand for the Aspen platform and an expansion of our implementation services organization to assist these clients with the installation of Aspen. Costs as a percent of revenue grew from 15% in 2000 to 17% in 2001 due to lower service staff utilization prior to Aspen’s launch in the second half of 2001. We anticipate that software licenses will continue to make up the majority of Platforms revenue, however, if this changes and services become a greater portion of Platforms revenue then cost as a percent of revenue would increase.

Operating Expenses.

      Research and Development. Research and development expenses include expenses associated with the development of new products and new product versions and consist primarily of salaries, depreciation of development equipment, supplies and overhead. Research and development expenses decreased 7% from $9.5 million in 2000 to $8.9 million in 2001. This decrease was due to a reduction in incremental spending on the e-Learning Network platform offset by higher expenditures for Aspen product development. Research and development expenses as a percentage of total revenue decreased from 22% in 2000 to 20% in 2001. In the near term, we expect research and development expenses to increase in absolute dollars as we work to expand the functionality of the Aspen platform.

      Sales and Marketing. Sales and marketing expenses consist primarily of sales and marketing personnel costs, including sales commissions, travel, advertising, public relations, seminars, trade shows and other marketing literature and overhead costs. Sales and marketing expenses decreased 10% from $20.5 million in 2000 to $18.5 million in 2001. The decrease was due primarily to the inclusion of a $2.1 million charge in 2000 to accelerate all remaining costs from a three-year co-marketing agreement with Go2Net, Inc. Excluding the charge, sales and marketing costs were comparable. Sales and marketing expenses as a percentage of total revenue decreased from 48% in 2000 to 41% in 2001. Excluding the 2000 charge, sales and marketing as a percent of revenue declined from 43% in 2000 to 41% in 2001. We expect

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      General and Administrative. General and administrative expenses consist primarily of salaries and other personnel-related expenses for administrative, executive and finance personnel as well as outside advisors. General and administrative expenses decreased 3% from $6.6 million in 2000 to $6.5 million in 2001. The slight reduction was due to lower overall headcount in the company, which reduced administrative requirements. General and administrative expenses as a percentage of total revenue decreased from 16% in 2000 to 14% in 2001. We expect that general and administrative expenses will increase in absolute dollars in the near term if we continue to experience growth in revenues.

      Amortization of Goodwill and Impairment Charges. Amortization of goodwill relates to the amortization of excess purchase price over the fair value of identifiable tangible and intangible assets acquired in acquisitions recorded using the purchase method of accounting. Amortization of goodwill and impairment charges increased 867% from $946,000 in 2000 to $9.1 million in 2001. We periodically assess the recoverability of our long-lived assets, including goodwill for indications of impairment. During the fourth quarter of 2001, we determined that the declining profitability of our custom content development business provided an indication that an impairment had occurred and all of the goodwill related to acquired content development businesses was written-off. As a result, we wrote-off $7.6 million of unamortized goodwill from our acquisitions of Oakes Interactive, Inc., TopShelf Multimedia, Inc., Acorn Consulting, Inc., Communication Strategies, Inc., Strategic Systems Associates, Inc., Graham-Wright Interactive, Inc., 3 Dog Multimedia, Inc. and other small custom development companies acquired over the past several years. Unamortized goodwill at December 31, 2001 relates to our Platforms business. To a lesser extent, the increase in amortization of goodwill is related to the acquisition of IntelliPrep in May of 2001. We recognized approximately $550,000 of amortization expense in 2001 related to this acquisition. For 2002, we are required to adopt Financial Accounting Standards Board Statement 142, “Goodwill and Other Intangible Assets” (“Statement 142”). Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually. Intangible assets with definite useful lives will continue to be amortized over their respective estimated useful lives. Click2learn will adopt the provisions of Statement 142 effective January 1, 2002.

      Other Income (Expense). Interest income, net, on cash and cash equivalents in 2001 was $107,000 as compared to $981,000 in 2000. The reduction was due primarily to lower cash balances and reduced interest rates in 2001. In April 2000, we established a joint venture with SOFTBANK Media & Marketing Corp. and SOFTBANK Forums Japan, Inc. creating Click2learn Japan K.K. We account for our portion of the joint venture’s operating results under the equity method. In 2001 we recorded a loss of $400,000 as compared to $510,000 in 2000. The remaining value of our investment at December 31, 2001 was approximately $470,000. We anticipate in the near term our portion of the joint ventures losses will remain at current levels or decline slightly. We do not have obligations to provide future financing.

Year Ended December 31, 2000 Compared To Year Ended December 31, 1999

      Revenue. Our total revenue increased 23% from $34.7 million in 1999 to $42.6 million in 2000. Revenue growth was attributable to a 121% growth in the Platforms category from $5.6 million in 1999 to $12.5 million in 2000. Additional growth was achieved through the Content Services category, which grew 56% from $13.8 million in 1999 to $21.5 million in 2000. These increases were due to our increased success at selling e-Learning solutions that include elements of each category. Solutions that include both our Platforms and Content Services offerings grew 75% from $19.4 million in 1999 to $34.0 million in 2000 and represented 80% of total revenues up from 56% in 1999. Offsetting the e-Learning solutions growth was a decline in the Tools category of 44% from $15.3 million in 1999 to $8.6 million in 2000. Our primary sales and marketing focus in 2000 was on our e-Learning solutions including Platforms and Content Services and which seldom included the products and services from the Tools category. As a result, little marketing or sales effort was focused on the Tools category contributing to the decline in revenues.

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      Cost of Revenue. Total cost of revenue increased 38% from $16.1 million in 1999 to $22.2 million in 2000. Increased costs of revenue were due primarily to higher total revenues and a change in the revenue mix between Tools, Content Services and Platforms. In 1999, Content Services represented 40% of total revenues and grew to 50% in 2000. The costs associated with Content Services were primarily labor and overhead and are therefore significantly higher as a percentage of revenue than is the case for the costs of the Tools or Platforms categories, which are primarily costs associated with product licenses and the services that support them. The cost of Content Services revenues grew 65% from $11.2 million in 1999 to $18.5 million in 2000. Cost of Platforms revenues grew 46% from $1.3 million in 1999 to $1.9 million in 2000. The increased costs for both categories were due primarily to the higher revenues produced. The cost of Tools revenues declined 50% from $3.6 million in 1999 to $1.8 million in 2000 due to the lower revenues from this category.

Operating Expenses

      Research and Development. Research and development expenses increased 28% from $7.4 million in 1999 to $9.5 million in 2000. This increase was due to increases in spending to develop the e-Learning Network platform as well as increased functionality development for the Ingenium platform. Research and development expenses as a percentage of total revenue increased from 21% in 1999 to 22% in 2000.

      Sales and Marketing. Sales and marketing expenses increased 28% from $16.0 million in 1999 to $20.5 million in 2000. Sales and marketing expenses as a percentage of total revenue increased from 46% in 1999 to 48% in 2000. The increase was due primarily to increased staffing in the sales area and a charge of $2.1 million to accelerate all remaining costs from a three-year co-marketing agreement with Go2Net, Inc. Excluding the one-time charge, sales and marketing as a percent of revenue declined from 46% in 1999 to 43% in 2000.

      General and Administrative. General and administrative expenses increased 27% from $5.2 million in 1999 to $6.6 million in 2000. This increase was due primarily to the support of higher total headcount and expansion of European operations. General and administrative expenses as a percentage of total revenue increased from 15% in 1999 to 16% in 2000.

      Amortization of Goodwill. Amortization of goodwill increased 7% from $888,000 in 1999 to $946,000 in 2000 as a result of a full year’s amortization being taken on an acquisition completed in 1999.

      Other Income (Expense). Interest income on cash and cash equivalents in 1999 was $853,000 as compared to $981,000 in 2000. Our portion of Click2learn Japan K.K.’s operating loss under the equity method was $510,000 in 2000.

IntelliPrep Acquisition

      In May 2001, we acquired IntelliPrep, a provider of technology for personalized learning. We issued 1,812,500 shares of common stock and 450,000 options to acquire its common stock valued at $4,419,688. In connection with the acquisition, we incurred approximately $600,000 of acquisition related expenditures of which $241,000 was unpaid as of December 31, 2001. Goodwill of $3.3 million and other identifiable intangible assets of $1.4 million representing acquired software were recorded in connection with the acquisition. No elements of in-process research and development were identified as part of the acquisition. Goodwill is amortized over 5 years through December 31, 2001 and other intangible assets are amortized over 3 years.

New Accounting Pronouncements

      In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (Statement 141), and No. 142, “Goodwill and Other Intangible Assets” (Statement 142). Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies the criteria that

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      The provisions of Statement 141 were adopted effective June 30, 2001. We did not complete any business combinations during the period from July 1, 2001 to December 31, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.

      Statement 141 requires, upon adoption of Statement 142 on January 1, 2002, that we evaluate our existing intangible assets and goodwill that were acquired in prior purchase business combinations, and that we make any necessary reclassifications in order to conform with the new criteria in Statement 141 for recognition apart from goodwill. Upon adoption of Statement 142, we are required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, we are required to test the intangible asset for impairment in accordance with the provisions of Statement 142 within the first quarter of 2002. Any impairment loss will be measured as of January 1, 2002 and recognized as the cumulative effect of a change in accounting principle in the first quarter of 2002.

      In connection with the transitional goodwill impairment evaluation, Statement 142 requires that we perform an assessment of whether there is an indication that goodwill and equity-method goodwill is impaired as of January 1, 2002. To accomplish this we must identify our reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. We will then have until June 30, 2002 to determine the fair value of each reporting unit and compare it to the reporting unit’s carrying amount. To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired and we must perform the second step of the transitional impairment test. In the second step, we must compare the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with Statement 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than December 31, 2002.

      Upon adoption of Statement 142, we will no longer amortize goodwill. During 2001, 2000 and 1999, we recognized goodwill amortization expense and impairment charges of $888,000, $946,000 and $9.1 million, respectively. Although we do not anticipate an impairment charge upon the adoption of Statement 142, we have not yet completed our analysis as of the date of this report.

      In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (Statement 144), which is effective for fiscal years beginning after December 15, 2001. Statement 144 supersedes certain provisions of APB Opinion No. 30, “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes Statement 121. We do not expect the adoption of Statement 144 to have a material effect on our consolidated financial position or results of operations

Liquidity and Capital Resources

      At December 31, 2001, our principal source of liquidity was $20.9 million of working capital, a decrease from $21.8 million the prior year. At December 31, 2001, we had cash and cash equivalents

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      In order to increase the liquidity of our receivables, we have established a $4 million working capital line of credit and a two-year $1 million term loan facility for purchases of capital assets with Silicon Valley Bank. Both lines bear interest at the Silicon Valley Bank prime rate plus 1.50% and are collateralized by our assets. Covenants in the loan agreements include restrictions on our ability to pay dividends or make other distributions, make acquisitions or investments, merge or consolidate with others or dispose of assets. If not renewed the working capital line terminates and any advances made are due on November 5, 2002. The term loan is payable in 24 monthly payments of $41,666.67 plus interest ending October 1, 2003. At December 31, 2001, we had a balance of $917,000 on the two-year term loan facility and $0 on the working capital line.

      We have had negative cash flows from operating activities to date. Net cash used by operating activities was $13.1 million, $12.4 million, and $13.4 million in 1999, 2000 and 2001, respectively. However, over the past three quarters cash used in operating activities has declined, with the $1.2 million of cash used in the fourth quarter of 2001 representing less than 10% of cash used from operations in 2001. This trend is a result of our emphasis on the Platforms portion of our business and its higher gross margins. In the near term, we intend to increase this focus further as evidenced by the sale of our commercial content development business in the first quarter of 2002. As a result, we believe that the revenue required to generate positive cash from operations is now lower than have been historically. Based on these trends we anticipate that our cash and cash equivalents will be sufficient to meet our working capital needs and capital expenditures for at least the next 12 months.

      Net cash used in investing activities was $2.5 million, $2.0 million, and $2.8 million in 1999, 2000 and 2001, respectively. In 1999, net cash used in investing activities was primarily the result of capital expenditures for computer equipment, purchased software, office equipment, furniture and fixtures. Net cash used in investing activities in 2000 and 2001 was primarily the result of capital expenditures and investments in Click2learn Japan K.K. As of December 31, 2001, we had no material commitments for capital expenditures and had commitments under non-cancelable operating leases with terms in excess of one year of $5.6 million through 2007.

      Cash provided by financing activities was $13.5 million, $10.5 million, and $10.5 million in 1999, 2000 and 2001, respectively, resulting primarily from our private placements of common and preferred stock and warrants with Go2Net, Inc., Marshall Capital Management, Inc. and Vulcan Ventures, Inc., in 1999; a private placement of common stock and warrants with Marshall Capital Management, Inc. in 2000; and a private placement of common stock and warrants managed by Jefferies & Company, Inc. in 2001. Cash provided by financing activities also includes amounts received from exercise of employee stock options and purchases under our Employee Stock Purchase Plan. Cash used for payments on long-term debt was $120,000, $4,000, and $87,000 in 1999, 2000 and 2001, respectively.

      Although we anticipate that our business will become cash flow positive during 2002, it currently does not generate the cash needed to finance our operations and may not begin to do so in 2002. Our long-term liquidity will be affected by numerous factors, including acquisitions of businesses or technologies, demand for our Aspen platform, the extent to which our e-Learning solutions achieve market acceptance, the timing and extent to which we invest in new technology, the expenses of sales and marketing and new product development, the extent to which competitors are successful in developing their own products and services and increasing their own market share, the level and timing of revenues, the collection of these receivables, the availability of our lines of credit and other factors. Our loan agreement requires us to maintain certain financial ratios and meet other financial covenants. The failure to meet those covenants could prevent us from accessing the working capital line and result in the acceleration of any balances under either the working capital line or the term loan. We were in compliance with these covenants at

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      We had the following contractual commitments and obligations at December 31, 2001:

Factors That May Affect Future Results of Operations

Our quarterly operating results are uncertain and may fluctuate significantly, which could negatively affect the value of your investment.

      Our operating results have varied significantly from quarter to quarter and are likely to continue to fluctuate as a result of a variety of factors, many of which we cannot control. Factors that may adversely affect our quarterly operating results include:

	•	the size and timing of product orders and the timing and execution of professional services engagements;
	•	the mix of revenue from products and services;
	•	the mix of products sold;
	•	the ability to meet client project milestones;
	•	the market acceptance of our products and services;
	•	our ability to develop and market new or enhanced products and services in a timely manner and the market acceptance of these products and services;
	•	the timing of revenues and expenses;
	•	recognition of impairment of existing assets; and
	•	the timing of revenue recognition.

      Our future revenues are difficult to predict and we may not be able to adjust spending in response to revenue shortfalls. Our limited operating history with our current e-Learning solutions, possible acquisitions and the emerging nature of the e-Learning market, make prediction of future revenue and expenses difficult. Expense levels are based, in part, on expectations as to future revenue and largely are fixed in the short term. We will likely be unable to, or may not elect to, reduce spending quickly enough to offset any unexpected revenue shortfall. If we are unable to predict future revenue accurately, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall.

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We have a limited operating history in our current markets, which makes it difficult to predict our future performance.

      Our limited operating history in our current markets makes it difficult to predict our future performance and may not provide investors with a meaningful basis for evaluating an investment in our common stock. From our inception until early 1995, we were engaged in various research and development activities and in developing and marketing multimedia-authoring products, database and Internet tools, web publishing products and other ancillary products, most of which we do not currently sell. In 1995, we began to focus our development and marketing efforts on products and services for the enterprise learning market. We released the Aspen platform in September 2001. Accordingly, we have a limited operating history on which to evaluate our current business and future prospects.

Our business currently does not generate the cash needed to finance our operations, and for that and other reasons we may need additional financing in the future, which we may be unable to obtain.

      Our business currently does not generate the cash needed to finance our operations and may not begin to do so in 2002. As a result, we may need additional funds to finance our operations in the future as well as to enhance our products and services, fund our expansion, respond to competitive pressures or acquire complementary businesses or technologies. In addition, poor financial results, additional expenses or unanticipated opportunities that require capital commitments could give rise to additional financing requirements sooner than we expect. We may be unable to obtain financing on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to finance our operations, enhance our services, fund our expansion, respond to competitive pressures or take advantage of business opportunities and we may need to significantly restrict our operations.

We have a history of losses and may have continued losses in the future.

      We incurred a net loss of approximately $19.6 million in the year ended December 31, 2001. As of December 31, 2001, our accumulated deficit was $211.9 million. Although we anticipate that we will achieve profitability on a quarterly basis by the end of 2002, we have not yet achieved profitability and may not do so during 2002. Even if we do achieve profitability, we may be unable to sustain or increase profitability on a quarterly or annual basis.

We face risks encountered by early-stage companies in emerging markets and may be unsuccessful in addressing these risks.

      We face risks frequently encountered by early-stage companies in new and rapidly evolving markets. Specific risks we face relate to the demand for and market acceptance of our e-Learning solutions. We may fail to adequately address these risks, and therefore our business may suffer. To address these risks, we must:

	•	effectively market our e-Learning solutions to new and existing customers;
	•	continue to enhance the technology upon which our e-Learning solutions are based;
	•	successfully implement our e-Learning solutions for our customers and generate continuing revenues from those customers; and
	•	address and establish new technologies and technology standards.

The e-Learning market is in the early stages of development and may not grow to a sufficient size or at a sufficient rate to sustain our business.

      The e-Learning market is in the early stages of development, and may not grow to a sufficient size or at a sufficient rate for our business to succeed. Corporate training and education historically have been conducted primarily through classroom instruction and traditionally have been performed by internal personnel. Although technology-based training applications have been available for several years, they

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      Many companies that have already invested substantial resources in traditional training methods may be reluctant to adopt a new strategy that may limit or compete with their existing investments. Even if companies implement technology-based training or e-Learning solutions, they may still choose to design, develop, deliver or manage all or a part of their education and training internally. If e-Learning does not become widespread, or if companies do not use the products and services of third parties to develop, deliver or manage their training needs, then our e-Learning solutions may not be commercially successful.

A deterioration of general economic conditions may materially and adversely affect our business.

      Our revenues are subject to fluctuation as a result of general economic conditions. A significant portion of our revenue is derived from the sale of products and services to large companies or government agencies, which historically have reduced their expenditures for education and training during economic downturns. In recent months, our sales force has experienced increased delays, cancellations or reductions in scope of sales opportunities as a result of the downturn in the economy. Additional incidents of terrorism could cause the economy to weaken further. Should the economy weaken further in any future period, these organizations may further delay, cancel, or reduce their expenditures on education and training, which could adversely affect our business.

We face intense competition from other e-Learning providers and may be unable to compete successfully.

      The e-Learning market is highly fragmented and competitive, with no single firm accounting for a dominant market share. Our competitors vary in size, scope and the breadth of products and services offered. We face competition from:

	•	other developers of learning management systems, such as Saba and Docent, as well as publishers of e-Learning courses that sell management systems with their titles such as SmartForce;
	•	large professional consulting firms and in-house training departments;
	•	many small, regional e-Learning and technology-based training services businesses; and
	•	developers of web authoring tools.

      Certain of our existing and potential competitors have longer operating histories and significantly greater financial, technical, marketing and other resources and therefore may be able to respond more quickly to new or changing opportunities, technologies, standards and customer requirements or to compete more aggressively on pricing. Price competition would likely result in reduced gross margins and may prevent the Aspen platform from yielding results sufficient for our business to succeed.

      Strategic relationships are important in expanding the distribution reach of companies in the e-Learning market. If our competitors were to establish strategic relationships to bundle their products with the products and services of their strategic partners, the demand for our products and services might be substantially reduced and our ability to market and sell products and services successfully may be substantially diminished. In addition, the existence or announcement of strategic relationships involving our competitors could adversely affect our ability to attract and retain customers.

      Because of the lack of significant barriers to entry in the e-Learning market, new competitors are likely to enter this market in the future. In particular, vendors of other enterprise software applications such as enterprise resource planning, human resource management or customer relationship management have indicated an intent to add e-Learning functionality to extend their current product lines within their existing customer base. If such vendors were to announce plans to add such functionality, our ability to sell to our products and service to their customers could be substantially diminished and our business could be

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Our Aspen platform is a new product and may contain defects or otherwise perform improperly.

      Our Aspen platform was initially released in September 2001, and we anticipate continuing to add new features, functionality and components. Complex enterprise software products frequently contain errors or failures, especially when first introduced or when new versions are released. In the past, we have discovered errors in our products after their initial release. Because the Aspen platform products are complex software packages with new features and functionality being added and new versions being released on a regular basis, there is a greater likelihood that they may contain such errors. In addition, since the Aspen platform is targeted at enterprise customers with large numbers of users, customers and potential customers may have a greater sensitivity to product defects or product integration than the market for software products generally. To date we have experienced minor errors in the Aspen platform that are typical of a newly released software product. Although these errors have not had a material impact on our business, serious product defects could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation, or increased service and warranty costs.

If we are unable to build the Click2learn and Aspen brands, we may be unable to grow our business.

      We believe that establishing and maintaining the Click2learn and Aspen brands will be critical to the success of our e-Learning strategy and that the importance of brand recognition will increase due to the growing number of enterprise learning software products. We intend to increase our marketing and branding expenditures in our effort to increase our brand awareness. If our brand building strategy is unsuccessful, these expenses may never be recovered, and our business could be materially harmed.

Acquisitions or investments may drain capital and equity resources, divert management’s attention or otherwise harm our business.

      In the future we may acquire or make investments in other businesses, products or technologies. Such acquisitions or investments may require that we pay significant cash, issue stock or incur substantial debt. In addition, such acquisitions or investments may require significant managerial attention, which may be diverted from our other operations. These capital, equity and managerial commitments may impair the operation of our business. Furthermore, acquired businesses may not be effectively integrated, may be unable to maintain key pre-acquisition business relationships, may contribute to increased fixed costs and may expose us to unanticipated liabilities.

International expansion may impose substantial burdens on our resources, divert management’s attention or otherwise harm our business.

      Our current and planned expansion into international markets will require extensive management attention and resources. In addition, we will need to rely extensively on third parties in foreign countries to help conduct our international operations and conduct sales and marketing efforts. Our success in international markets consequently will depend to a large degree on the success of these third parties, over which we have little control. If they are unwilling or unable to dedicate sufficient resources to our relationships, our international operations will suffer. Furthermore, our efforts abroad are subject to a number of additional risks inherent in international operations, including:

	•	difficulties and costs of staffing and managing foreign offices;
	•	different learning styles and cultures;
	•	numerous and potentially conflicting regulatory requirements;
	•	export controls, import tariffs and other barriers to trade;

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	•	reduced protection of intellectual property rights;
	•	regional political and economic instability; and
	•	fluctuations in currency exchange rates.

The loss of the services of our senior executives and key personnel would likely cause our business to suffer.

      Our success depends to a significant degree on the performance of the senior management team and other key employees. The loss of any of these individuals could harm our business. We do not have employment agreements with several of our executives or with any other key employees, and we do not maintain key person life insurance for any officers or key employees.

      Our success also depends on our ability to attract, integrate, motivate and retain additional highly skilled technical, sales and marketing and professional services personnel. Competition for qualified personnel in the e-Learning and enterprise software industries is intense. To the extent we are unable to attract and retain a sufficient number of additional skilled personnel our business will suffer.

We may not be able to adapt to rapidly changing technology and evolving industry standards.

      The e-Learning market is characterized by rapidly changing technologies, frequent new product and service introductions, short development cycles and evolving industry standards. The introduction of new products and services embodying new technologies and the emergence of new industry standards may render our products and services obsolete. Our success depends on our ability to adapt to a rapidly changing landscape and to offer new products and services to address our customers’ changing demands. We may experience difficulties that delay or prevent the successful design, development, introduction or marketing of our products and services. To the extent we in fact experience such delays, we may experience difficulty in attracting new customers and may lose existing ones.

Our intellectual property may become subject to legal challenges, unauthorized use or infringement, any of which could diminish the value of our products and services.

      Our success depends in large part on our proprietary technology. We rely on a combination of copyrights, trademarks, trade secret laws, restrictions on disclosure and other methods to protect our proprietary technology. While we have patent applications pending, we do not have issued patents for any of the technology underlying our Aspen platform. If we fail to successfully enforce our intellectual property rights, the value of these rights, and consequently the value of our products and services to our customers, could diminish substantially. It may be possible for third parties to copy or otherwise obtain and use our intellectual property or trade secrets without our authorization, and it may be possible for third parties to independently develop substantially equivalent intellectual property.

      Litigation may be necessary in the future to enforce our intellectual property rights, to protect trade secrets or to determine the validity and scope of the proprietary rights of others. From time to time we have received, and may in the future receive, notice of claims of infringement of other parties’ proprietary rights. Such claims could result in costly litigation and could divert management and technical resources. They could also delay product shipment or require us to develop non-infringing technology or enter into royalty or licensing agreements, which agreements may not be available on reasonable terms, or at all.

Our products include third-party technology, the loss of which could materially harm our business.

      We use some licensed third-party technology components in our products. Future licenses to this technology may not be available to us on commercially reasonable terms, or at all. The loss of or inability to obtain or maintain any of these technology licenses could result in delays in the introduction of new products or could force us to discontinue offering portions of our e-Learning solutions until equivalent technology, if available, is identified, licensed and integrated. Furthermore, we may become subjected to

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We face the risk of liability for failures to meet unique customer requirements, and the risk of cost overruns on fixed-price projects.

      The failure or inability to meet a customer’s unique expectations or requirements in the performance of services could impair our reputation or result in a claim for damages, regardless of our responsibility for the failure. Although generally we attempt to limit contractually our liability for damages arising from product defects and other mistakes in rendering professional services, these contractual protections are not always obtained and may not be enforced or otherwise may not protect us from liability. Our insurance may not be sufficient to cover any of these claims.

      In addition, many of our professional services projects are performed on a fixed-price basis rather than on a time and materials basis. If we do not accurately predict the costs of these projects, we could incur unexpected costs. If we do not complete fixed-price engagements within budget, on time and to clients’ satisfaction, we bear the risk of cost overruns.

An increase in the traffic may strain our hosted e-Learning systems, and our hosted e-Learning systems are vulnerable to other technical malfunctions.

      The systems that support our hosted e-Learning network may be unable to accommodate an increased volume of traffic. Internet sites and service providers have been subject to denial of service attacks, in which unauthorized persons intentionally overload systems with a heavy volume of traffic. Consequently, our hosted e-Learning systems may experience slower response times or other problems. In addition, we depend on Internet service providers and telecommunications companies and the efficient operation of their computer networks and other computer equipment for the operation and delivery of our hosted e-Learning solutions. Each of these has experienced significant outages in the past and could experience outages, delays and other difficulties due to system failures unrelated to our systems. Any delays in response time or performance problems could cause users to perceive our systems as not functioning properly and therefore not use our hosted e-Learning solutions for their training needs.

Security and privacy breaches could subject us to litigation and liability and deter consumers from using our hosted e-Learning solutions.

      Our hosted e-Learning solutions are often delivered over the Internet. The Internet is a public network and data is sent over this network from many sources. Although we take reasonable steps in accordance with current industry practices to ensure the security of our hosted solutions, computer viruses could be introduced into our systems or those of our customers, which could disrupt our hosted e-Learning solutions or make them inaccessible to users. In addition, well-publicized Internet security breaches could deter customers from using the Internet to conduct transactions that involve the transmission of confidential information. We cannot predict the extent to which transactions over the Internet will be, or will be perceived to be, secure against breaches by third parties. As a result, we cannot be certain the Internet ultimately will become widely accepted for the delivery of e-Learning solutions.

      We could become subject to litigation and liability if third parties penetrate security for our hosted e-Learning solutions or otherwise misappropriate our users’ confidential information. Advances in computer capabilities, new discoveries in the field of cryptography or other technological events or developments could result in compromises or breaches of our security systems. Anyone who circumvents our security measures could misappropriate proprietary information or cause interruptions in our services or operations. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by breaches. Furthermore, to the extent that our hosted e-Learning solutions may involve the storage and transmission of proprietary information, security breaches could expose us to a risk of loss or litigation and possible liability.

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Our debt covenants may significantly restrict our operations.

      We are subject to numerous covenants in our agreement with Silicon Valley Bank that impose financial and operating restrictions on our business. These restrictions may affect our ability to operate our business, may limit our ability to take advantage of potential business opportunities as they arise, and may adversely affect the conduct of our current business. These covenants place restrictions on our ability to, among other things:

	•	incur more debt;
	•	pay dividends, redeem or repurchase our stock or make other distributions;
	•	make acquisitions or investments;
	•	use assets as security in other transactions;
	•	enter into transactions with affiliates;
	•	merge or consolidate with others;
	•	dispose of assets or use asset sale proceeds;
	•	create liens on our assets; and
	•	extend credit.

      In addition, the terms of our indebtedness require that we meet certain financial ratios and tests. The covenants governing our existing indebtedness restrict our operations and those of our subsidiaries, and these limitations could impair our ability to meet such financial ratios and tests. In addition, our ability to meet these ratios and tests and to comply with other provisions governing our indebtedness may be affected by changes in economic or business conditions or other events beyond our control. Moreover, our failure to comply with our debt-related obligations could result in an event of default that, if not cured or waived, could result in an acceleration of our indebtedness.

      Market Rate Risk. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

      Interest Rate Risk. We hold our assets primarily in cash and cash equivalents, such as short-term marketable debt securities, money market funds and other cash equivalents. We minimize risk by investing in financial instruments with maturity of three months or less. As a result, if market interest rates were to increase immediately and uniformly by 10% from levels at December 31, 2001, the fair value of cash and cash equivalents would not change by a material amount.

      Foreign Currency Exchange Risk. We have foreign currency risk as a result of foreign subsidiary activities. For the year ended December 31, 2001, international revenues from foreign subsidiaries accounted for approximately 5% of total revenues. All foreign subsidiaries use the local currency as their functional currency.

      Our exposure to foreign exchange rate fluctuations arises in part from intercompany accounts in which costs incurred in the United States are charged to the foreign subsidiaries. These intercompany accounts are typically denominated in the functional currency of the foreign subsidiary in order to centralize foreign exchange risk with the parent company in the United States. We are also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated in U.S. dollars in consolidation. As exchanges rates vary, these results, when translated, may vary from expectations and adversely impact overall expected profitability. The effect of foreign exchange rate fluctuations for the year ended December 31, 2001 was not material. Due to the substantial volatility of currency exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations on our future operating results.

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Index to Financial Statements, Supplementary Data, and Financial Statement Schedule

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Stockholders

We have audited the accompanying consolidated balance sheets of Click2learn, Inc. and subsidiaries as of December 31, 2000 and 2001, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Click2learn, Inc. and subsidiaries as of December 31, 2000 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.

KPMG LLP

January 30, 2002

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CLICK2LEARN, INC. AND SUBSIDIARIES

See accompanying notes to Consolidated Financial Statements

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CLICK2LEARN, INC. AND SUBSIDIARIES