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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

COMMISSION FILE NUMBER 0-28977
VARSITY GROUP INC.
(Exact name of registrant as specified in its charter)

1825 I Street, N.W., Suite 400
WASHINGTON, D.C. 20006
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (202) 667-3400

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

COMMON STOCK, $.0001 PAR VALUE

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. [ _]

The aggregate market value of common stock held by non-affiliates of the registrant was $1,944,266 based on the last reported sale price of $0.25 on The Nasdaq National Market on March 5, 2001.

As of March 5, 2001, there were 16,202,218 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant intends to file a definitive Proxy Statement for its Annual Meeting of Stockholders pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2000. Portions of such proxy statement are incorporated by reference into Part III of this report.

Forward-Looking Statements

This Annual Report on Form 10-K (“Form 10-K”) contains certain forward-looking statements within the meaning of Section 27A of the Securities and Exchange Act of 1934, which statements can be identified by the use of forward looking terminology, such as “may”, “will”, “expect”, “anticipate”, “estimate”, or “continue” or the negative thereof or other variations thereon or comparable terminology. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth elsewhere in this Form 10-K. See the “Risk Factors” section of Item 1 “Business” for cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from results referred to in forward-looking statements.

PART I

ITEM 1.     BUSINESS

GENERAL

We are a leading online retailer of new textbooks and a provider of marketing services for businesses interested in reaching the college and private middle and high school markets. Our solution is comprised of two primary components, our retail book business and marketing services businesses.

Using our Web site, www.varsitybooks.com, we provide our customers with an opportunity to purchase textbooks online. Through eduPartners, our program serving schools directly, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience and value to their students by outsourcing to us the sale of new textbooks and other learning materials.

In addition, we provide marketing services for other businesses seeking to reach the college and private middle and high school demographics. We reach and market to students online through our Web site and on college campuses through our nationwide network of student marketing representatives.

Throughout 2000, our business priorities, focus and resources have adapted to meet the changing market dynamics and economic realities. We have successfully lowered overall expenses and increased the margins of our retail book business to accelerate our path to profitability. In addition, we made significant reductions in the marketing and sales overhead expenses associated with our business, scaled back our network of student representatives, reduced consumer advertising and marketing expenditures targeting the national college market and refocused resources on the continued growth of eduPartners. As a result of these actions, and the considerably lower costs associated with marketing and executing eduPartners, we expect to achieve profitability from operations in the second half of 2001.

Our overall success and ability to achieve profitability from operations will depend upon our ability to attract additional schools to eduPartners, provide a compelling and satisfying shopping experience to our retail customers, manage and enhance our online and offline capabilities to successfully serve our marketing services clients and maintain our cost structure. Finally, we must continue to attract and retain experienced personnel to effectively grow our business.

RETAIL

Market Overview

The college student market is large and growing. The U.S. Census Bureau reports that there are 15.5 million undergraduate and graduate students at more than 4,000 colleges and universities in the United States. According to the National Center for Educational Statistics, college enrollment will increase to approximately 16 million students by 2008.

College students are actively using the Internet and are increasingly purchasing goods and services online. According to Student Monitor, during the spring 2000 semester, 97% of college students used the Internet. Approximately 70% of these students accessed the Internet one or more times daily, up from 57% in spring 1999. During a one-year period ending in the spring of 2000, approximately 37% of these students made online purchases, up from 26% last year.

Students are powerful retail consumers. Although the college market is large and diverse, students still have common needs. For instance, students typically must buy expensive school related goods and services such as textbooks and school supplies. In fact, textbooks are most students’ single largest school related expenditure after tuition, room and board. The Almanac 2000-2001 reports that the average per student expense for books and supplies is $625 to $700, and does not vary significantly between two

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and four year colleges, or private and public institutions. According to Student Monitor, during a one-year period ending Spring 2000, students purchased more than $59 million in textbooks online, with an average student purchase of $228. In addition, the number of students purchasing textbooks online has increased to 13%, up from 8% over the prior year. Overall, new textbook sales were approximately $4.3 billion in the academic year 1998-1999, based on statistics published by the National Association of College Stores.

The private school market represents approximately 11% of all students and 25% of all schools, according to the National Center of Education Statistics (NCES). More than 6 million students are enrolled in private schools, with approximately 1.3 million students in high school, grades 9-12, and 2.5 million students in middle and high school combined, grades 5-12.

Purchasing new textbooks through traditional retailers tends to be expensive and inconvenient. The new textbook market is presently dominated by on-campus bookstores, with most schools either operating their own bookstore or contracting these services to a third party. Most campus bookstores face little competition, have significant overhead, and are crowded at the beginning of each semester, forcing students to endure high prices, long lines, and frequent out-of-stock inventory problems.

Online commerce provides the opportunity to better serve and more efficiently reach the college and private middle and high school student markets. We believe that, for a variety of reasons, few businesses have succeeded in offering students a unified marketplace to meet their varied needs in a convenient and cost-effective manner.

Strategy

Build an Opportunistic, Profitable Retail Book Business.

We continue to take the steps necessary to create an online book business that can achieve profitability from operations. We have successfully lowered the expenses and increased the margins of our retail book business through various means, including the imposition of increased retail pricing. As part of the increased emphasis on eduPartners, we anticipate that costs and expenses related to brand development, marketing and other activities associated with our traditional retail book business will continue to decrease from past levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than if we continued to spend at or above our current levels, we believe, in the aggregate, that this will reduce the losses and negative cash flows from sales of new textbooks.

Increase the Number of eduPartners.

We intend to invest in the development of eduPartners and expand our reach into the traditional two and four year colleges, private middle and high schools, distance learning and other continuing education programs.

The Varsity Solution

We provide students with a reliable, convenient alternative to the traditional campus textbook shopping experience. We are able to reduce the overhead associated with textbook sales because we do not maintain individual stores and we outsource our ordering, inventory, warehousing and fulfillment needs with Baker & Taylor, a leading distributor of books, videos and music products. In addition to providing new textbooks at competitive prices, we are committed to providing top quality customer service.

eduPartners

Through eduPartners, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience to their students by outsourcing new textbook sales to us. We believe that for many schools, including traditional two and four year colleges, private middle and high schools, distance learning programs, and other continuing education programs the expense and inconvenience of maintaining a bookstore exceed the schools’ financial return. We provide an innovative solution for schools and enable them to offer increased convenience and value to students, their parents, and the entire school community. Through these relationships, we are endorsed as the exclusive new textbook retailer at our eduPartners schools and gain direct access and exposure to their students. As a result, eduPartners is an attractive way for us to acquire customers.

As of March 25, 2001 we were the exclusive new textbook supplier for about 60 educational institutions. At these institutions, which include smaller, traditional two and four year colleges, private middle and high schools, distance learning and other continuing education programs, we are endorsed as the exclusive new textbook retailer and gain direct access and exposure to their students. In addition, through eduPartners, we reach students early, enabling us to extend our brand and establish a customer relationship with students prior to their attending college. Our exclusive relationships generally are for a period of two

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years and automatically renew on a year-to-year basis. As of March 25, 2001 approximately 12 agreements were within 90 days of expiration based upon their original term. These will automatically renew for one year if neither we nor the partner institution serves notice of intent to terminate as per the terms of the agreement.

With eduPartners, we create a personalized virtual bookstore for each school on our Web site. When students click on their school, they link directly to a co-branded bookstore at our Web site. The student or parent proceeds through the school bookstore, clicking on the appropriate grade, discipline and class to select required and optional books. The school benefits from the decreased costs, inconveniences and inefficiencies inherent in the seasonal business of purchasing, inventory management and selling learning materials directly to students on campus. In addition, schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features.

User Experience

Our Web site, www.varsitybooks.com, offers several benefits to students including convenience, ease of use and depth of product selection. When logging on to our Web site, visitors are presented with several shopping options, including:

	•		Searching by School. Students at eduPartners schools can use our customized map to locate their school. Once they find their school they can link through a list of departments to a list of classes and to the specific booklists for the courses they are taking. Our customers have the option of placing all the textbooks for a particular class in their shopping cart with a single click or selecting only those titles that interest them.
	•		Searching for Books. If we have not posted a specific school’s booklist, our customers can search for the books they need by author, title, keyword, publisher or ISBN number. Our Web site offers additional book verification for many selections, including pictures of jacket art, editor’s name, volume number, table of contents and other identifying characteristics.

Ordering and Delivery

When our customers are ready to place an order, they can proceed through our shopping cart function directly to our checkout page. We presently accept American Express, Discover, MasterCard and Visa as payment for our products. At our eduPartners schools, we also offer school and student credit accounts. During the ordering process, we ask our customers for basic information about themselves, which we maintain in our customer database. Once a customer places an order, he or she immediately receives an e-mail that includes a unique order number and confirms that the order has been received and processed. Presently, we do not accept orders for out-of-stock items, however through our BookPager option, students can request that we notify them by e-mail for up to 28 days if a desired book becomes available. After an order is shipped, the customer receives a second e-mail that includes a UPS tracking number and a link to a page on our Web site where they can follow their order through the delivery process. We use a variety of UPS services to ensure our customers will receive their orders timely.

Customer Service

We are committed to delivering superior customer service. Our customers can access our customer service representatives at any time during their visits to our Web site. The customer service page of our Web site offers answers to frequently asked questions and enables our customers to ask their own questions through e-mail. We also have a toll-free customer service telephone number. We increase our customer service staffing during our peak periods to ensure a fast response to customer queries.

Fulfillment

We fulfill all of our textbook orders through Baker & Taylor, a leading distributor of books, videos and music products with whom we have a series of written agreements, each of which are scheduled to expire on October 1, 2002 with automatic renewal for one year unless either party elects in writing not to renew. The agreements are terminable upon up to 30 days’ notice by either party in the event of a default. Under these agreements with Baker & Taylor, we agree to provide Baker & Taylor with our written demand forecasts for each upcoming semester and we agree to use Baker & Taylor as our principal supplier of textbooks and drop-ship and fulfillment services. We pay fees and expenses related to the services Baker & Taylor provides and we purchase products from Baker & Taylor at a discount to the suggested price. In return, Baker & Taylor agrees not to provide drop-ship services to any online textbook retailer serving students at colleges and universities or distance learning programs located in the United States that require students to purchase textbooks, unless the retailer was an existing customer of Baker & Taylor on or prior to June 10, 1998, the date we initially contracted with Baker & Taylor. Our agreements with Baker & Taylor provide us access to, and use of, an electronic set of data elements from Baker & Taylor’s title file database that contains bibliographic records. In addition, under these agreements, Baker & Taylor provides us with promotional, customer service, and database management services.

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As a result of the data access our agreements provide, information on availability of book titles is automatically updated on our Web site on an hourly basis from 8:00 a.m. to 10:00 p.m. eastern standard time based on a direct feed from Baker & Taylor, ensuring our customers receive accurate in-stock inventory information. Orders placed on our Web site are automatically transmitted to Baker & Taylor within twenty minutes of their receipt. At the Baker & Taylor warehouse currently used for fulfillment, the order is processed, packaged in a VarsityBooks.com branded box and shipped directly to our customers via UPS. We extend a convenient return policy to our customers under which returns are shipped directly to Baker & Taylor to expedite processing. Finally, providing Baker & Taylor with our demand forecasts for each semester helps to ensure they maintain an adequate and relevant inventory to meet the demands of our customers.

Technology

We use an array of site management, search, customer interaction, transaction-processing and fulfillment services and systems using a combination of proprietary technologies and commercially available, licensed technologies. Our strategy is to license commercially available technology whenever possible rather than seek internally developed solutions.

Our technology environment is designed to provide:

	•		a satisfying customer experience;
	•		consistent system availability and good performance;
	•		high security for all transactions, particularly, our customers’ commerce transactions;
	•		scalability for continued growth; and
	•		the collection, maintenance and security of valuable information.

We currently use a Microsoft Windows NT operating system platform and multiple Compaq application servers that house our Web server and search engine applications. These servers are able to handle applications including accepting and validating customer orders, handling multiple shipment methods and accepting, authorizing and charging customer credit cards. In addition, our system maintains ongoing automated e-mail communications with customers throughout the ordering process. These systems entirely automate many routine communications, facilitate management of customer e-mail inquiries and allow customers to, on a self-service basis, check order status and order history, change their personal information and check subscriptions to personal notification services.

We manage user requests and other traffic-using load balancing devices that work across the entire complement of our hardware. This strategy of balancing traffic allows all customers and site users to enjoy favorable response times and other performance measures, regardless of traffic fluctuations. Although we own and maintain our hardware and software systems, GlobalCenter Inc. located in Herndon, Virginia, hosts our two separate server environments and acts as our Internet service provider and we lease the space in which our hardware system resides from GlobalCenter Inc. A group of in-house systems administrators and network engineers and GlobalCenter Inc. personnel monitor and operate our Web site, network operations and transaction-processing systems.

Our agreement with GlobalCenter Inc. currently provides for service to be provided on an annual basis, subject to renewal. We pay for the space in which our hardware system resides and our Internet access based on our usage, on a monthly basis. We may terminate this agreement on any annual renewal date without penalty.

We use the Microsoft suite of tools for our development environment, including Site Server Commerce, InterDev and SQL SVR for the database engine. Additionally, we have separate database servers that capture and retain transaction “logs” of all activity that occurs on the site. These log databases can, among other things, trace a transaction from its inception to its completion. Our separate recording database generates and delivers reports and interfaces for our marketing, operations and financial systems.

We employ SSL data encryption technology to protect credit card data while it is passed from the customer through the site during a purchase transaction. This prevents outside parties from intercepting the customer’s credit card data during transaction processing.

Competition

E-commerce, in general, and online textbooks, more specifically, are highly competitive markets. The number of e-commerce Web sites competing for customers’ attention has increased rapidly, and the market for online textbook sales is relatively new, intensely competitive and rapidly changing. We currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:

	•		traditional new textbook retailers, such as campus bookstores;
	•		traditional used college textbook retailers, some of which have or are expected to begin online selling;

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	•		Internet-based textbook retailers such as ecampus.com (affiliated with Wallace’s Bookstores, Inc.) and efollett.com (affiliated with The Follett Corporation); and
	•		Internet-based general booksellers such as Amazon.com and barnesandnoble.com.

We believe that the principal competitive factors in attracting and retaining retail customers are:

	•		entering relationships with educational institutions;
	•		convenience;
	•		competitive pricing;
	•		selection of available products;
	•		customer service;
	•		quality of content and navigability tools;
	•		brand recognition; and
	•		reliability and speed of fulfillment.

MARKETING SERVICES

Market Overview

College students are powerful retail consumers and are an important demographic to many companies across the business spectrum. In 1998, college students spent over $105 billion on goods and services, excluding tuition, room and board, according to Student Monitor. Also, students are geographically dispersed and frequently change their addresses, making them difficult to target with traditional direct marketing. While national and regional media campaigns build brand recognition, they are not necessarily a cost-effective method of targeting students. Although students do watch television and read newspapers and magazines, we believe they tend to be more influenced by the opinions and actions of their peers than by traditional media advertising.

As a result, we believe there is a significant market opportunity for a company that aggregates students to market to them the products and services of other businesses. We also believe that our online presence is complemented effectively by an on-campus presence where we can market to college students on a peer-to-peer basis.

Strategy

Expand Marketing Services for Other Companies.

We intend to continue to build opportunistically our business of marketing on behalf of other companies seeking to reach the college and private middle and high school demographics.

Leverage Our Network of Student Representatives.

We believe that our network of student representatives is a significant competitive advantage. However our focus is on maintaining a cost effective and scalable network. During the fourth quarter of 2000, we scaled back our network of student representatives and currently serve the markets and campuses most frequently targeted by our marketing services clients.

The Varsity Solution

Through our online and offline assets, we are able to market on behalf of other companies to the elusive college and private middle and high school demographics. We use the combination of our Web site, email, and other online tools to reach students where they spend much of their time —on the Internet. In addition, through our carefully selected, trained network of student representatives, we are able to market for other companies that are trying to reach college students. We believe that our campus presence and peer-to-peer marketing approach enables us to reach college students for other businesses more effectively than traditional marketing campaigns alone.

In 2000, for example, we executed marketing campaigns for companies such as AT&T Wireless, Inc., Papa John’s, Inc, Polariod, Inc., Palm, Inc. and Ben & Jerry’s Homemade, Inc. These campaigns were developed to meet the goals of each client. Marketing activities included traditional flyering and postering, peer-to-peer marketing, on-campus events, product trial and demonstrations, and sponsorship opportunities.

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Online

We aggregate college and private middle and high school students on our VarsityBooks.com Web site through the eduPartners purchasing process. Online products and services that are available to meet the need of our marketing services clients include co-branded newsletters and emails to our database of approximately 300,000 customers, advertising banners and customized sponsorship opportunities.

Offline

As of February 12, 2001, we had a network of over 530 student representatives on the campuses of over 58 colleges and universities. Our marketing representatives, who are enrolled students at their respective schools, allow us to customize our marketing solutions for other businesses to each campus. Student representatives reach our business clients’ potential customers wherever students gather: in classrooms, student organizations, dormitories, fraternities and sororities. We believe that using our student representative network, in combination with our online tools, more effectively builds brand awareness than a traditional national or regional marketing campaign would alone.

Competition

Marketing services is a highly competitive industry. We also currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:

	•		mass-market and niche media companies;
	•		advertising agencies;
	•		college market-focused companies such as Student Advantage and Youthstream Media Networks; and
	•		general purpose consumer online services such as America Online and Microsoft Network, each of which provides access to student-related content and services.

We believe that the principal competitive factors in attracting and retaining marketing services clients are:

	•		creative and compelling campaigns;
	•		comprehensive online and on campus capabilities;
	•		extensive knowledge of the college demographic; and
	•		professional execution.

INTELLECTUAL PROPERTY

We regard our trademarks, service marks, trade dress, copyrights, trade secrets, proprietary technology and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality and license agreements with our employees, customers, independent contractors, sponsors and others to protect our proprietary rights. We have applied to register VarsityBooks.com as a service mark with the United States Patent and Trademark Office. The Trademark Office approved this application for publication on January 6, 2000. If no oppositions are filed against our application, it will be “allowed” and we will file evidence of use and be issued a registration.

We may be required to obtain licenses from others to refine, develop, market and deliver new products and services. There can be no assurance that we will be able to obtain any such license on commercially reasonable terms or at all, or that rights granted pursuant to any licenses will be valid and enforceable.

Domain names are the user’s Internet “address.” Domain names have been the subject of significant trademark litigation in the United States. Domain names derive value from the individual’s ability to remember such names, therefore there can be no assurance that our domain name will not lose its value if, for example, users begin to rely on mechanisms other than domain names to access online resources.

GOVERNMENT REGULATION

Internet Regulation

There are an increasing number of laws and regulations pertaining to the Internet. In addition, a number of legislative and regulatory proposals are under consideration by federal, state, local and foreign governments and agencies. Laws or regulations may be adopted relating to issues such as to liability for information retrieved from or transmitted over the Internet, online

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content regulation, user privacy, taxation and quality of products and services. Moreover, it may take years to determine whether and how existing laws such as those governing intellectual property ownership and infringement, privacy, libel, copyright, trade mark, trade secret, obscenity, personal privacy, taxation and the regulation of the sale of other specified goods and services apply to the Internet. The requirement that we comply with any new legislation or regulation, or any unanticipated application or interpretation of existing laws, may decrease the growth in the use of the Internet, which could in turn decrease the demand for our Internet-based services, increase our cost of doing business or otherwise materially harm our business.

Privacy Concerns

Federal, state and foreign governments have enacted or may enact laws or consider regulations regarding the collection and use of personal identifying information obtained from individuals when accessing Web sites, with particular emphasis on access by minors. Such regulations may include requirements that companies establish procedures to:

	•		give adequate notice to consumers regarding information collection and disclosure practices;
	•		provide consumers with the ability to have personal identifying information deleted from a company’s data;
	•		provide consumers with access to their personal information and with the ability to rectify inaccurate information;
	•		clearly identify affiliations or a lack thereof with third parties that may collect information or sponsor activities on a company’s Web site;
	•		obtain express parental consent prior to collecting and using personal identifying information obtained from children; and
	•		the Federal Children’s Online Privacy Act.

Such regulation may also include enforcement and redress provisions. While we have implemented programs designed to enhance the protection of the privacy of our users, including children, there can be no assurance that such programs will conform to applicable laws or regulations. Moreover, even in the absence of such regulations, the Federal Trade Commission has begun investigations into the privacy practices of companies that collect information on the Internet. One such investigation has resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the privacy safeguards described above. We may become subject to such an investigation, or the FTC’s regulatory and enforcement efforts may adversely affect the ability to collect demographic and personal information from users, which could have an adverse effect on the our ability to provide highly targeted opportunities for advertisers and e-commerce marketers. Any such developments could harm our business.

It is also possible that “cookies” may become subject to laws limiting or prohibiting their use. The term “cookies” refers to information keyed to a specific server, file pathway or directory location that is stored on a user’s hard drive, possibly without the user’s knowledge, and which is used to track demographic information and to target advertising. Some of the currently available Internet browsers allow users to modify their browser settings to remove cookies or prevent cookies from being stored on their hard drives. In addition, a number of Internet commentators, advocates and governmental bodies in the United States and other countries have urged the passage of laws limiting or abolishing the use of cookies. Limitations on or elimination of the use of cookies could limit the effectiveness of our targeting of advertisements, which could harm our ability to generate advertising revenue.

We currently obtain and retain personal information about our Web site users with their consent. We have a stringent privacy policy covering this information. However, if third persons were able to penetrate our network security and gain access to, or otherwise misappropriate, our users’ personal information, we could be subject to liability. Such liability could include claims for misuses of personal information, such as for unauthorized marketing purposes or unauthorized use of credit cards. These claims could result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant financial resources.

Data Protection

Legislation pending in Congress, if passed, would afford broader rights to owners of databases of information, such as stock quotes and sports scores. Such protection already exists in the European Union. If enacted, this legislation could result in an increase in the price of services that provide data to Web sites. In addition, such legislation could create potential liability for unauthorized use of such data.

Internet Taxation

A number of legislative proposals have been made at the federal, state and local level, and by foreign governments, that would impose additional taxes on the sale of goods and services over the Internet and some states have taken measures to tax Internet-related activities. Although Congress recently placed a three-year moratorium, due to expire in October 2001, on state and local taxes on Internet access or on discriminatory taxes on e-commerce, existing state or local laws were expressly excepted from this moratorium. Further, once this moratorium is lifted, some type of federal or state taxes may be imposed upon Internet commerce.

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Such legislation or other attempts at regulating commerce over the Internet may substantially impair the growth of commerce on the Internet and, as a result, adversely affect our opportunity to derive financial benefit from such activities.

Jurisdiction

Due to the global reach of the Internet, it is possible that, although our transmissions over the Internet originate primarily in the Commonwealth of Virginia, the governments of other states and foreign countries might attempt to regulate Internet activity and our transmissions or take action against us for violations of their laws.

RISK FACTORS

We Have a Limited Operating History Upon Which to Evaluate an Investment in Our Company.

We were founded in December 1997 and began selling textbooks on our Web site in August 1998. Due to the seasonality of textbook sales, our peak selling periods are currently in July/August/September, when the new academic year begins and students purchase the majority of their textbooks. As a new company, we face risks and uncertainties relating to our ability to successfully implement our strategy. You must consider the risks and uncertainties that an early stage company like ours faces. If we are unsuccessful in addressing these risks and uncertainties or are unable to execute our strategy, our business would be harmed.

We Have Not Been Profitable, Have Generated Negative Cash Flows and We Expect Our Losses and Negative Cash Flows to Continue.

We have never been profitable. We base current and future expense levels on our operating plans and our estimates of future revenues. If our revenues do not materialize or grow at a slower rate than we anticipate, or if our spending levels exceed our expectations or cannot be adjusted to reflect slower revenue growth, we may not achieve profitability or positive cash flows. For the year ended December 31, 1998, we incurred a loss from operations of approximately $2.7 million and had negative cash flows from operations of approximately $1.2 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and had negative cash flows from operations of approximately $29.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.6 million and had negative cash flows from operations of approximately $27.5 million. As of December 31, 1999 and 2000 we had an accumulated deficit of approximately $34.2 million and $68.2 million, respectively.

We expect that operating losses and negative cash flows will continue until at least the second half of 2001. As part of the increased emphasis on eduPartners, we anticipate that costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our current levels, we believe, in the aggregate, that this will reduce the losses and negative cash flows from our sales of new textbooks. We intend to increase spending on the development of eduPartners and relationships with other businesses. We believe that we can capture additional revenues, on which we expect to recognize higher gross margins, by increasing the number of businesses for whom we provide marketing services. Our failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures until such time as we achieve operating profitability. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed our current expectations. Any required additional financing may be unavailable on terms favorable to us, or at all.

We May Not Be Able to Obtain Sufficient Funds to Grow Our Business and Any Additional Financing May Be on Terms Adverse to Your Interests.

We intend to continue to grow our business. We currently anticipate that our available funds will be sufficient to meet our anticipated needs for the next twelve months. We may continue to lose money and generate negative cash flows from operations for the foreseeable future. We may need to raise additional funds in the future to fund more aggressive marketing programs, to acquire or develop new technology, to increase our staff to meet operational demands, to introduce new products or services or to acquire complementary businesses or services or intellectual property rights. Any required additional financing may be unavailable on terms favorable to us or at all. If we raise additional funds by issuing equity securities, you may experience significant dilution of your ownership interest and such securities may have rights senior to those of the holders of our common stock. Obtaining additional financing will be subject to a number of factors, including:

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	•		market and economic conditions;
	•		our financial condition and operating performance; and
	•		investor sentiment.

These factors may make the timing, amount, terms and conditions of additional financing unattractive for us. Currently, companies that are considered primarily on-line retailers are not perceived well by the market. If additional financing is not available when required or is not available on acceptable terms, we may be unable to:

	•		fund our expansion;
	•		successfully promote our brand name;
	•		develop or enhance our products and services;
	•		develop or purchase new servers, software and other technology to enable us to process increased transactions and service increased traffic on our Web site;
	•		attract and retain the appropriate talent and a sufficient number of employees to handle our increasing operations; and
	•		take advantage of business opportunities or respond to competitive pressures.

Our Business and Revenue Model is Unproven.

Our ability to generate significant revenues and profits from the sale of textbooks and other products and services we may offer in the future is uncertain. To be successful, we must attract and retain a significant number of customers to our Web site at a reasonable cost. Any significant shortfall in the expected number of purchases occurring through our Web site will negatively affect our financial results by increasing or prolonging operating losses and negative cash flows. Conversion of customers from traditional shopping methods to electronic shopping may not occur as rapidly as we expect, if at all. Therefore, we may not achieve the customer traffic we believe is necessary to become successful. Specific factors that could prevent widespread customer acceptance of our business and our ability to increase retail revenues include:

	•		lack of consumer awareness of our online presence;
	•		pricing that does not meet consumer expectations;
	•		consumer concerns about the security of online transactions;
	•		shipping charges, which do not apply to shopping at traditional retail stores and are not always charged by some of our online competitors;
	•		delivery time associated with online orders, as compared to the immediate receipt of products at traditional retail stores;
	•		product damage from shipping or shipments of the wrong products, which may result in a failure to establish trust in purchasing our products online;
	•		delays in responses to consumer inquiries or in deliveries to consumers; and
	•		difficulty in returning or exchanging orders.

We may not be able to retain existing eduPartners member schools or sign-up new eduPartners member schools.

In addition, our ability to generate revenues through the sale of online advertising and the use of our network of student representatives by other businesses to market their goods and services will depend, in part, on our ability to reach students with demographic characteristics attractive to advertisers and other businesses.

We May Not Be Able to Attract Businesses Interested in Using Our Services to Market to College, Private High School Middle School, Distance Learning and Continuing Education Students.

Although we do not currently derive a substantial portion of our revenues from allowing other businesses to reach the college, private high school and middle school markets, our business model depends in part on increasing the amount of such revenue. We cannot be certain we will be able to attract businesses interested in using our marketing services. If we cannot attract these businesses, our business could be harmed.

You Should Not Rely on Our Quarterly Operating Results as an Indication Of Our Future Results Because They are Subject to Significant Fluctuations.

Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. We expect to experience seasonality in our business related to the academic calendar and the corresponding demand for textbooks and educational materials. Sales in the textbook industry traditionally are

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significantly higher in the first and third calendar quarters of each year compared with the second and fourth calendar quarters. Fluctuations in our quarterly operating results could cause our stock price to decline. You should not rely on sequential quarter-to-quarter comparisons of our results of operations as an indication of future performance. Factors that may affect our quarterly results include:

	•		seasonal trends in the textbook industry and in the buying habits of students;
	•		our ability to manage or influence inventory and fulfillment operations;
	•		the level of merchandise returns we experience;
	•		our ability to attract new customers, retain existing customers and maintain customer satisfaction;
	•		introduction of enhancements or a change in pricing policies, by us or our competitors, or a change in pricing policy by our sole fulfillment source;
	•		changes in the amount and timing of expenditures related to marketing, information technology and other operating expenses to support future growth;
	•		technical difficulties or system downtime affecting the Internet generally or the operation of our Web site specifically;
	•		increasing consumer acceptance and use of the Internet for the purchase of consumer products;
	•		potential acquisitions or strategic alliances either by us or our competitors; and
	•		general economic conditions and economic conditions specific to the Internet, online commerce and the book industry.

As a result of the seasonal fluctuations and because the online sale of textbooks and online selling in general is new and it is difficult to predict consumer demand, it is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. In that event, it is likely that the price of our stock would decline.

We Rely on One Supplier to Meet Our Fulfillment Demands.

We depend on Baker & Taylor, Inc. as our current sole supplier of the textbooks we offer. Our relationship with Baker & Taylor is critical to our success. If we were unable to rely on them for inventory maintenance and shipping services, our business would be materially harmed.

We do not warehouse any of our own inventory, so we rely on Baker & Taylor to maintain an adequate inventory and rapidly fill our customers’ orders. We are able to sell textbooks at reduced prices in part because we do not maintain our own inventory. Prices we pay for promotional, customer service and database management services and credits that we receive from Baker & Taylor are currently based on volume and average cost requirements. Failure to meet these benchmarks could increase our costs. If they do not maintain sufficient inventory, or if they are unable to deliver the specific books our customers order or deliver these books in a timely fashion, we would not be able to meet our obligations to our customers, our revenues would decrease and we would likely experience a reduction in the value of our brand. Baker & Taylor fills orders for a number of textbook retailers. Baker & Taylor has advised us that it fills all the orders it receives on a first-come, first-served basis without providing preferential treatment for us or any of our competitors. If other Baker & Taylor customer orders depleted Baker & Taylor’s inventory, and Baker & Taylor was unable to quickly replenish its inventory, our orders would not be processed or filled in a timely manner. If our relationship with Baker & Taylor is disrupted or does not continue for any reason and we are unable to establish a comparable vendor relationship or open our own warehouse before the Baker & Taylor relationship discontinues, we would not be able to fulfill our customers’ orders. We cannot be certain that we would be able to establish new vendor relationships to ensure acquisition and distribution of textbooks in a timely and efficient manner or on acceptable commercial terms. In such event, we may determine that we need to maintain inventory, establish warehouse facilities and provide distribution services, which would require us to change our business model. In addition, a single publisher supplied approximately 22% of the books we purchased from Baker & Taylor in 2000. If Baker & Taylor’s relationship with this publisher is disrupted or discontinued, our business would be harmed.

We benefit from the shipping discounts offered to Baker & Taylor by United Parcel Service and we rely on UPS and other third party carriers for all shipments to and from Baker & Taylor. If Baker & Taylor’s relationship with UPS is discontinued or disrupted for any reason, we cannot be certain we would be able to affordably obtain comparable delivery services and might not be able to deliver textbooks to our customers in a timely manner. In addition, because we rely on third party carriers to ship products to and from the single Baker & Taylor warehouse that our fulfillment is currently conducted from, we are subject to the risks, including employee strikes and inclement weather, that may prevent such third parties from meeting our fulfillment and delivery needs. Failure to deliver products to our customers in a timely and accurate manner would harm our reputation, our brand and our business.

We May Be Required to Record Significant Expense Because of Targets Set Forth in Our Agreements With Third Parties.

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In April 1999, we entered into an agreement with Campus Pipeline under which a warrant to purchase 25,000 shares of our common stock with an exercise price of $6.00 per share was issued which would have been exercisable upon the achievement of contractual revenues of $30.0 million on or before December 31, 2000, with an additional warrant for 50,000 shares of our common stock with an exercise price of $6.00 per share which will be exercisable if contractual revenues equal or exceed $80.0 million on or before July 31, 2001. Campus Pipeline did not achieve the revenue targets required to exercise the December 31, 2000 warrants. Since the exercisability of the July 31, 2001 warrants is based on the achievement of uncertain future revenue targets, we have not recorded any expense for these warrants. If and when it becomes probable that our contractual revenues will reach the necessary level for these warrants we issued to Campus Pipeline to vest, we will begin to record an expense in the manner described above.

Failure to Cost-Effectively Develop Awareness of Our Brand Name Could Harm Our Future Success.

We believe that continuing to build awareness of the “VarsityBooks.com” and eduPartners brands is important to achieving widespread acceptance of our business. We believe brand recognition could become more important as competition in the online textbook market increases. If we fail to successfully promote and maintain our brand, incur significant expenses in promoting our brand or fail to generate a corresponding increase in revenue as a result of our branding efforts, our business could be harmed. To maintain and build our brand awareness, we must succeed in executing for existing eduPartners members by providing high-quality services and continue to refine our brand marketing efforts. Historically, these efforts have required significant expenses. We believe eduPartners provides an attractive model for customer acquisition that can be supported with marketing expenditures significantly below historical levels. However, we may not be able to aggressively scale our eduPartners program with reduced marketing expenditures and may find it necessary to increase expenditures relating to our marketing and sales efforts or otherwise increase our financial commitment to creating and maintaining brand awareness among potential customers.

We Face Significant Competition, and That Competition May Increase Substantially Because of the Low Barriers to Market Entry.

The e-commerce, online textbook and marketing services markets are new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new Web sites at a relatively low cost. We currently compete with a variety of other companies in the sale of textbooks, and if we are able to add other product or service offerings we will have additional competition in those markets. Our current and potential competition includes the following categories of companies:

	•		traditional new textbook retailers, such as campus bookstores;
	•		traditional used college textbook retailers, some of which have or are expected to begin online selling;
	•		Internet-based textbook retailers such as ecampus.com (affiliated with Wallace’s Bookstores, Inc.) and efollett.com (affiliated with The Follett Corporation);
	•		Internet-based general booksellers such as Amazon.com, barnesandnoble.com and Borders.com;
	•		college market focused companies such as Student Advantage and Youthstream; and
	•		general purpose consumer online services such as America Online and Microsoft Network, each of which provides access to college student-related content and services.

We are not able to reliably estimate the number of our direct competitors. Many of our current and potential competitors have longer general retail operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing, technological, operational and other resources than we do. Some of our competitors may be able to secure textbooks from vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing, shipping policies or inventory availability policies and devote substantially more resources to Web site and systems development than we can. As competition increases, we may experience reduced operating margins, loss of market share and a diminished brand franchise. To remain competitive, we may from time to time make pricing, service or marketing decisions or acquisitions that could affect our financial condition and results of operations. It is possible that our supply channel (distributors and, indirectly, publishers) may enter the market and match our pricing through direct retail centers or that either or both our supply channel and traditional college bookstores may enter the online commerce market as our competitors. It is also possible that companies that control access to transactions through network access or Web browsers could promote our competitors or charge us a substantial fee for inclusion. As Internet use becomes increasingly prevalent, it is possible that the full text of books we offer for sale will be available for viewing on the Web or on other electronic devices such as virtual textbooks. If virtual textbooks become a reality and students rely on them in lieu of purchasing hard copies of textbooks, our business may decline.

We Are Bound by a Legal Settlement That May Restrict Future Advertising.

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The National Association of College Stores, or N.A.C.S., a trade association whose members are largely college bookstores, filed a lawsuit against the Company on October 29, 1999, claiming that the Company had engaged in false and misleading advertising. On November 29, 1999, the Company filed a motion to dismiss the complaint, claiming that N.A.C.S failed to state a claim upon which any relief could be granted. On May 26, 2000 the United States District Court for the District of Columbia announced that it would grant the Company’s motion to dismiss as to the first of the two counts in the complaint and would defer its ruling on the second count to permit the parties to continue settlement negotiations. On August 7, 2000, the Company announced that it settled the lawsuit. This settlement agreement contains no admission of liability on the part of the Company. As part of the settlement, we are limited in advertising discounts on textbooks. Our inability to advertise discounts could harm our business.

Loss of Any of Our Key Management Personnel or the Inability of Our Key Management Personnel to Work Together Effectively or Successfully Manage Our Growth Could Negatively Affect Our Business.

Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder, Chief Executive Officer, President and Chairman of the Board. We have entered into an agreement with Mr. Kuhn that provides, among other things, that he be compensated in the event he is terminated without cause. We have not entered into similar agreements with any other personnel. Nonetheless, the loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team. In addition, a number of members of our management team have joined us within the last year. These individuals have not previously worked together and are becoming integrated into our management team. They may not be able to work together effectively or successfully manage our growth, resulting in adverse consequences to our business.

We Will Only Be Able to Execute the Online Retail Aspect of Our Business Model if Use Of the Internet and Online Commerce Grows.

Our business would be adversely affected if Internet usage does not continue to grow. Internet usage may be inhibited for any of the following reasons:

	•		the Internet infrastructure may be unable to support increased demand or its performance and reliability may decline as usage grows;
	•		the inability of Web sites to provide security and authentication of confidential information contained in transmissions over the Internet;
	•		the quality of Internet products and services may not continue to generate user interest;
	•		online commerce is at an early stage and buyers may be unwilling to shift their traditional purchasing to online purchasing;
	•		increased government regulation or taxation of online commerce, at the state or federal level, may adversely affect the viability of online commerce;
	•		insufficient availability of telecommunication services or changes in telecommunication services may result in slower response times; and
	•		Web sites may not have the ability to respond to privacy concerns of potential users, including concerns related to the placement by Web sites of information on a user’s hard drive without the user’s knowledge or consent.

If We Are Unable to Adapt as Internet Technologies and Customer Demands Continue to Evolve, Our Services and Products Could Become Less Desirable.

A key element of our strategy is to generate a high volume of traffic to, and use of, our Web site. Accordingly, the satisfactory performance, reliability and availability of our Web site, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and maintain adequate customer service levels. An unanticipated dramatic increase in the volume of traffic on our Web site or the number of orders placed by our customers may force us to expand and upgrade our technology, transaction-processing systems and network infrastructure. There can be no assurance that we will be able to accurately project the rate or timing of increases, if any, in the use of our Web site or timely expand and upgrade our systems and infrastructure to accommodate such increases. To be successful, we must adapt to our rapidly changing market by continually enhancing the technologies used in our Internet products and services and introducing new technology to address the changing needs of our business and customers. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing market conditions or business and customer requirements, our business could be harmed.

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As an Internet-Based Retailer, We Depend Heavily on Our Information Technology Infrastructure and Our Operations Could be Jeopardized by Any System Failure Or Inadequacy.

Our operations are dependent on our ability to maintain our computer and communications software and equipment in effective working order and to protect our systems against damage from fire, natural disaster, power loss, communications failure or similar events. In addition, the growth of our customer base may strain or exceed the capacity of our computer and communications systems and lead to degradations in performance or systems failure. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We use an internally developed system for our Web site, search engine and substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping.

Substantially all of our computer and communications hardware and software systems are located at a single facility in Herndon, Virginia. That facility is owned, maintained and serviced by GlobalCenter Inc. Although we own and maintain our hardware and software systems, including the software which is central to the sales, ordering and shipping processes, we rely on GlobalCenter Inc. to ensure our computer and communications hardware and software operate efficiently and continuously. We do not presently have fully redundant systems or a formal disaster recovery plan and do not carry sufficient business interruption insurance to compensate for losses that may occur. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins, fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. Any damage, failure or delay that causes interruptions in our system operations could have a material adverse effect on our business.

In addition to our offsite software and hardware related to our Web site, at our headquarters we maintain a local area network, or LAN, which we use for our financial reporting systems, customer service operations, monitoring of our customer orders, e-mails and other internal processes. Any loss of service or other failure of this LAN, regardless of the availability of our Web site, would significantly impair our ability to service our customers and monitor and fulfill customer orders, which could have a material adverse effect on our business.

The failure of either our Web site or our LAN or any other systems interruptions that results in unavailability of our Web site or reduced order fulfillment performance, especially during our peak sales period of July/August/September, could result in negative publicity or could reduce the volume of goods sold and attractiveness of our Web site and would seriously impair our ability to service our customers’ orders, all of which could negatively affect our revenues. Because our servers are located at a third-party’s facility and because some of the reasons for a systems interruption may be outside of our control, we also may not be able to exercise sufficient control to remedy the problem quickly or at all. Regardless of whether we or a third-party controls or creates system failure, the occurrence of system failure could adversely affect our reputation, seriously harm our business and cause us to lose a significant and disproportionate amount of revenues.

Concerns About Security on the Internet May Reduce the Use of Our Web Site and Impede Our Growth.

A significant barrier to confidential communications over the Internet has been the need for security. We rely on SSL encryption technology to prevent the misappropriation of customer credit card data during the transaction process. Under current credit card practices, a merchant is liable for fraudulent credit card transactions where, as is the case with the transactions we process, that merchant does not obtain a cardholder’s signature. A failure to adequately control fraudulent credit card transactions could reduce our collections and harm our business. Internet usage could decline if any well-publicized compromise of security occurred. Our site could be particularly affected by any such breach because our online commerce model requires the entry of confidential customer ordering, purchasing and delivery data over the Internet, and we maintain a database of this historical customer information. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential customers may inhibit the growth of the Internet as a medium for commerce. We cannot be certain that advances in computer capabilities, new discoveries in the field of cryptography or other developments will not result in the compromise or breach of the algorithms we use to protect content and transactions on our Web site or proprietary information in our databases. Anyone who is able to circumvent our security measures could misappropriate proprietary, confidential customer or company information or cause interruptions in our operations. We may incur significant costs to protect against the threat of such security breaches or to alleviate problems caused by these breaches.

We May Become Subject to Burdensome Government Regulations and Legal Uncertainties Affecting the Internet That Could Adversely Affect Our Business.

To date, governmental regulations have not materially restricted use of the Internet in our markets. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. Uncertainty and new regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. The growth of the Internet

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may also be significantly slowed. This could delay growth in demand for our online services and limit the growth of our revenues. In addition to new laws and regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues, which include:

	•		sales and other taxes;
	•		user privacy;
	•		pricing controls;
	•		characteristics and quality of products and services;
	•		consumer protection;
	•		libel and defamation;
	•		copyright, trademark and patent infringement; and
	•		other claims based on the nature and content of Internet materials.

We May Be Unable to Obtain a United States Trademark Registration for Our Brand or to Protect Our Other Proprietary Intellectual Property Rights.

Our application to register the mark VarsityBooks.com has been approved for publication by the Trademark Office. After the application is published, it will be open to opposition by third parties for a period of 30 days. If we are unable to secure the right to use the VarsityBooks.com mark and related derivative marks, a key element of our strategy of promoting “VarsityBooks.com” as our brand could be disrupted and, as a result, the value of your investment could be reduced. Even if we are able to secure federal trademark registration for the mark VarsityBooks.com, federal trademark laws only provide us with limited protection because, for example, we would be unable to prevent the use of an unregistered similar mark by a prior user or to prevent the use of a similar name in our markets or similar mark for products and services we would like to offer.

The unauthorized reproduction or other misappropriation of our proprietary technology could enable third parties to benefit from our technology and brand name without paying us for them. If this were to occur, our revenues and the value of your investment could be reduced. The steps we have taken to protect our proprietary rights may not be adequate to deter misappropriation of proprietary information. We may not be able to detect unauthorized use of our proprietary information or take appropriate steps to enforce our intellectual property rights. In addition, the validity, enforceability and scope of protection of intellectual property in Internet-related industries are uncertain and still evolving. The laws of other countries in which we may market our services in the future may afford little or no effective protection of our intellectual property. If we resort to legal proceedings to enforce our intellectual property rights, the proceedings could be burdensome and expensive.

Defending Against Intellectual Property Infringement Claims Could Be Time Consuming and Expensive and, if We are Not Successful, Could Subject Us to Significant Damages and Disrupt Our Business.

We cannot be certain that our products do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We expect that infringement claims in our markets will increase in number as more participants enter the market. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others in the ordinary course of our business. We may incur substantial expenses in defending against these third-party infringement claims, regardless of their merit. Successful infringement claims against us may result in substantial monetary liability or may materially disrupt the conduct of our business.

As Internet Technology and Regulation Advances, We May Not Be Able to Protect Our Domain Names.

We currently hold various Web domain names relating to our brand, including the “VarsityBooks.com” domain name. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the generic category of domain names (i.e., .com,    .net and .org) is now controlled by a non-profit corporation, which may create additional top-level domains. Requirements for holding domain names have also been affected. As a result, there can be no assurance that we will be able to acquire or maintain relevant domain names. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. Any such inability could harm our business.

Some States May Impose a New Sales Tax On Our Business.

A 1992 Supreme Court decision confirmed that the commerce clause of the United States Constitution prevents a state from requiring the collection of its sales and use tax by a mail-order company unless such company has a physical presence in the

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state. However there continues to be uncertainty due to inconsistent application of the Supreme Court decision by state and federal courts. We attempt to conduct our operations consistent with our interpretation of the applicable legal standard, but there can be no assurance that such compliance will not be challenged. In recent challenges, various states have sought to require companies to begin collection of sales and use taxes and/or pay taxes from previous sales. We currently collect and forward sales tax on all shipments to Illinois and the District of Columbia. As of the date of this form two additional states have contacted us regarding activity in their state. One of these states has determined the Company has no sales tax liability for the audit period. The other state has notified us of an assessment for sales tax liability for which we have submitted a petition for redetermination. The Supreme Court decision also established that Congress has the power to enact legislation that would permit states to require collection of sales and use taxes by mail-order companies. Congress has from time to time considered proposals for such legislation. We anticipate that any legislative change, if adopted, would be applied on a prospective basis. While there is no case law on the issue, we believe that this analysis could also apply to our online business. Recently, several states and local jurisdictions have expressed an interest in taxing e-commerce companies who do not have any contacts with their jurisdictions other than selling products online to customers in such jurisdictions. The Internet Tax Freedom Act imposed a moratorium on new taxes or levies on e-commerce for a three-year period due to expire in October 2001. However, there is a possibility that Congress may not renew this legislation. Any such taxes could have an adverse effect on online commerce, including our business.

Our Executive Officers, Directors and Existing Stockholders, Whose Interests May Differ from Other Stockholders, Have the Ability to Exercise Significant Control Over Us.

Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially own approximately 52.0% of our outstanding common stock. These stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors, the approval of significant corporate transactions and the power to prevent or cause a change of control. The interests of these stockholders may differ from the interests of our other stockholders.

There May Be No Active Trading Market In Our Common Stock.

As discussed below, effective with the open of business on March 21, 2001, our common stock was delisted from The Nasdaq National Market. Currently, our common stock is eligible to be traded on the OTC Bulletin Board and we believe that certain broker/dealers are making a market in our common stock. These broker/dealers are under no obligation to make a market and there can be no assurance that they will continue to make such a market or that they will not decide to discontinue making a market without notice to us or our stockholders. In any event, since we have been delisted from Nasdaq, we can not assure you that an active trading market for our common stock will develop, or if it develops, that it will continue. If an active trading market for our common stock does not develop or is not sustained, you may not be able to sell your common stock when you need to do so, or at a price acceptable to you, or even at all.

On March 20, 2001, The Nasdaq Stock Market notified us that effective with the open of business on March 21, 2001 our securities would be delisted from The Nasdaq Stock Market. On March 8, 2001 we appeared before a Nasdaq Listing Qualifications Panel (the “Panel”) to present our case for continued inclusion on The Nasdaq National Market pursuant to an exception to the bid price and market value of public float requirements, as set forth in Nasdaq Marketplace Rules 4450(a)(5) and 4450(a)(2). However, in a letter dated March 20, 2001 the Panel informed us of their decision to delist our securities from The Nasdaq National Market and that we did not satisfy all the requirements for continued listing on The Nasdaq SmallCap Market. Effective with the Panel decision, our securities immediately became eligible to trade on the OTC Bulletin Board.

The Trading Price For Our Common Stock Has Fallen Substantially And This Could Affect Our Ability To Raise Capital And Your Ability To Resell Your Shares At Or Above The Price You Paid To Purchase Such Shares.

The stock market in general and the trading prices of shares in public technology companies, particularly those such as ours that offer Internet-based products and services, have been extremely volatile and have experienced a substantial drop in market price. Indeed, the trading price of our common stock dropped significantly, thereby precipitating our delisting from Nasdaq. We believe that this drop has resulted from many factors, some of which are beyond our control, such as:

	•		investor perception of us and online retailing services in general;
	•		general economic conditions both in the United States and in foreign countries;
	•		our results in operations
	•		adverse business developments
	•		changes in financial estimates by securities analysts; and
	•		announcements by our competitors of new products and services.

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As a result of these factors, and due to the risks related to the absence of an active trading market for our common stock (which are described above) we cannot assure you that the trading price of our common stock will not continue to drop or stay at its currently low price. The significant decreases in the trading price of our common stock and the currently low trading price that we are experiencing is likely to affect our visibility and credibility in our market and will likely limit our ability to raise capital in the future. Additionally, as a result of our low stock trading price and our delisting for Nasdaq, you may not be able to resell your shares of common stock when you need to or at prices higher than what you paid to purchase such shares.

If Our Stock Price is Volatile, We May Become Subject to Securities Litigation Which is Expensive and Could Result in a Diversion of Resources.

Securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against the lawsuit and a diversion of management’s attention that could cause our business to be harmed.

Future Sales of Our Common Stock May Negatively Affect Our Stock Price.

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

It May Be Difficult for a Third Party to Acquire Our Company and this Could Depress Our Stock Price.

Delaware corporate law and our amended and restated certificate of incorporation and our by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of Varsity Group or a change of our management that stockholders may consider favorable or beneficial. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include those which:

	•		authorize the issuance of “blank check” preferred stock, which is preferred stock that can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of common stock;
	•		provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors;
	•		prohibit stockholder action by written consent; and
	•		establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting.

EMPLOYEES

As of February 12, 2001, we had approximately 20 employees and over 530 student representatives. We hire temporary employees, particularly at the beginning of each school semester, and contract service providers as necessary. None of our employees is represented by a labor union or is the subject of a collective bargaining agreement. We believe that relations with our employees are good.

ITEM 2.     PROPERTIES

Our headquarters are at 1825 I Street, N.W. in Washington D.C. The Company was previously headquartered at 2020 K Street, N.W. in Washington, D.C. At this previous site, we leased an aggregate of approximately 34,000 square feet pursuant to a lease that was scheduled to expire in February 2003. On March 8, 2001 we terminated the operating lease for this office space located at 2020 K Street, NW, Washington, DC. Under the terms of this settlement, we effectively agreed to pay all rents through March 2001 in addition to a buyout amount for the remaining lease term.

ITEM 3.     LEGAL PROCEEDINGS

On October 29, 1999, the Company was sued by the National Association of College Stores, or N.A.C.S., in the United States District Court for the District of Columbia. In their complaint, N.A.C.S. alleged that the Company uses false and misleading advertisements in its efforts to sell textbooks. Specifically, the complaint also alleged that the Company falsely advertises discounts of 40% on textbooks on its Web site and that there is no suggested retail price for textbooks from which to calculate discounts. N.A.C.S. claimed that, in making the alleged false and misleading statements, the Company was implying that

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N.A.C.S. member stores overcharge students for their textbooks. The complaint requested that the Company be prevented from claiming in any advertising or promotional material, packaging or the like, or representing in any way, that it offers discounts or percentages off of textbooks unless the Company clearly and prominently identifies the true basis for the claimed discount, the source of the comparative price it uses to determine the discounts it offers and the true percentage of textbooks offered at the stated discounted price. In addition, N.A.C.S. sought to have the Company retract all prior claims through prominent statements on its Web site. The complaint did not seek monetary damages, other than attorneys’ fees.

On August 7, 2000 the Company announced in a press release that it had reached a full and final settlement of its lawsuit with N.A.C.S. The settlement agreement contained no admission of liability on the part of the Company. N.A.C.S. filed its lawsuit on October 29, 1999, claiming that VarsityBooks.com had engaged in false and misleading advertising in its sale of college textbooks. On November 22, 1999, VarsityBooks.com filed a motion to dismiss the complaint, claiming that NACS failed to state a claim upon which any relief could be granted. On May 26, 2000, the District Court announced that it would grant VarsityBooks.com’s motion to dismiss as to the first of the two counts in NACS’ complaint and would defer its ruling on the second count to permit the parties to continue settlement negotiations. Those negotiations resulted in the settlement announced on August 7, 2000.

The Company is a party to various other legal proceedings and claims incidental to their business. Management does not believe that these matters will have a material adverse effect on the results of operations or financial condition of the Company.

ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

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

Our common stock has been traded on the Nasdaq National Market under the symbol VSTY since February 15, 2000. Prior to February 15, 2000, our common stock was not publicly traded. For the period from February 15, 2000 to December 31, 2000, the high and low closing prices per share of our Common stock as reported by the Nasdaq National Market were:

On February 1, 2001 , the closing price per share of our common stock was $0.25, as reported on The Nasdaq National Market and we had approximately 245 stockholders of record and approximately 3,800 beneficial holders of our common stock.

On March 8, 2001 we appeared before a Nasdaq Listing Qualifications Panel (the “Panel”) to present our case for continued inclusion on The Nasdaq National Market pursuant to an exception to the bid price and market value of public float requirements, as set forth in Nasdaq Marketplace Rules 4450(a)(5) and 4450(a)(2). However, in a letter dated March 20, 2001 the Panel informed us of their decision to delist our securities from The Nasdaq National Market, effective with the open of business on March 21, 2001. The letter also informed us we did not satisfy all the requirements for continued listing on The Nasdaq SmallCap Market. Effective with the Panel decision, our securities immediately became eligible to trade on the OTC Bulletin Board.

We have never declared or paid any cash dividends on our common stock and we anticipate that we may continue to retain any earnings for the foreseeable future for use in the operation of our business and that we may not pay any cash dividends in the foreseeable future.

Our Registration Statement on Form S-1 (File No. 333-89049) was declared effective by the SEC on February 15, 2000. A total of 4,075,000 shares of our common stock was registered with the SEC, 4,000,000 of which were registered on behalf of the Company and 75,000 of which were registered on behalf of the selling stockholders. The offering commenced on February 15, 2000, and all 4,075,000 shares of common stock were sold for an aggregate registered offering price of $40,750,000 through a syndicate of underwriters, consisting of FleetBoston Robertson Stephens Inc., Thomas Weisel Partners LLC, Friedman, Billings, Ramsey & Co., Inc. and DLJdirect Inc. The sale of all of the registered shares closed on February 17, 2000.

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As of December 31, 2000, we had used the estimated aggregate net proceeds of $35.9 million that we had received from our initial public offering as follows:

RECENT SALES OF UNREGISTERED SECURITIES

On January 31, 2000, we granted to employees options to purchase an aggregate of 488,550 shares of common stock at an exercise price of $10.00 per share. This transaction was exempt from registration under rule 701.

On February 15, 2000, we granted to our Chief Executive Officer, Eric J. Kuhn, an option to purchase an aggregate of 107,913 shares of common stock at an exercise price of $10.00 per share. This transaction was exempt from registration under rule 701.

ITEM 6.     SELECTED FINANCIAL DATA

The selected financial data presented below as of and for the fiscal years ended December 31, 1998, 1999 and 2000 have been derived from the Company’s audited consolidated financial statements. This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company’s Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K.

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ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                    RESULTS OF OPERATIONS

OVERVIEW

We are a leading online retailer of new textbooks and we provide marketing services to other businesses interested in reaching the nation’s 15 million college students and 2.5 million private middle and secondary school students.

We were incorporated in December 1997 and began offering books for sale on our Web site on August 10, 1998. For the period from inception through August 9,1998, our primary activities consisted of:

	•		developing our business model;
	•		establishing, negotiating and consummating a relationship with our supplier, Baker & Taylor;
	•		initial planning and development of our Web site;
	•		developing our information systems infrastructure;
	•		developing our marketing plans; and
	•		establishing finance and administrative functions.

Since the launch of our Web site, we have continued these activities and have also focused on increasing sales, expanding our product and service offerings, improving the efficiency of our order and fulfillment process, recruiting and training employees, enhancing finance and administrative functions and increasing customer service operations and the depth of our management team to help implement our growth strategy.

We began to generate sales when we launched our Web site in August 1998. To date, our revenues have consisted primarily of sales of new textbooks. In January 1999 we created eduPartners, whereby we become the exclusive provider of new books and learning materials to a variety of learning institutions. This program is a cost-effective model that enables us to increase the number of customers to our Web site and generate book sales. In quarter ending September 30, 2000, revenues from eduPartners accounted for approximately 69% of our overall sales of books. We expect this contribution to continue to expand. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer.

We also generate revenue from banner advertisements and other online marketing agreements, as well as offline marketing service agreements for which we use College Impact, our student representative network. During the fourth quarter of fiscal 1999, we began generating revenues from marketing programs. In May 2000, we accelerated our efforts in developing the marketing services business, and subsequently signed marketing services agreements with a number of public and private companies, including AT&T Wireless Services, Inc., Palm, Inc., Papa John’s International, Inc. and Ben & Jerry’s Homemade, Inc. We continue to develop marketing services agreements with businesses that are seeking to reach the college and private middle and high school markets. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable. Costs associated with our marketing programs are recognized as incurred.

In addition, we have successfully lowered the overall expenses and increased the margins of our retail book business through various means, including the imposition of increased retail pricing. Although our margins are increasing and our overall expenses have been lowered significantly, our ability to reach operating profitability depends on our ability to generate and sustain higher net revenues. If we do achieve profitability from operations, we cannot be certain that we can sustain or increase profitability on a quarterly or annual basis in the future. We do not expect to achieve positive cash flow from operations until the second half of 2001. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have little experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as indication of future performance. If we cannot achieve and sustain profitability or positive cash flow from operations, we may be unable to meet our working capital requirements or to obtain additional financing, which would adversely affect our business and my cause us to discontinue operations.

We have incurred substantial losses and negative cash flows from operations in every fiscal period since our inception. For the year ended December 31, 1998, we incurred a loss from operations of approximately $2.7 million and negative cash flows from operations of $1.2 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and negative cash flows from operations of $29.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.6 million and negative cash flows from operations of $27.5 million. As of December 31, 1998, 1999 and 2000 we had accumulated deficits of approximately $2.7 million, $34.2 million and $68.2 million, respectively. We expect that operating losses and negative cash flows will continue until at least the second half of 2001. As part of the increased emphasis on eduPartners, we anticipate that costs and expenses related to brand development, marketing and other

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promotional activities associated with our traditional retail book business will continue to decrease from historical levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our current levels, we believe, in the aggregate, that this will reduce the losses and negative cash flows from our sales of new textbooks. We intend to increase spending on the development of eduPartners program and relationships with other businesses. We believe that we can capture additional revenues, on which we expect to recognize higher gross margins, by increasing the number of businesses for whom we provide marketing services. Our failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

We granted options to purchase 179,490 shares for the period ended December 31, 1998, 2.1 million shares for the year ended December 31, 1999, and 0.6 million shares for the year ended December 31, 2000 that have been deemed to be compensatory. As a result, we recorded deferred compensation of $354,000, $5.1 million and $1.8 million during the year ended December 31, 1998, 1999 and 2000, respectively.

Additionally, effective August 1, 1999, we sold 207,077 shares of our common stock at a price of $0.30 per share to each of our founders, Mr. Kuhn and Mr. Levy. The shares vest at a rate of 40% upon the completion of one year of service and the remaining 60% vest at the end of the second year. Mr. Levy’s shares accelerated upon his separation, which was effective March 15, 2000. We have deemed that the fair value of the underlying stock for the sale of common stock is in excess of the related sales or exercise price. As a result, we recorded deferred compensation of $2.6 million during August 1999 for these transactions.

Furthermore, effective August 24, 1999, Mr. Kuhn was granted an option to purchase 138,052 shares of our common stock at an exercise price of approximately $0.30 per share. The option vests in equal monthly installments over each of the next 48 months assuming Mr. Kuhn remains employed by us. Further, on December 17, 1999, we granted to Mr. Kuhn an option to purchase 345,470 of the Company’s fully diluted common stock at an exercise price of $10 per share. We have deemed that the fair value of the underlying stock for the option grants is in excess of the related sales or exercise price. As a result, we recorded deferred compensation of $0.9 million and $1.1 million during August 1999 and December 1999, respectively, for these transactions.

Effective December 21, 2000, we sold 350,000 shares of our common stock at a price of $0.001 per share to Mr. Kuhn. These shares were issued with certain restrictions limiting or preventing their sale or transfer. We have deemed that the fair value of the underlying stock for the sale of common stock is in excess of the related sales or exercise price. As a result, we recorded non-cash compensation expense of $21,840 in December 2000. There was no deferred compensation expense associated with this transaction.

Amortization of deferred compensation is included in non-cash compensation in the accompanying consolidated statements of operations as a component of the marketing and sales, product development and general and administrative line items, as appropriate. Non-cash compensation is being charged to operations over the vesting period of the underlying shares and options. Due to staffing reductions during the year ended December 31, 2000, a significant percentage of granted options and the associated deferred compensation outstanding as of December 31, 1999 were cancelled.

The following table compares the relative deferred compensation amortization schedules at year ended December 31, 1999 and 2000 (in thousands):

YEARS ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999

Net Sales

Net sales increased to $28.5 million for the year ended December 31, 2000 from $10.6 million for year ended December 31, 1999, as a result of a much stronger selling season in January/February of 2000 compared to the similar period in 1999, the expansion of eduPartners and the commencement of our marketing services business. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer. Revenues from our marketing

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programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable.

Operating Expenses

Cost of Product —Related Party (Baker & Taylor)

Cost of product —related party consists of the cost of products sold to customers. Cost of product —related party increased to $21.3 million for the year ended December 31, 2000 from $9.1 million for year ended December 31, 1999. This increase was primarily attributable to our increased sales volume. We expect that cost of product —related party would continue to increase in absolute dollars as eduPartners and our customer base expands.

Cost of Shipping —Related Party (Baker & Taylor)

Cost of shipping —related party consists of outbound shipping. Cost of shipping increased to $2.2 million for the year ended December 31, 2000 from approximately $0.9 million for year ended December 31, 1999. This increase was primarily attributable to our increased sales volume. Also, for the year ended December 31, 2000, cost of shipping —related party exceeded shipping revenue by $0.4 million or 24.2%. As part of our business strategy, we have historically charged a flat rate for shipping, which in many cases was less than our actual costs. In the fourth quarter of 2000, we increased our shipping rates to ensure that shipping revenue exceeded cost of shipping on most orders. While we will continue to offer competitive, value-based shipping prices to our customers, we expect that shipping revenue will exceed cost of shipping in 2001. We recognize this action may negatively impact our ability to aggressively expand eduPartners and our customer base.

Effective October 1, 1999 we amended the documents governing our relationship with Baker & Taylor. The amendment provides for assignment of separate values to the separate services provided by Baker & Taylor: supply of books, shipping and other services, including Web site content and customer database management. Such assignment is based on the relative fair value of each element as determined by Baker & Taylor. Effective with the amendment of our agreement with Baker & Taylor on October 1, 1999, we have included in “cost of product—related party” in our statement of operations the cost of purchased books from Baker & Taylor, we included in “shipping—related party” the cost of shipping charges from Baker & Taylor and we included in marketing and sales the cost of other services including web site content and customer database management charged from Baker & Taylor.

Since the effective date of these amendments, these agreements have served to reduce cost of product—related party (Baker & Taylor) as a percentage of revenue and increase marketing and sales expense as a percentage of revenue.

Equity Transactions—Related Party (Baker & Taylor)

Equity transactions—related party consists of the fair value of warrants and the amortization of the excess of the fair value over the cost of common stock issued to Baker & Taylor. During 1998, we issued a warrant to purchase 107,143 shares of our common stock at an exercise price of $2.33 per share in July; a warrant to purchase up to 50,000 shares of our common stock at an exercise price of $0.20 per share in October; and a warrant to purchase up to 53,571 shares of our common stock at an exercise price of $2.33 per share in December. Additional warrants to purchase up to 5,950 and 62,500 shares of our common stock at an exercise price of $2.33 and $0.22 per share, respectively, were issued to Baker & Taylor in 1999. We estimated the fair value of the warrants on the date of grant using an established option pricing model (see note 3 to the accompanying consolidated financial statements). On July 10, 1998, we sold 535,714 shares of our common stock to Baker & Taylor at par value. We subsequently determined that the fair value of the common stock was in excess of the exercise price and sales price. Fair value per share was derived by reference to the preferred stock value since inception —see note 3 to the accompanying consolidated financial statements. We expensed the excess of the fair value of the common stock over its cost, which was approximately $643,000, in July 1998. In connection with all of the Baker & Taylor equity transactions, we recorded an aggregate expense of $169,000 for the year ended December, 31 1999, a decrease from the $798,000 we recorded for such transactions for the year ended December 31, 1998. There we no similar expenses incurred during the year ended December 31, 2000.

Cost of Marketing Services

Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. Cost of marketing services totaled $0.4 million for the year ended December 31, 2000. There were no material direct costs associated with the delivery of marketing services for the year ended December 31, 1999.

Marketing and Sales

Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses for personnel engaged in marketing, including the expenses associated with the continued development of our nationwide network of student representatives. Marketing and sales expense increased to $25.4 million for the year ended December 31, 2000 from $20.8 million for year ended December 31, 1999. This increase was primarily attributable to increases in non-cash compensation

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expense, sales and marketing expenses associated with our agreement with Baker & Taylor and increased sales and marketing staffing levels in the first half of the year. Advertising expense decreased to $7.0 million for the year ended December 31, 2000 from $11.4 million for year ended December 31, 1999. This decrease was primarily attributable to the contraction of our online and offline advertising in the second half of 2000. Certain marketing and sales expenses associated with our agreement with Baker & Taylor are the product of the classification of services such as Web site content and customer database management as marketing and sales expense and we expect these costs will continue to increase in absolute dollars as we expand grow our business. However, during the fourth quarter of 2000, we made reductions in other marketing and sales overhead associated with our business. We scaled back our network of student representatives to focus more closely on markets and campuses most frequently targeted by our marketing services clients. We reduced or eliminated consumer advertising and marketing budgets targeting the national college market and refocused resources on the continued growth of eduPartners. We made similar reductions in the headquarter staffing associated with our consumer marketing effort and management of our student representative network. As a result of these actions and the considerably lower costs associated with marketing and promoting eduPartners, we expect that marketing and sales expense will be lower in absolute dollars in 2001.

Product Development

Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense decreased to $4.1 million for the year ended December 31, 2000 from $4.7 million for year ended December 31, 1999. This decrease was primarily attributable to the capitalization of certain technology development costs associated with feature and functionality enhancements made to our website during 2000, overall reductions in technology staffing levels in the second half of 2000, the reduction or elimination of booklist development for non-eduPartner schools, and negative non-cash compensation expense associated with the cancellation of non-vested employee options for employees who left the Company during 2000. We believe that the majority of site features and functionality necessary to support and expand our businesses have been successfully implemented. Based upon observing customer navigation patterns on our site and the related cost-benefit analysis, we made a strategic decision to reduce or eliminate the development of detailed “booklists” for non-eduPartners institutions on our site. Accordingly, we reduced our new technology development and booklist efforts and related staff and expect product development expenses will decrease in absolute dollars in 2001.

General and Administrative

General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense increased to $9.8 million for the year ended December 31, 2000 from $6.7 million for year ended December 31, 1999. This increase was primarily attributable to the hiring of additional personnel and increased professional services expenses during 2000. Consistent with efforts taken in other areas of our business, we have taken steps to reduce the overhead associated with managing and growing our enterprise. During the second half of 2000 we have reduced headcount, renegotiated vendor agreements and reduced ongoing administrative expenses. Therefore, we expect that general and administrative expenses will decrease in absolute dollars in 2001.

Other Expense

During the year ended December 31, 2000 we sold or disposed of certain fixed assets that were no longer critical to the successful execution of our business plan. The disposal of these assets resulted in a loss or expense of approximately $0.5 million during the year ended December 31, 2000.

Interest Income, net

Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $1.0 million for the year ended December 31, 2000 compared to $0.4 million for the year ended December 31, 1999. This increase was primarily attributable to interest income on higher average cash and cash equivalent and short-term investment balances during the year ended December 31, 2000.

Income Taxes

As of December 31, 1999 and December 31, 2000, we had net operating loss carryforwards for federal income tax purposes of $29.9 million and $54.8 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See note 10 to our consolidated financial statements.

YEARS ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998

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Net Sales

Net sales increased to $10.6 million for the year ended December 31, 1999 from $0.1 million for year ended December 31, 1998, as a result of the additional selling season we experienced in January/February of 1999, the significant growth in orders primarily from our expanding customer base as well as the commencement of eduPartners.

Operating Expenses

Cost of Product —Related Party (Baker & Taylor)

Cost of product —related party consists of the cost of products sold to customers. Cost of product —related party increased to $9.1 million for the year ended December 31, 1999 from $0.1 million for year ended December 31, 1998. This increase was primarily attributable to our increased sales volume. We expect that cost of product —related party will continue to increase as we expand our customer base and eduPartners.

Cost of Shipping —Related Party (Baker & Taylor)

Cost of shipping —related party consists of outbound shipping. Cost of shipping increased to $0.9 million for the year ended December 31, 1999 from approximately $10,000 for year ended December 31, 1998. This increase was primarily attributable to our increased sales volume. Also for the year ended December 31, 1999, cost of shipping – related party exceeded shipping revenue by $0.2 million or 34.9%. As part of our business strategy, we charge a flat rate for shipping, which is less than our actual costs. We believe that this strategy is responsive to the competitive nature of our business and is positively perceived by our customer base. We expect that cost of shipping – related party will continue to exceed shipping revenue and will increase as we expand our customer base.

Effective October 1, 1999 we amended the documents governing our relationship with Baker & Taylor. The amendment provides for assignment of separate values to the separate services provided by Baker & Taylor: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by Baker & Taylor. Effective with the amendment of our agreement with Baker & Taylor on October 1, 1999, we have included in “cost of product – related party” in our statement of operations the cost of purchased books from Baker & Taylor, we included in “shipping – related party” the cost of shipping charges from Baker & Taylor and we included in “marketing and sales – related party” the cost of other services charged from Baker & Taylor.

On a prospective basis, these agreements will serve to reduce Cost of Product – Related Party (Baker & Taylor) as a percentage of revenue and increase Marketing and Sales – Related Party (Baker & Taylor) as a percentage of revenue.

Equity Transactions—Related Party (Baker & Taylor)

Equity transactions—related party consists of the fair value of warrants and the amortization of the excess of the fair value over the cost of common stock issued to Baker & Taylor. During 1998, we issued a warrant to purchase 107,143 shares of our common stock at an exercise price of $2.33 per share in July; a warrant to purchase up to 50,000 shares of our common stock at an exercise price of $0.20 per share in October; and a warrant to purchase up to 53,571 shares of our common stock at an exercise price of $2.33 per share in December. Additional warrants to purchase up to 5,950 and 62,500 shares of our common stock at an exercise price of $2.33 and $0.22 per share, respectively, were issued to Baker & Taylor in 1999. We estimated the fair value of the warrants on the date of grant using an established option pricing model (see note 3 to the accompanying consolidated financial statements). On July 10, 1998, we sold 535,714 shares of our common stock to Baker & Taylor at par value. We subsequently determined that the fair value of the common stock was in excess of the exercise price and sales price. Fair value per share was derived by reference to the preferred stock value since inception —see note 3 to the accompanying consolidated financial statements. We expensed the excess of the fair value of the common stock over its cost, which was approximately $643,000, in July 1998. In connection with all of the Baker & Taylor equity transactions, we recorded an aggregate expense of $169,000 for the year ended December, 31 1999, a decrease from the $798,000 we recorded for such transactions for the year ended December 31, 1998.

Marketing and Sales

Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses for personnel engaged in marketing, including the expenses associated with the continued development of our nationwide network of student representatives. Marketing and sales expense increased to $20.8 million for the year ended December 31, 1999 from $0.6 million for year ended December 31, 1998. Advertising expense increased to $11.4 million for the year ended December 31, 1999 from $0.4 million for year ended December 31, 1998. This increase was primarily attributable to the expansion of our online and offline advertising, increased personnel and related expenses and the continued expansion of our network of student representatives and eduPartners. We expect that marketing and sales expense will continue to increase in absolute dollars as we expand our network of student representatives and incur additional advertising and promotional expenses to build our sales base. Marketing and sales expense will also increase as a result of the amendment of our agreements with Baker & Taylor, which will

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result in the classification of services such as website content and customer database management as marketing and sales expense.

Product Development

Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense increased to $4.7 million for the year ended December 31, 1999 from $0.7 million for year ended December 31, 1998. This increase was primarily attributable to increased staffing and other costs related to feature and functionality enhancements to our website. We expect that product and development expenses will continue to increase as we add additional features and functionality to our website.

General and Administrative

General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense increased to $6.7 million for the year ended December 31, 1999 from $0.6 million for year ended December 31, 1998. This increase was primarily attributable to the hiring of additional personnel and increased professional services expenses. WE expect that general and administrative expenses will increase as we continue to build our back-office infrastructure.

Interest Income, net

Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $0.4 million for the year ended December 31, 1999 compared to less than $0.1 million for the year ended December 31, 1998. This increase was primarily attributable to interest income on higher average cash and cash equivalent and short term investment balances during the year ended December 31, 1999.

Income Taxes

As of December 31, 1998 and December 31, 1999, we had net operating loss carryforwards for federal income tax purposes of $1.7 million and $29.9 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See note 10 to our consolidated financial statements.

SEASONALITY

We have experienced significant seasonality in our results of operations. Due to the academic calendar and the seasonal nature of the textbook industry, our peak selling periods have historically been August/September and January/February, when college students return to school and new semesters begin. However, consistent with our focus on the expansion of eduPartners and its current concentration of private middle and high school institutions, we expect our peak selling period will be July/August/September. We expect the impact of this shift to result in significantly lower revenues for the three months ending March 31, 2001 than the comparable period ending March 31, 2000. While many private middle and high school institutions have an active book buying season in December/January, the volume of purchases are typically significantly lower than the initial back-to-school season. Part of our strategy is to expand eduPartners more deeply into the college and distance learning markets. This would result in more balanced selling seasons between fall and winter. Our marketing services business offers more balanced revenue potential throughout the academic calendar year (September-May), but the net sales generated from these products and services may be significantly less than those generated from our sales of textbooks. As a result, we may continue to experience fluctuations in quarterly operating results.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2000, we had $15.7 million of cash and cash equivalents. As of that date, our principal commitments consisted of obligations outstanding under operating leases, accounts payable and accrued liabilities. Although we have no material commitments for capital expenditures, we may experience increases in our capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel.

As of December 31, 2000, prepaid marketing expenses were $5,000 compared to $4.6 million at December 31, 1999. This decrease is a result of the contraction of our offline and online advertising efforts and refocusing of resources toward the marketing and promotion of eduPartners. Also, as of December 31, 1999, we deferred expenses of approximately $1.0 million related to our initial public offering. These costs were offset against additional-paid-in-capital upon the completion of our offering in February 2000. Such costs are reflected as a deferred charge in the accompanying December 31, 1999 consolidated balance sheet.

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Net cash used in operating activities was $27.4 million for the year ended December 31, 2000, and $29.4 million the year ended December 31, 1999, consisting primarily of net losses adjusted for changes in accounts receivable, accounts payable and accrued expenses.

Net cash used in investing activities was $1.2 million for the year ended December 31, 2000, and $2.7 million the year ended December 31, 1999, consisting primarily of purchases of computer equipment, fixtures and furniture, as well as the purchase of a six month certificate of deposit of $0.5 million in 1999.

Net cash provided by financing activities was $36.5 million for the year ended December 31, 1999 and $38.5 million the year ended December 31, 2000. Net cash provided by financing activities during the year ended December 31, 2000 consisted primarily of net proceeds of $35.8 million from the issuance of common stock.

On January 19, 2000 we entered into a revolving credit facility with Imperial Bank in an aggregate amount of $7.5 million with sublimits of $3.0 million for purchases of property, equipment and software and $750,000 for letters of credit. The maturity date for working capital advances was December 31, 2000 and the maturity date for property, equipment and software advance is October 18, 2002. Interest on outstanding balances accrued at Imperial’s prime rate plus 1.0% until the closing of our initial public offering, and afterwards at Imperial’s prime rate. All amounts outstanding, which could be up to $7.5 million, would be collateralized by a pledge of all of our assets. Under the terms of the credit facility, as amended, we must maintain a tangible net worth of $15 million and we must maintain a ratio of our current assets to our current liabilities of 1.5 to 1. We also issued a warrant to Imperial to purchase 37,500 shares of our common stock at an exercise price of $10.00 per share. We borrowed $2.5 million under the revolving credit facility during February 2000 and repaid such borrowings with a portion of the proceeds of our initial public offering on February 22, 2000. This credit facility matured on December 31, 2000 and was not renewed in 2001. At the time of the maturity, the outstanding balance under the facility totaled $264,073, comprised entirely from an issued and irrevocable Letter of Credit. The outstanding Letter of Credit was subsequently secured by cash deposits, and as a result, the outstanding balance under the matured revolving credit facility is $0.

We expect that operating losses and negative cash flows will continue until at least the second half of 2001. As part of the increased emphasis on eduPartners, we anticipate that costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our current levels, we believe, in the aggregate, that this will reduce the losses and negative cash flows from our sales of new textbooks. We intend to increase spending on the development of eduPartners and relationships with other businesses. We believe that we can capture additional revenues, on which we expect to recognize higher gross margins, by increasing the number of businesses for whom we provide marketing services. Our failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures until such time as we achieve operating profitability. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed our current expectations. Any required additional financing may be unavailable on terms favorable to us, or at all.

Substantially all of our cash equivalents are at fixed interest rates, and, therefore, the fair value of these instruments is affected by changes in market interest rates. However, as of December 31, 2000, all of our cash equivalents mature within three months. As of December 31, 2000, we believe the reported amounts of cash equivalents and short-term investments to be reasonable approximations of their fair values. As a result, we believe that the market risk arising from our holdings of financial instruments is minimal. As of December 31, 2000 we were not subject to any material variable rate indebtedness.

27 of 27

To the Board of Directors and Stockholders Varsity Group Inc.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Varsity Group Inc. and its subsidiaries at December 31, 2000 and December 31, 1999, and the results of their operations and their cash flows for the three years ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. These 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 of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

McLean, Virginia
March 8, 2001,
     except with respect to Note 11, as
     to which the date is March 20, 2001

28 of 28

VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 1998, 1999 and 2000
(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

29 of 29

VARSITY GROUP INC.
CONSOLIDATED BALANCE SHEETS
As of December 31, 1999 and 2000
(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

30 of 30

Varsity Group, Inc.
Consolidated Statements of Stockholders’ (Deficit) Equity
Years ended December 31, 1998, 1999 and 2000
(in thousands, except share data)

			Series A								Series B								Series C																				Notes
			Convertible								Convertible								Convertible																Add'l Paid-In				Rec
Description			Preferred Stock								Preferred Stock								Preferred Stock								Common Stock								Capital				Stkholdr
			Shares				Amt				Shares				Amt				Shares				Amt				Shares				Amt
Balance at December 31, 1997				—			$	—				—			$	—				—			$	—				—			$	—			$	—			$	—
Issuance of common stock																												2,035,714								642
Issuance of Series A convertible preferred stock				2,071,420				—																												1,433
Issuance of warrants:
	Related party																																			155
	Convertible debt ($__ from issuance to related party)																																			214
Deferred compensation																																				354
Net Loss
Balance at December 31, 1998				2,071,420				—				—				—				—				—				2,035,714				—				2,798				—
Issuance of common stock																												193,409				—				59
Issuance of Series B convertible preferred stock												5,996,306				1																				8,552
Conversion of convertible notes to Series B preferred stock												937,500																								1,160
Issuance of Series C convertible preferred stock																				8,928,571				1												29,895
Issuance of warrants:
	Related party																																			169
	AOL warrants																																			1,208
	Convertible Debt																																			31
Deferred compensation																																				9,711
Issuance of common stock in exchange for loans to stckhldrs																												414,154				—				124				(124	)
Net loss
Balance at December 31, 1999				2,071,420				—				6,933,806				1				8,928,571				1				2,643,277				—				53,707				(124	)
Issuance of common stock – IPO																												4,035,000				1				35,822
Issuance of common stock – ESPP																												71,468				—				104
Issuance of common stock – options exercised																												85,594				—				24
Issuance of restricted common stock to stockholder																												350,000				—				22
Conversion of convertible preferred stock				(2,071,420	)			—				(6,933,806	)			(1	)			(8,928,571	)			(1	)			8,966,879				1				1
Issuance of warrants:
	AOL																																			205
	Imperial Bank																																			256
	Sallie Mae																																			2,601
Deferred Compensation																																				(5,455	)
Net Loss
Balance at December 31, 2000				—			$	—				—			$	—				—			$	—				16,152,218			$	2			$	87,287			$	(124	)

[Additional columns below]

[Continued from above table, first column(s) repeated]

			Warrant
			Rec and				Deferred				Accum
Description			Other				Comp.				Deficit				Totals
Balance at December 31, 1997			$	—			$	—			$	—			$	—
Issuance of common stock																642
Issuance of Series A convertible preferred stock																1,433
Issuance of warrants:
	Related party															155
	Convertible debt ($__ from issuance to related party)															214
Deferred compensation								(208	)							146
Net Loss												(2,689	)			(2,689	)
Balance at December 31, 1998				—				(208	)			(2,689	)			(99	)
Issuance of common stock																59
Issuance of Series B convertible preferred stock																8,553
Conversion of convertible notes to Series B preferred stock																1,160
Issuance of Series C convertible preferred stock																29,896
Issuance of warrants:
	Related party															169
	AOL warrants															1,208
	Convertible Debt															31
Deferred compensation								(7,133	)							2,578
Issuance of common stock in exchange for loans to stckhldrs																—
Net loss												(31,508	)			(31,508	)
Balance at December 31, 1999				—				(7,341	)			(34,197	)			12,047
Issuance of common stock – IPO																35,823
Issuance of common stock – ESPP																104
Issuance of common stock – options exercised																24
Issuance of restricted common stock to stockholder																22
Conversion of convertible preferred stock																—
Issuance of warrants:
	AOL															205
	Imperial Bank															256
	Sallie Mae			(707	)											1,894
Deferred Compensation								6,218								763
Net Loss												(34,024	)			(34,024	)
Balance at December 31, 2000			$	(707	)		$	(1,123	)		$	(68,221	)		$	17,114