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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

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

THE SECURITIES EXCHANGE ACT of 1934

For the fiscal year ended December 31, 2004

Commission file number: 000-50784

Blackboard Inc.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code:

(202) 463-4860

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

None

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

Common Stock, $0.01 par value per share

          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 þ          No o

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.     þ

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes o          No þ

      The aggregate market value of outstanding voting stock held by non-affiliates of the registrant as of June 30, 2004 was $285.5 million based on the last reported sale price of the registrant’s common stock on The NASDAQ National Market as of the close of business on that day.

      There were 26,070,903 shares of the registrant’s common stock outstanding as of January 31, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the registrant’s definitive proxy statement for its 2005 annual meeting of stockholders to be filed pursuant to Regulation 14A with the Securities and Exchange Commission not later than 120 days after the registrant’s fiscal year end of December 31, 2004, are incorporated by reference into Part III of this Form 10-K.

BLACKBOARD INC.

Form 10-K

TABLE OF CONTENTS

      This report contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially from those expressed or implied by such statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Factors That Could Affect Future Results.” When used in this report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. You should not place undue reliance on these forward-looking statements, which reflect our opinions only as of the date of this report. Blackboard assumes no obligation and does not intend to update these forward-looking statements.

PART I

General

      We are a leading provider of enterprise software applications and related services to the education industry. Our product line consists of five software applications bundled in two suites, the Blackboard Academic Suite™ and the Blackboard Commerce Suite™. We license these products on a renewable basis, typically for an annual term. Our clients include colleges, universities, schools and other education providers, as well as textbook publishers and student-focused merchants who serve these education providers and their students. These clients use our software to integrate technology into the education experience and campus life, and to support activities such as a professor assigning digital materials on a class website; a student collaborating with peers or completing research online; an administrator managing a departmental website; or a merchant conducting cash-free transactions with students and faculty through pre-funded debit accounts.

      We believe that our operating history provides us with experience that enables us to analyze and address the needs of the education industry. We began operations in 1997 as a limited liability company organized under the laws of the state of Delaware and served as a primary contractor to an education industry technical standards organization. In 1998, we incorporated under the laws of the state of Delaware and acquired CourseInfo LLC, which had developed an internal online learning system used by faculty at Cornell University, and had begun marketing its technology to universities and school districts in the United States and Canada. Since the time of our acquisition of CourseInfo, we have grown from approximately 26 licenses of one software application as of December 31, 1998 to more than 3,000 licenses of five software applications, in two suites, as of December 31, 2004.

      Our software applications can be installed locally at a client site or hosted centrally in our data centers. As of December 31, 2004, approximately 86% of our installations were installed locally and 14% were hosted by us. As of December 31, 2004, approximately 2,225 clients in approximately 64 countries held more than 3,000 licenses of our software. We count a university or school district as a single client even if it includes multiple entities that are separately licensing our products. We count each license for any one of our software applications as a separate license. As a result, it is possible for a single client to have multiple licenses.

Market Overview

      Our primary market is the U.S. postsecondary education market, which accounted for approximately 63% of our total revenues for 2004. We also sell into the international postsecondary, the U.S. K-12 education markets and other markets, including primarily education publishers, commercial education providers and United States government organizations, which accounted for approximately 15%, 8% and 14% of our total revenues for 2004, respectively.

Products and Services

      We have created a broad product line of enterprise software applications for the education industry. Clients can license our enterprise software applications individually or bundled into one of two suites, the Blackboard Academic Suite and the Blackboard Commerce Suite. We offer the Blackboard Academic Suite in all of our markets, and currently offer the Blackboard Commerce Suite in the U.S. and Canadian postsecondary markets. We also sometimes serve as an application service provider, offering hosting for our clients that prefer to outsource the management of the hardware, bandwidth and servers necessary to run our applications. In addition to our products, we offer a variety of professional services that help clients maximize the benefit received from our products, including project management, custom application development and training.

The Blackboard Academic Suite

      The Blackboard Academic Suite provides a scalable and easy-to-use technology platform for delivering education online, managing digital content and aggregating access to tools, information and content through an integrated Web portal environment. The applications that make up the Blackboard Academic Suite are:

      The Blackboard Learning System allows education providers to support a feature-rich online teaching and learning environment that can be used to augment a classroom-based program or for distance learning. The major capabilities of the Blackboard Learning System include:

      The Blackboard Learning System is also available in two other versions that address the needs of specific client communities in the education market: The Blackboard Learning System-Basic Edition^TM is a

stand-alone, entry-level version of the Blackboard Learning System suitable for small-scale implementations; and the Blackboard Learning System ML™ is our multi-language version, which currently supports 13 language configurations that we sell separately.

      The Blackboard Community System is an enterprise information portal application designed specifically for the education industry. As part of the Blackboard Academic Suite, the Blackboard Community System extends the Blackboard Learning System to include functionality for student organizations, faculty and staff, departmental collaboration, information distribution and single sign-on access to existing administrative systems. The major academic capabilities of the Blackboard Community System include:

      The Blackboard Content System, which we released in March 2004, provides enterprise content management capabilities. The application supports teaching, learning, research, archival, extracurricular and departmental activities that require the central management, tagging, sharing and re-use of electronic files, such as scanned manuscripts, lecture notes for multiple sections of a course and departmental mission statements. The major capabilities of the Blackboard Content System include:

The Blackboard Commerce Suite

      The Blackboard Commerce Suite can be used for on- and off-campus commerce, online e-commerce, meal plan administration, vending, laundry services, copy and print management and student and staff identification. The applications that make up the Blackboard Commerce Suite are:

      The Blackboard Transaction System is an enterprise software application that we license along with various hardware to allow clients to establish an integrated student debit account program for charging incidental expenses such as meals and academic materials, typically using the campus ID card. The hardware that we sell as part of the Blackboard Transaction System includes servers, cards, card readers and point-of-sale devices. The Blackboard Transaction System can also support activities such as facilities access and identity verification. The principal features of the Blackboard Transaction System include:

      In addition to the functionalities it provides as part of the Blackboard Academic Suite, the Blackboard Community System enables additional transaction capabilities when licensed as part of the Blackboard Commerce Suite, including:

      Blackboard One is bundled with the Blackboard Transaction System and enables students and faculty to use their university ID cards as a form of payment off-campus. We recruit local merchants to accept student debit accounts as a form of payment and facilitate the processing of transactions by third-party merchants that use the Blackboard Transaction System. By utilizing the existing Blackboard Transaction System debit account at the university, Blackboard One provides students with a secure, cashless and convenient way to make purchases while assuring parents that their funds will be spent within a university-approved merchant network. We develop the off-campus merchant network on behalf of each university and manage the program, from merchant acquisition and funds settlement to transaction terminal support. Also, if requested by the client, we simultaneously conduct customized marketing campaigns designed to build the card program brand and increase deposits into the accounts.

Professional Services

      Our professional services support the implementation and maintenance of the educational environment in order to help clients maximize the value of our various enterprise software applications. Our services group offers:

      Training is available online and on-site for both the Blackboard Academic Suite and the Blackboard Commerce Suite, as is instructional design consulting for the Blackboard Academic Suite.

Competition

      The market for education enterprise software is highly fragmented and rapidly evolving, and we expect competition in this market to persist and intensify. Our primary competitors for the Blackboard Academic Suite are companies that provide course management systems, learning content management systems and education enterprise information portal technologies. Companies that fit this description include eCollege.com, WebCT, Inc., SunGard SCT Inc., an operating unit of SunGard Data Systems Inc., HarvestRoad Ltd., Concord USA, Inc., Desire2Learn Inc., ANGEL Learning, Inc. and Jenzabar, Inc. We also face competition from clients that develop their own applications internally, large diversified software vendors who offer products in numerous markets including the education market and open source software applications such as Moodle and Sakai. Our primary competitors for the Blackboard Commerce Suite are companies that provide university transaction systems and off-campus merchant relationship programs. Companies that fit this description include Diebold, Incorporated’s Card Systems division and The CBORD Group, Inc.

      It is possible that other vendors will develop and market competitive products in the future. Some of our competitors and potential competitors are larger than us and have greater financial and technical resources than we do.

      We believe that the primary competitive factors in our markets are:

      We believe that we compete favorably on the basis of these factors.

Our Growth Strategy

      We seek to capitalize on our position as a leader in our market to grow our business by supporting several significant aspects of education, including teaching, learning, commerce and campus life. Key elements of our growth strategy include:

Research and Development

      Each of the individual applications in our two product suites is developed and maintained by a dedicated team of software engineers, product managers and documentation specialists. In addition, we maintain three cross-product groups: an engineering services team, which focuses on highly technical product support issues that have been escalated by our telephone support operation; a quality control team, which tests our applications with a view to ensuring that software errors and usability issues are identified and corrected before a new product or update is released; and a corporate development engineering team that works on special development projects that involve third parties, including software tools for integrating our products with other campus systems. Our research and development group receives extensive feedback on product improvement suggestions and new products from clients, either directly or through our sales and client support organizations. We periodically release maintenance updates to and new versions of our existing products. In addition, our research and development group works on new product initiatives as appropriate. Our products are primarily developed internally and, in support of the development of our products, we have acquired or licensed specialized products and technologies from other software firms. Our research and development expenses were $10.3 million, $11.4 million and $13.7 million in the years ended December 31, 2002, 2003 and 2004, respectively.

Marketing and Sales

      We engage in a variety of traditional and online marketing activities designed to provide sales lead generation, sales support and increasing market awareness. Our specific marketing activities include print advertising in trade publications, direct mail campaigns, speaking engagements and industry trade-shows and seminars, which help create awareness of our brand and products and services. Examples of specific marketing events include the Blackboard Summit, which is our annual meeting of educational and technology leaders from the United States and abroad; the Blackboard Users’ Conference, which is our annual conference dedicated to all users of Blackboard products as well as prospective clients; and Blackboard Days, which provide information sessions at current client sites for current and prospective clients. Our marketing group also manages our website, which serves as a source of information about us and our products.

      We sell our products through a direct sales force and, in some emerging international markets, through re-sellers. Regional sales managers are responsible for sales of our products in their territories and supervise account managers who are responsible for maintaining software and service renewal rates among our clients. Account managers are typically compensated in part based upon their achievement of renewal rate quotas, and pursue a variety of client relations activities aimed at maintaining and improving renewal rates. In addition, our sales organization includes technical sales engineers, who are experts in the technical aspects of our products and client implementations.

      In our experience, colleges, universities and schools frequently rely on references from peer institutions when selecting a vendor and often involve a variety of internal constituencies, such as instructors and students, when evaluating a product. In addition, most public education institutions and many private institutions utilize request for proposal, or RFP, processes, by which they announce their interest in purchasing an application and detail their requirements so that vendors may bid accordingly. As a result, we generate sales leads from sources such as interacting with attendees at conferences, visiting potential clients’ sites to provide briefings on the industry and our products, responding to inbound calls based on client recommendations and monitoring and responding to RFPs. We often structure our licenses in a manner that anticipates expansion from one product in a suite to multiple products in a suite, and we engage in state or regional agreements when appropriate to provide umbrella pricing and contractual terms for a group of institutions. We have U.S. sales offices in Washington, D.C. and Phoenix, Arizona. We have international sales offices in Amsterdam and Tokyo.

Executive Officers

      The following table lists our executive officers and their ages as of February 28, 2005.

      Matthew Pittinsky has served as chairman of the board of directors since our founding in 1997. From June 1997 to November 1998, Mr. Pittinsky also served as chief executive officer. Before co-founding

Blackboard, from July 1995 to June 1997 Mr. Pittinsky was a consultant with KPMG Consulting (now BearingPoint, Inc.) serving colleges and universities. Mr. Pittinsky is the editor of The Wired Tower, a book published in June 2002 analyzing the Internet’s impact on higher education. Mr. Pittinsky serves on the board of trustees of American University. Mr. Pittinsky received a BS degree from American University and an Ed.M degree from Harvard University Graduate School of Education. He is currently a Ph.D candidate at Columbia University Teachers College.

      Michael Chasen has served as chief executive officer since January 2001, as president since February 2004 and as a director since our founding in 1997. From June 1997 to January 2001, Mr. Chasen served as president. Before co-founding Blackboard, from May 1996 to June 1997, Mr. Chasen was a consultant with KPMG Consulting (now BearingPoint, Inc.) serving colleges and universities. Mr. Chasen received a BS degree from American University and a MBA degree from Georgetown University School of Business.

      Peter Repetti has served as chief financial officer since June 2001. Prior to joining us, from March 2000 to April 2001, Mr. Repetti served as the chief financial officer of WebOS Inc., an Internet infrastructure software company. From December 1995 to August 1999, Mr. Repetti served as chief financial officer and, from August 1994 to August 1999, as vice president of finance of Manugistics Group, Inc., a supply chain management software company. Mr. Repetti received a BBA degree from The George Washington University and a MBA degree from the University of Chicago.

      Todd Gibby has served as senior vice president for sales since August 2002. From January 2001 to August 2002, Mr. Gibby served as general manager of our learning systems and community portal systems product lines, and from September 1999 to January 2001, he served as vice president for business development and Web properties. Prior to joining us, from February 1999 to September 1999, Mr. Gibby was director of business development with Campus Pipeline Inc. Mr. Gibby received a BA degree from Dartmouth College and a MBA degree from the Wharton School of Business, University of Pennsylvania.

      George Calvert has served as senior vice president for product development since February 2004. Prior to joining us, from December 1999 to February 2004, Mr. Calvert served as president of Loud Think, Inc., an information technology consulting firm. From November 1998 to October 1999, Mr. Calvert served as director of consulting at FirePond, Inc., a customer relations management software company. Mr. Calvert received a BA degree from the University of Delaware and a MS degree from The Johns Hopkins University.

      James Hermens has served as senior vice president for global services and support since May 2003. From December 2001 to May 2003, Mr. Hermens served as the general manager of our transaction systems product line. Prior to joining us, from June 2000 to November 2001, Mr. Hermens was a general manager at Hollinger Digital Inc., a global media company, and from June 1997 to June 2000, as vice president and director at Sylvan Learning Systems, Inc. (now known as Laureate Education, Inc.). Mr. Hermens received an AB degree from Princeton University and a MBA degree from the Darden School, University of Virginia.

      Matthew Small has served as general counsel since January 2004, secretary since February 2004 and senior vice president for legal since February 2005. Mr. Small served as corporate counsel from September 2002 to January 2004 and assistant secretary from November 2002 to February 2004. Prior to joining us, from September 1999 to September 2002, Mr. Small was an associate at the law firm of Testa, Hurwitz & Thibeault LLP. Mr. Small received a BA degree from the University of Denver, a MBA degree from the University of Connecticut School of Business and a JD degree from the University of Connecticut Law School.

      Mary Good has served as senior vice president for human resources and facilities since April 2004. Prior to joining us, Ms. Good served as vice president, human resources for American Management Systems, Inc., a professional services and information technology firm, from June 2000 to June 2003. From 1988 to June 2000, Ms. Good served in a variety of human resource positions at American Management Systems, Inc. Ms. Good received a BS degree from The Pennsylvania State University and a MBA degree from Syracuse University.

      Michael Beach has served as vice president for finance since June 2001 and treasurer since February 2004. Prior to joining us, from February 1997 to June 2001, Mr. Beach was an audit senior manager at the public accounting firm of Ernst & Young LLP. Mr. Beach received a BBA degree from James Madison University.

Employees

      As of December 31, 2004, we had 481 employees, including 142 in sales and marketing; 96 in support, ASP hosting and production; 90 in research and development; 79 in professional services; and 74 in general administration. None of our employees are represented by a labor union. We have never experienced a work stoppage and believe our relationship with our employees is good.

International Operations

      We currently operate predominately in the United States. Our revenues derived from operations in foreign countries for fiscal years 2002, 2003 and 2004 were $8.4 million, $12.5 million and $16.8 million, respectively. All of our material identifiable assets are located in the United States.

Website Access to U.S. Securities and Exchange Commission Reports

      Our Internet address is http://www.blackboard.com. Through our website, we make available, free of charge, access to all reports filed with the U.S. Securities and Exchange Commission including our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to these reports, as filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Copies of any materials we file with, or furnish to, the SEC can also be obtained free of charge through the SEC’s website at http://www.sec.gov or at the SEC’s Public Reference Room at 450 Fifth St., N.W., Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

      Our corporate headquarters are located in Washington, D.C., where we lease approximately 46,000 square feet of space under a lease expiring in May 2007 and approximately 11,000 square feet of space under a lease expiring November 2009. We also lease offices in Phoenix, Arizona, Amsterdam and Tokyo.

      We are involved in various legal proceedings from time to time incidental to the ordinary conduct of our business. We are not currently involved in any legal proceeding the ultimate outcome of which, in our judgment based on information currently available, would have a material adverse effect on our business, financial condition or results of operations

      No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

PART II

      Our common stock trades on the NASDAQ National Market under the symbol “BBBB.” The following table sets forth, for the period indicated, the range of high and low sales prices for our common stock since our initial public offering on June 18, 2004.

      As of January 31, 2005 there were approximately 434 holders of record of our outstanding common stock.

      We have not paid or declared any cash dividends on our common stock. We currently expect to retain all of our earnings for use in developing our business and do not anticipate paying any cash dividends in the foreseeable future. Future cash dividends, if any, will be paid at the discretion of our board of directors and will depend, among other things, upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and such other factors as our board of directors may deem relevant.

      We did not repurchase any of our equity securities in 2004.

      Our net proceeds from our initial public offering after expenses were approximately $50.9 million. As of December 31, 2004, since our initial public offering, we have expended cash in excess of our net proceeds from our initial public offering.

      The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and the related notes, and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this annual report. The statement of operations data for the years ended December 31, 2000, 2001, 2002, 2003 and 2004, and the balance sheet data as of December 31, 2000, 2001, 2002, 2003 and 2004, are derived from, and are qualified by reference to, our audited consolidated financial statements that have been audited by Ernst and Young, LLP, our independent auditors.

      The following table sets forth a summary of our balance sheets data:

      You should read the following discussion together with our financial statements and the related notes included elsewhere in this annual report. This discussion contains forward-looking statements that are based on our current expectations, estimates and projections about our business and operations. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including those we discuss under “Risks Related to Our Business” and elsewhere in this annual report.

General

      We are a leading provider of enterprise software applications and related services to the education industry. Our clients use our software to integrate technology into the education experience and campus life, and to support activities such as a professor assigning digital materials on a class website; a student collaborating with peers or completing research online; an administrator managing a departmental website; or a merchant conducting cash-free transactions with students and faculty through pre-funded debit accounts. Our clients include colleges, universities, schools and other education providers, as well as textbook publishers and student-focused merchants who serve these education providers and their students.

      We generate revenues from sales and licensing of products and professional services. Our product revenues consist principally of revenues from annual software licenses, client hosting engagements and the sale of bundled software-hardware systems. We typically sell our licenses and hosting services under annually renewable agreements, and our clients generally pay the annual fees at the beginning of the contract term. We recognize revenues from these agreements, as well as revenues from bundled software-hardware systems, ratably over the contractual term, which is typically 12 months. Billings associated with licenses and hosting services are recorded initially as deferred revenues and then recognized ratably into revenues over the contract term. We also generate product revenues from the sale and licensing of third-party software and hardware that is not bundled with our software. These revenues are generally recognized upon shipment of the products to our clients.

      We derive professional services revenues primarily from training, implementation, installation and other consulting services. Substantially all of our professional services are performed on a time-and-materials basis. We recognize these revenues as the services are performed.

      We typically license our individual applications either on a stand-alone basis or bundled as part of either of two suites, the Blackboard Academic Suite and the Blackboard Commerce Suite. The Blackboard Academic Suite includes the Blackboard Learning System, the Blackboard Community System (formerly known as Blackboard Portal System) and the Blackboard Content System. The Blackboard Commerce Suite includes the Blackboard Transaction System, the Blackboard Community System and Blackboard One. We generally price our software licenses on the basis of full-time-equivalent students or users. Accordingly, annual license fees are generally greater for larger institutions.

      Our operating expenses consist of cost of revenues, research and development expenses, sales and marketing expenses, general and administrative expenses, amortization of intangibles resulting from acquisitions and stock-based compensation expenses.

      Major components of our cost of product revenues include license and other fees that we owe to third parties upon licensing software, and the cost of hardware that we bundle with our software. We initially defer these costs and recognize them into expense over the period in which the related revenue is recognized. Cost of product revenues also includes amortization of internally developed technology available for sale, employee compensation and benefits for personnel supporting our hosting, support and production functions, as well as related facility rent, communication costs, utilities, depreciation expense and cost of external professional services used in these functions. All of these costs are expensed as incurred. The costs of third-party software and hardware that is not bundled with software are also expensed when incurred, normally upon delivery to our client. Cost of product revenues excludes the

amortization of acquired technology recognized from acquisitions, which is included in amortization of intangibles resulting from acquisitions.

      Cost of professional services revenues primarily includes the costs of compensation and benefits for employees and external consultants who are involved in the performance of professional services engagements for our clients, as well as travel and related costs, facility rent, communication costs, utilities and depreciation expense used in these functions. All of these costs are expensed as incurred.

      Research and development expenses include the costs of compensation and benefits for employees who are associated with the creation and testing of the products we offer, as well as the costs of external professional services, travel and related costs attributable to the creation and testing of our products, related facility rent, communication costs, utilities and depreciation expense. All of these costs are expensed as incurred.

      Sales and marketing expenses include the costs of compensation, including bonuses and commissions, and benefits for employees who are associated with the generation of revenues, as well as marketing expenses, costs of external marketing-related professional services, facility rent, bad debts, utilities, communications and travel attributable to those sales and marketing employees in the generation of revenues. All of these costs are expensed as incurred.

      General and administrative expenses include the costs of compensation and benefits for employees in the human resources, legal, finance and accounting, management information systems, facilities management, executive management and other administrative functions who are not directly associated with the generation of revenues or the creation and testing of products. In addition, general and administrative expenses include the costs of external professional services and insurance, as well as related facility rent, communication costs, utilities and depreciation expense used in these functions.

      Amortization of intangibles includes the amortization of costs associated with products, acquired technology, customer lists, non-compete agreements and other identifiable intangible assets. These intangible assets were recorded at the time of our acquisitions and relate to contractual agreements, technology and products that we continue to utilize in our business. For periods prior to 2002, we also amortized goodwill and the assembled-workforce intangible assets we acquired in our acquisitions.

      Stock-based compensation expenses relate to historic stock option grants and have arisen primarily as a result of options granted below fair market value, modifications made to outstanding options and options granted to non-employees.

Critical Accounting Policies and Estimates

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

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

      Revenue recognition. Our revenues are derived from two sources: product sales and professional services sales. Product revenues include software license, hardware, premium support and maintenance, and hosting revenues. Professional services revenues include training and consulting services. We recognize software license and maintenance revenues in accordance with the American Institute of Certified Public Accountants’ Statement of Position, or SOP, 97-2, “Software Revenue Recognition”, as modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions”. Our software does not require significant modification and customization services. Where services are not essential to the functionality of the software, we begin to recognize software licensing revenues when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the fee is fixed and determinable; and (4) collectibility is probable.

      We do not have vendor-specific objective evidence, or VSOE, of fair value for our support and maintenance separate from our software. Accordingly, when licenses are sold in conjunction with our support and maintenance, we recognize the license revenue over the term of the maintenance service period.

      We sell hardware in two types of transactions: sales of hardware in conjunction with our software licenses, which we refer to as bundled hardware-software systems, and sales of hardware without software, which generally involve the resale of third-party hardware. After any necessary installation services are performed, hardware revenues are recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the fee is fixed and determinable; and (4) collectibility is probable. We have not determined VSOE of the fair value for the separate components of bundled hardware-software systems. Accordingly, when a bundled hardware-software system is sold, all revenue is recognized over the term of the maintenance service period. Hardware sales without software are recognized upon delivery of the hardware to our client.

      Hosting revenues are recorded in accordance with Emerging Issues Task Force, or EITF, 00-3, “Application of AICPA SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware”. We recognize hosting fees and set-up fees ratably over the term of the hosting agreement.

      We recognize professional services revenues, which are generally contracted on a time-and-materials basis and consist of training, implementation and installation services, as the services are provided.

      We do not offer specified upgrades or incrementally significant discounts. Advance payments are recorded as deferred revenue until the product is shipped, services are delivered or obligations are met and the revenue can be recognized. Deferred revenues represent the excess of amounts invoiced over amounts recognized as revenues. We provide non-specified upgrades of our product only on a when-and-if-available basis.

      Allowance for uncollectible accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability, failure or refusal of our clients to make required payments. We analyze accounts receivable, historical percentages of uncollectible accounts and changes in payment history when evaluating the adequacy of the allowance for uncollectible accounts. We use an internal group of collectors, augmented by our sales and services groups as we deem appropriate, in our collection efforts. Although we believe that our reserves are adequate, if the financial condition of our clients deteriorates, resulting in an impairment of their ability to make payments, or if we underestimate the allowances required, additional allowances may be necessary, which will result in increased expense in the period in which such determination is made.

      Long-lived assets. We record our long-lived assets, such as property and equipment, at cost. We review the carrying value of our long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable in accordance with the provisions of Statement of Financial Accounting Standards, or SFAS, No. 144, “Accounting for the

Impairment or Disposal of Long-Lived Assets”. We evaluate these assets by examining estimated future cash flows to determine if their current recorded value is impaired. We evaluate these cash flows by using weighted probability techniques as well as comparisons of past performance against projections. Assets may also be evaluated by identifying independent market values. If we determine that an asset’s carrying value is impaired, we will record a write-down of the carrying value of the identified asset and charge the impairment as an operating expense in the period in which the determination is made. Although we believe that the carrying values of our long-lived assets are appropriately stated, changes in strategy or market conditions or significant technological developments could significantly impact these judgments and require adjustments to recorded asset balances.

      Goodwill. We assess the impairment of goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Accordingly, we test our goodwill for impairment annually on October 1, or whenever events or changes in circumstances indicate an impairment may have occurred, by comparing its fair value to its carrying value. Impairment may result from, among other things, deterioration in the performance of the acquired business, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of the acquired business, and a variety of other circumstances. If we determine that impairment has occurred, we are required to record a write-down of the carrying value and charge the impairment as an operating expense in the period the determination is made. Although we believe goodwill is appropriately stated in our consolidated financial statements, changes in strategy or market conditions could significantly impact these judgments and require an adjustment to the recorded balance.

      On January 1, 2002, we adopted SFAS 142 and recorded a one-time charge of $26.6 million to reduce the carrying value of some of our goodwill. This charge was non-operational in nature and is reflected as a cumulative effect of change in accounting principle in our consolidated statements of operations. In calculating the impairment charge, we estimated the fair value of the goodwill using a discounted cash flow methodology as determined by an independent valuation of at-risk assets.

      Stock-based compensation. We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations, and comply with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, as modified by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of SFAS No. 123”. Several companies recently elected to change their accounting policies and record the fair value of options as an expense. We currently are not required to record stock-based compensation charges if the employee stock option exercise price equals or exceeds the deemed fair value of our common stock at the grant date. Because no market for our common stock existed prior to our initial public offering in June 2004, our board of directors determined the fair value of our common stock based upon several factors, including our operating performance, anticipated future operating results, the terms of redeemable convertible preferred stock issued by us, including the liquidation value and other preferences of our preferred stockholders, as well as the valuations of other companies.

      On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, known as SFAS 123(R), which is a revision of SFAS No. 123. SFAS 123(R) supersedes APB Opinion No. 25 and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally the approach in SFAS 123(R) is similar to the approach described in SFAS No. 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative upon adopting SFAS 123(R).

      SFAS 123(R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. SFAS 123(R) permits public companies to adopt its requirements using one of two methods:

      We plan to adopt SFAS 123(R) using the modified prospective method on July 1, 2005.

      If we had estimated the fair value of the options on the date of grant using the Black-Scholes pricing model and then amortized this estimated fair value over the vesting period of the options, our net (loss) income attributable to common stockholders would have changed, as shown in the table below.

      Accounting for income taxes. In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. We establish a valuation allowance if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized. We have included changes in the valuation allowance in our statements of operations as provision for or benefit from income taxes. We exercise significant judgment in determining our provisions for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefit from our deferred tax assets. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business.

      During 2004, the Internal Revenue Service issued an Internal Revenue Bulletin — Revenue Procedure 2004-34 (Rev Proc 2004-34), which allows for greater consistency between generally accepted accounting principles, or GAAP, and income tax revenue recognition for companies that recognize revenues in a ratable manner. During 2004, we determined that we would adopt this method for our 2004 and subsequent income tax filings. As a result of this adoption, we will recognize cumulative income tax expense adjustments that will decrease our federal and state taxable income by approximately $34.0 million. The provision for income taxes for the year ended December 31, 2004 reflects this adoption.

      As of December 31, 2004, we had a valuation allowance of $31.2 million to reduce our deferred tax assets. The valuation allowance primarily relates to deferred tax assets arising from operating loss carryforwards and the book treatment compared to tax treatment of deferred revenues. Should we generate taxable income in the future, we may be able to realize all or part of the operating loss carryforwards against which we have applied the valuation allowance. In that event, our current income tax expense would be reduced or our income tax benefits would be increased, resulting in an increase in net income or a reduction in net loss.

Acquisitions and Joint Venture

      In January 2002, we acquired the assets and liabilities of Prometheus, a division of The George Washington University, in consideration for 512,959 shares of our common stock, a $3.0 million note payable and the assumption of liabilities of $550,000, for total purchase consideration of $9.6 million. The note payable accrued interest at 6.5% per annum, payable quarterly. The note provided for three principal payments of $1.0 million each due in July 2003, January 2004 and July 2004. We accounted for this acquisition as a purchase and, accordingly, the results of operations have been included in our statements of operations since the date of the acquisition. We performed an analysis of the fair values of the identifiable intangible assets acquired in this transaction. Based upon this analysis, the fair values of these components exceeded the cost of the acquired business by $559,000. Therefore, we reduced, on a pro-rata basis, the value attributed to the assets acquired. The value we attributed to the identifiable intangible assets acquired included $2.8 million in customer lists, $4.7 million in acquired technology and $2.0 million attributed to the non-compete agreement entered into by the parties. The customer lists, acquired technology, and non-compete agreement are included in our intangible assets and are being amortized over three years. As a result of the exercise of warrants to purchase shares of our series E convertible preferred stock during 2002, we issued an additional 7,869 shares of our common stock to The George Washington University pursuant to an anti-dilution provision in the Prometheus sales agreement. In addition, in April 2004, we issued an additional 27,447 shares of our common stock to The George Washington University as a result of the expected exercise of warrants held by others prior to the consummation of our IPO in June 2004.

      On January 31, 2003, we acquired the assets and liabilities of SA Cash, a division of Student Advantage, Inc., for $4.5 million in cash and assumed liabilities of $467,000. The acquisition was accounted for as a purchase and, accordingly, the results of operations have been included in the accompanying consolidated statements of operations since the effective date of the acquisition. We performed an analysis of the fair values of the identifiable intangible assets acquired in the transaction. The value attributed to the identifiable intangible assets acquired included $1.3 million in customer lists. The customer lists are included in intangible assets and are being amortized over five years.

      In August 2003, we invested $150,000 in an international joint venture with CERNET Corporation, a Chinese corporation whose owners include China’s Ministry of Education and ten leading Chinese universities. CERNET is the principal provider of Internet access to universities throughout China. This joint venture was established to market our products and services in China. We own 47% of the joint venture’s voting equity and CERNET owns 53%. We have determined that the joint venture is a variable interest entity under Financial Accounting Standards Board, or FASB, Interpretation No. 46, “Consolidation of Variable Interest Entities — an Interpretation of ARB No. 51”, or FIN 46, and that CERNET is the joint venture’s primary beneficiary. Accordingly, we are not required to consolidate the results of operations and financial condition of the joint venture with ours. The operations and financial position of the joint venture were immaterial to us as of and for the years ended December 31, 2003 and 2004.

Important Factors Considered by Management

      We consider several factors in evaluating both our financial position and our operating performance. These factors, while primarily focused on relevant financial information, also include other measures such

as general market and economic conditions, competitor information and the status of the regulatory environment.

      To understand our financial results, it is important to understand our business model and its impact on our consolidated financial statements. The accounting for the majority of our contracts requires us to initially record deferred revenue on our consolidated balance sheet upon invoicing the sale and then to recognize revenue in subsequent periods ratably over the term of the contract in our consolidated statements of operations. Therefore, to better understand our operations, one must look at both revenues and deferred revenues.

      In evaluating our product revenues, we analyze them in three categories: recurring ratable revenues, non-recurring ratable revenues and other product revenues.

      In the case of both recurring ratable revenues and non-recurring ratable revenues, an increase or decrease in the revenues in one period would be attributable primarily to increases or decreases in sales in prior periods. Unlike recurring ratable revenues, which benefit both from new license sales and from license renewals, non-recurring ratable revenues primarily reflect one-time sales that do not renew.

      Other factors that we consider in making strategic cash flow and operating decisions include cash flows from operations, capital expenditures, total operating expenses and earnings.

Results of Operations

      The following table sets forth selected statement of operations data expressed as a percentage of total revenues for each of the periods indicated.

      The following table sets forth, for each component of revenues, the cost of these revenues expressed as a percentage of the related revenues for each of the periods indicated.

      Revenues. Our total revenues for the year ended December 31, 2004 were $111.4 million, representing an increase of $18.9 million, or 20.5%, as compared to total revenues of $92.5 million for the year ended December 31, 2003.

      Product revenues, including both domestic and international, for the year ended December 31, 2004 were $98.6 million, representing an increase of $15.3 million, or 18.4%, as compared to product revenues of $83.3 million for the year ended December 31, 2003. A detail of our total product revenues by classification is as follows:

      The increase in recurring ratable revenues was primarily due to a $6.8 million increase in revenues from Blackboard Learning System licenses, a $3.5 million increase in hosting revenues, a $2.5 million increase in revenues from Blackboard Transaction System licenses, a $2.2 million increase in revenues from Blackboard Community System licenses and a $1.1 million increase in revenues from Blackboard Content System licenses. The increases in each of these categories were attributable to prior period sales to new and existing clients. As of December 31, 2004, we had a 5% increase in the number of clients as compared to December 31, 2003. Further, during 2004, our clients renewed or upgraded approximately 92% of the renewable licenses eligible to be renewed during 2004, which is consistent with 2003. The increase in Blackboard Learning System license revenues was also attributable to the continued shift from the Blackboard Learning System — Basic Edition to the enterprise version of the Blackboard Learning System and the resulting higher average pricing and contractual value of these licenses.

      The decrease in non-recurring ratable revenues was primarily due to decreased revenues from Blackboard Transaction System hardware products due to a decrease in sales and shipments of Blackboard Transaction System hardware during the year ended December 31, 2004 as compared to the year ended December 31, 2003.

      Of our total revenues, our international revenues for the year ended December 31, 2004 were $16.8 million, representing an increase of $4.3 million, or 34.4%, as compared to $12.5 million for the year ended December 31, 2003. International product revenues were $14.9 million, representing an increase of $3.5 million, or 30.6%, as compared to international product revenues of $11.4 million for the year ended December 31, 2003. The increase in international product revenues was driven primarily by an increase in recurring ratable revenues. This increase was primarily due to a $3.5 million increase in revenues from Blackboard Learning System licenses resulting from prior period sales to new and existing clients, including a prior period sale to one large international client. The increase in Blackboard Learning System revenues internationally was primarily attributable to the same factors that contributed to the increase in overall revenues for these products. The increase in international revenues also reflected our continued investment in increasing the size of our international sales force and international marketing efforts during 2003, which expanded our international presence and enabled us to sell more of our products to new and existing clients in our international markets.

      Professional services revenues for the year ended December 31, 2004 were $12.8 million, representing an increase of $3.6 million, or 39.6%, as compared to professional services revenues of $9.1 million for the year ended December 31, 2003. The increase in professional services revenues was primarily attributable to an increase in the number of enterprise licensees, which generally purchase greater volumes of our service offerings.

      Cost of product revenues. Our cost of product revenues for the year ended December 31, 2004 was $25.9 million, representing an increase of $2.8 million, or 12.2%, compared to $23.1 million for the year ended December 31, 2003. The increase in costs of product revenues was primarily due to a $3.0 million increase in hosting costs associated with the increase in number of hosting clients, a $2.5 million increase in our technical support group expenses primarily due to increased personnel-related costs to provide improved service to our clients and a $650,000 increase in costs related to the Blackboard Content System. These increases were offset primarily by a decrease in Blackboard Transaction System hardware costs due to the decrease in sales and shipments of Blackboard Transaction System hardware during the year ended December 31, 2004 as compared to the year ended December 31, 2003.

      Cost of product revenues as a percentage of product revenues decreased to 26.3% for the year ended December 31, 2004 from 27.7% for the year ended December 31, 2003, due primarily to the decrease in Blackboard Transaction System hardware sales and shipments during the year ended December 31, 2004. Blackboard Transaction System hardware sales generally have lower gross margins than our software product sales.

      Cost of professional services revenues. Our cost of professional services revenues for the year ended December 31, 2004 was $8.0 million, representing an increase of $1.3 million, or 20.1%, compared to $6.6 million for the year ended December 31, 2004. The increase in cost of professional services revenues

is primarily due to an increase in personnel-related costs directly related to the increase in professional services revenues. Cost of professional services revenues as a percentage of professional services revenues decreased to 62.3% for the year ended December 31, 2004 from 72.5% for the year ended December 31, 2003 primarily due to an increase in our internal utilization rates and an increase in hourly bill rates for the year ended December 31, 2004 as compared to the year ended December 31, 2003.

      Research and development expenses. Our research and development expenses for the year ended December 31, 2004 were $13.7 million, representing an increase of $2.3 million, or 20.6%, as compared to research and development expenses of $11.4 million for the year ended December 31, 2003. This increase was primarily attributable to a $900,000 increase in personnel-related costs, a $400,000 increase in professional services costs and a $375,000 increase in relocation and recruiting costs. These increases are due to an increase in headcount and development efforts related to our continued efforts to increase the functionality of our products.

      Sales and marketing expenses. Our sales and marketing expenses for the year ended December 31, 2004 were $35.2 million, representing an increase of $4.3 million, or 13.8%, as compared to sales and marketing expenses of $30.9 million for the year ended December 31, 2003. This increase was primarily attributable to a $2.8 million increase in personnel-related costs in our sales and marketing departments primarily due to an increase in marketing personnel headcount, higher average salaries due to annual salary increases during 2004, including revised incentive compensation plans for our sales persons during 2004, and increased recruiting costs to replace and increase the number of quota-bearing sales persons during 2004. The increase in sales and marketing expenses was further due to a $1.3 million increase in general marketing activities, which included our User Conference in March 2004 that was larger than in prior years, a $1.0 million increase in personnel-related costs associated with movement of some personnel to other functional areas within the company during 2003, and a $700,000 increase in reseller costs primarily related to one large sale to an international client in prior periods. These increases were offset primarily by a $2.2 million decrease in bad debt expense due to improved collections on our accounts receivable and collections on previously written off accounts from prior periods.

      General and administrative expenses. Our general and administrative expenses for the year ended December 31, 2004 were $14.9 million, representing an increase of $164,000, or 1.1%, from $14.7 million for the year ended December 31, 2003. This increase was primarily attributable to a $630,000 increase in personnel-related costs due to a $375,000 increase in bonus expense due to revised compensation packages for key employees in general and administrative functional departments, a $200,000 increase in employee compensation related to the hiring of senior management positions during 2004 and higher average salaries across all general and administrative functional departments due to annual salary increases in 2004. General and administrative expenses also increased due to a $300,000 increase in insurance expenses due to higher liability coverage associated with being a public company, a $200,000 increase in Delaware state franchise expenses due to increase in number of shares outstanding associated with our IPO in June 2004 and option exercises, a $200,000 increase in professional service costs associated with being a public company, a $150,000 increase in professional service costs related to the implementation of a new customer relationship management system and a $120,000 increase in rent expense associated with our obtaining additional space at our Washington, D.C. office location. These increases were offset primarily by a $750,000 decrease in legal and accounting expenses associated with litigation and international operations during the year ended December 31, 2003 and a $600,000 decrease in personnel-related costs associated with movement of some personnel to other functional areas within the Company during 2003.

      Net interest (expense) income. Our net interest income for the year ended December 31, 2004 was $315,000 compared to net interest expense of $470,000 for the year ended December 31, 2003. The increase in net interest income was primarily due to higher cash balances during the year ended December 31, 2004 than the year ended December 31, 2003 resulting from the receipt of proceeds from our IPO in June 2004 and repayment of outstanding debt during current and prior periods.

      Income taxes. Our provision for income taxes for the year ended December 31, 2004 was $299,000 compared to $614,000 for the year ended December 31, 2003. During 2004, the Internal Revenue Service

issued an Internal Revenue Bulletin — Revenue Procedure 2004-34, which allows for greater consistency between GAAP and income tax revenue recognition for companies that recognize revenues in a ratable manner. During 2004, we determined that we would adopt this method for our 2004 and subsequent income tax filings. As a result of this adoption, we will recognize cumulative income tax expense adjustments, which will decrease our federal and state taxable income by approximately $34.0 million, and we will have a net loss for federal income tax purposes but will be subject to certain international and state taxes in 2004. Further, we will not be subject to federal alternative minimum taxes as were incurred in 2003. The provision for income taxes for the year ended December 31, 2004 reflects this adoption.

      (Loss) income before cumulative effect of change in accounting principle. As a result of the foregoing, we reported income before the cumulative effect of change in accounting principle of $10.0 million for the year ended December 31, 2004, compared to a loss of $1.4 million for the year ended December 31, 2003.

      Revenues. Our total revenues for the year ended December 31, 2003 were $92.5 million, representing an increase of $22.6 million, or 32.3%, as compared to total revenues of $69.9 million for the year ended December 31, 2002.

      Product revenues, including both domestic and international, were $83.3 million, representing an increase of $20.9 million, or 33.5%, as compared to product revenues of $62.4 million for the year ended December 31, 2002. A detail of our total product revenues by classification is as follows:

      The increase in recurring ratable revenues was primarily due to a $7.1 million increase in revenues from Blackboard Learning System licenses, a $2.7 million increase in revenues from Blackboard Community System licenses, a $4.2 million increase in revenues from Blackboard Transaction System licenses and a $2.7 million increase in hosting revenues. The increases in each of these categories were attributable to prior period sales to new and existing clients, primarily due to a 14% increase in the number of clients at December 31, 2003 as compared to December 31, 2002 and the high renewal rate of our existing clients. During 2003, our clients renewed or upgraded 91% of the renewable licenses eligible to be renewed during that period, a rate that was approximately the same as the rate for 2002. The increase in Blackboard Learning System license revenues was also attributable to the continued shift from the Blackboard Learning System — Basic Edition to the enterprise version of the Blackboard Learning System and the resulting higher average pricing and contractual value of these licenses. The increase in non-recurring ratable revenues was primarily due to increased revenues from Blackboard Transaction System hardware products resulting from prior period sales to new and existing clients. Other product revenues increased primarily due to Blackboard One revenues resulting from our acquisition of the SA Cash division of Student Advantage, Inc. in January 2003.

      Of our total revenues, our international revenues for the year ended December 31, 2003 were $12.5 million, representing an increase of $4.1 million, or 48.8%, as compared to $8.4 million for the year ended December 31, 2002. International product revenues were $11.4 million, representing an increase of $3.9 million, or 52.0%, as compared to international product revenues of $7.5 million for the year ended December 31, 2002. The increase in international product revenues was driven primarily by an increase in recurring ratable revenues. This increase was primarily due to a $2.5 million increase in revenues from

Blackboard Learning System licenses and a $600,000 increase in revenues from Blackboard Community System licenses, in each case resulting from prior period sales to new and existing clients. The increase in Blackboard Learning System and Blackboard Community System revenues internationally was primarily attributable to the same factors that contributed to the increase in overall revenues for these products. The increase in international revenues also reflected our continued investment in increasing the size of our international sales force and international marketing efforts during 2003, which expanded our international presence and enabled us to sell more of our products to new and existing clients in our international markets.

      In addition, professional services revenues were $9.1 million, representing an increase of $1.5 million, or 19.7%, as compared to professional services revenues of $7.6 million for the year ended December 31, 2002. The increase in professional services revenues was primarily attributable to an increase in the number of enterprise licensees, which generally purchase greater volumes of our service offerings.

      Cost of product revenues. Our cost of product revenues for the year ended December 31, 2003 was $23.1 million, representing an increase of $1.6 million, or 7.4%, compared to $21.5 million for the year ended December 31, 2002. Cost of product revenues as a percentage of product revenues decreased to 27.7% for the year ended December 31, 2003 from 34.5% for the year ended December 31, 2002, due primarily to lower sublicense costs on the renewal of our licenses. The cost of sublicenses is generally lower after the initial year of the sale.

      Cost of professional services revenues. Our cost of professional services revenues for the year ended December 31, 2003 was $6.6 million, representing an increase of $886,000, or 15.4%, compared to $5.7 million for the year ended December 31, 2002. Cost of professional services revenues as a percentage of professional services revenues decreased to 72.5% for the year ended December 31, 2003 from 76.0% for the year ended December 31, 2002 primarily due to increased professional services revenues.

      Research and development expenses. Our research and development expenses for the year ended December 31, 2003 were $11.4 million, representing an increase of $1.1 million, or 10.7%, as compared to research and development expenses of $10.3 million for the year ended December 31, 2002. This increase was primarily attributable to increased employee costs due primarily to a $1.0 million increase in personnel-related costs in our research and development department for the year ended December 31, 2003 as compared to the prior year due to an increase in headcount related to our increased development efforts to increase the functionality of our products.

      Sales and marketing expenses. Our sales and marketing expenses for the year ended December 31, 2003 were $30.9 million, representing an increase of $6.7 million, or 27.8%, as compared to sales and marketing expenses of $24.2 million for the year ended December 31, 2002. This increase was primarily attributable to a $4.1 million increase in personnel-related costs in our sales department primarily due to a $2.5 million increase in employee compensation and a $950,000 increase in travel expenses related to an increase in headcount.

      General and administrative expenses. Our general and administrative expenses for the year ended December 31, 2003 were $14.7 million, representing a decrease of $1.7 million, or 10.5%, from $16.5 million for the year ended December 31, 2002. This decrease was due primarily to lower depreciation expense as a result of lower capital expenditures for general and administrative functional departments and reflecting that some assets were fully depreciated in 2002.

      Net interest expense. Our net interest expense for the year ended December 31, 2003 was $470,000, which was relatively unchanged from $509,000 for the prior year. Our interest expense was attributable primarily to our line of credit, the note payable to The George Washington University in connection with the Prometheus acquisition and equipment financing. As of December 31, 2003, the interest rates on our borrowings ranged from 4.5% to 9.0%.

      Income taxes. Our provision for income taxes for the year ended December 31, 2003 was $614,000 compared to $283,000 for the year ended December 31, 2002. This increase was primarily due to higher

state income taxes and federal alternative minimum taxes resulting from increased taxable income during 2003.

      Loss before cumulative effect of change in accounting principle. As a result of the foregoing, we reported a loss before the cumulative effect of change in accounting principle of $1.4 million for the year ended December 31, 2003, compared to $15.0 million for the year ended December 31, 2002.

Quarterly Results

      The following table sets forth selected statements of operations and cash flow data for each of the quarters in the years ended December 31, 2003 and 2004.

Liquidity and Capital Resources

      We recognize revenues ratably on annually renewable agreements, which results in deferred revenues. Deferred revenues as of December 31, 2004 were $67.1 million, representing an increase of $14.1 million, or 26.7%, from $52.9 million as of December 31, 2003. Deferred revenues increased due to the higher number of renewing licenses during 2004 than 2003, offset by the recognition of revenues from prior period sales.

      Our cash and cash equivalents were $98.1 million at December 31, 2004 as compared to $30.5 million at December 31, 2003.

      Net cash provided by operating activities was $32.7 million during the year ended December 31, 2004 as compared to $19.7 million during the year ended December 31, 2003. This change was primarily due to increased sales to new and existing clients and improved collections during the year ended December 31, 2004 as compared to the year ended December 31, 2003.

      Net cash used in investing activities was $7.4 million during the year ended December 31, 2004, a decrease of $2.1 million, or 21.9%, from $9.5 million during the year ended December 31, 2003. This decrease in cash usage was primarily due to our payment of the $4.5 million cash purchase price for the SA Cash division of Student Advantage, Inc. in January 2003. Exclusive of the SA Cash acquisition, investing activities increased $2.4 million for the year ended December 31, 2004 as compared to the year

ended December 31, 2003, primarily due to the purchase of internal telecommunications equipment and additional computer equipment for our hosting facility attributable to the increase in the number of clients purchasing our hosting offering.

      Net cash provided by financing activities was $42.4 million for the year ended December 31, 2004 as compared to net cash used in financing activities of $97,000 for the year ended December 31, 2003. This change was primarily due to the $50.9 million in proceeds from our IPO in June 2004, net of offering costs, offset by the $7.9 million repayment of our working capital line of credit in April 2004 and a total of $2.0 million in debt payments to The George Washington University in January 2004 and July 2004.

      We have an $8.0 million working capital line of credit and a $4.0 million equipment line of credit, each with Silicon Valley Bank. The working capital line of credit expires on April 30, 2005, at which time we intend to negotiate a new working capital line of credit. The interest rate on the working capital line is equal to the prime rate, effectively 5.25% as of December 31, 2004, and the interest rate on new advances under the equipment line is 9.0%. Prior borrowings under the equipment line had interest rates ranging from 6.0% to 9.0%. Pursuant to the terms of these lines of credit, we must comply with financial covenants that require us to maintain on a quarterly basis: specified revenue amounts; a quick ratio of 1.5; and positive earnings before interest, taxes, depreciation and amortization. For the quarter ended December 31, 2004, we were obligated to recognize revenues of at least $22.3 million. We were in compliance with all covenants as of December 31, 2004. If we were not compliant with these covenants, the bank would have the right to accelerate the debt under the equipment and working capital lines of credit. We have pledged all of our domestic assets to secure the working capital and equipment lines of credit. As of December 31, 2004, $762,000 was outstanding on the equipment lines and there was no amount outstanding on the working capital line of credit, each subject to covenants and restrictions. As of December 31, 2004, we had $7.9 million in borrowings available under the working capital line of credit due to letter of credit restrictions.

      We believe that our existing cash and cash equivalents and cash provided by operating activities will be sufficient to meet our working capital and capital expenditure needs over the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of introductions of new products or services, the timing of enhancements to existing products and services and the timing of capital expenditures. To the extent that available funds are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.

      We do not have any off-balance sheet arrangements with unconsolidated entities or related parties and accordingly, there are no off-balance sheet risks to our liquidity and capital resources from unconsolidated entities.

Obligations and Commitments

      As of December 31, 2004, debt principal payments, minimum future rental payments under noncancelable operating leases and rental income from subleases are as follows for the years below:

Seasonality

      Our operating results normally fluctuate as a result of seasonal variations in our business, principally due to the timing of client budget cycles and student attendance at client facilities. Historically, we have had lower new sales in our first and fourth quarters than in the remainder of the year. Our expenses, however, do not vary significantly with these changes and, as a result, such expenses do not fluctuate significantly on a quarterly basis. Historically, we have performed a disproportionate amount of our professional services, which are recognized as incurred, in our second and third quarters each year. In addition, deferred revenues can vary on a seasonal basis for the same reasons. We expect quarterly fluctuations in operating results to continue as a result of the uneven seasonal demand for our licenses and services offerings. This pattern may change, however, as a result of acquisitions, new market opportunities or new product introductions.

Recent Accounting Pronouncements

      In January 2003, the FASB issued FIN 46, which requires variable interest entities, often referred to as special purpose entities, or SPEs, to be consolidated if certain criteria are met. FIN 46 was effective upon issuance for all variable interest entities created after January 31, 2003 and effective July 1, 2003 for variable interest entities. In October 2003, the FASB issued FASB Staff Position No. FIN 46-6, “Effective Date of FASB Interpretation No. 46”, which defers the effective date of FIN 46 until December 31, 2003 for variable interest entities that existed prior to February 1, 2003. FIN 46-6, however, also provided that companies could adopt the provisions of FIN 46 effective July 1, 2003 for some or all of the variable interest entities in which they hold an interest. We have adopted the provisions of FIN 46 effective July 1, 2003. Currently, we have not consolidated any variable interest entities, and we do not believe the impact of adopting FIN 46 will have a material impact on our consolidated financial statements.

      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. SFAS 150 requires that an issuer classify certain financial instruments as a liability because they embody an obligation of the issuer. The remaining provisions of FAS 150 revise the definition of a liability to encompass certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer. The provisions of SFAS 150 require that any financial instruments that are mandatorily redeemable on a fixed or determinable date or upon an event certain to occur be classified as liabilities. Our mandatorily redeemable convertible preferred stock have been converted into common stock at the option of the stockholder, and therefore it is not classified as a liability under the provisions of SFAS 150.

      In August 2003, the FASB ratified the consensus reached by the EITF in Issue 03-5, “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software”. The issue addressed in this guidance is whether non-software deliverables included in an arrangement that contains software that is more than incidental to the products or services as a whole are included within the scope of SOP 97-2. The application of EITF 03-5 did not have a material impact on our consolidated financial statements during 2003 or 2004.

      On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, or SFAS 123(R), which is a revision of SFAS 123. SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative upon adopting SFAS 123(R).

      SFAS 123(R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. SFAS 123(R) permits public companies to adopt its requirements using one of two methods:

      The Company plans to adopt SFAS 123(R) using the modified prospective method on July 1, 2005.

Factors That Could Affect Future Results

      Although we achieved profitability for the year ended December 31, 2004 on a net income basis, we had not been profitable for a full calendar year previously, and we may not be profitable in future periods, either on a short-or long-term basis. We incurred a net loss of $41.7 million and $1.4 million for the years ended December 31, 2002 and 2003, respectively, and had net income of $10.0 million for the year ended December 31, 2004. As of December 31, 2004, we had an accumulated deficit of $122.6 million. We can give no assurance that operating losses will not occur in the future or that we will ever sustain profitability on a quarterly or annual basis.

      Our federal net operating loss carryforwards are subject to limitations in how much may be utilized on an annual basis. The use of the net operating loss carryforwards may have additional limitations resulting from certain future ownership changes or other factors. If our net operating loss carryforwards are further limited, and we have taxable income which exceeds the available net operating loss carryforwards for that period, we would incur an income tax liability even though net operating loss carryforwards may be available in future years prior to their expiration and our future cash flow, financial position and financial results may be negatively impacted.

      Our success will depend on our ability to generate revenues by providing enterprise software applications and services to colleges, universities, schools and other education providers. This market has only recently developed and the viability and profitability of this market is unproven. Our ability to grow our business will be compromised if we do not develop and market products and services that achieve broad market acceptance with our current and potential clients and their students and employees. The use of online education, transactional or content management software applications and services in the education industry may not become widespread and our products and services may not achieve commercial success. Even if potential clients decide to implement products of this type, they may still choose to design, develop or manage all or a part of their system internally.

      Given our clients’ relatively early adoption of enterprise software applications aimed at the education industry, they are likely to be less risk-averse than most colleges, universities, schools and other education providers. Accordingly, the rate at which we have been able to establish relationships with our clients in the past may not be indicative of the rate at which we will be able to establish additional client relationships in the future.

      Our success will depend in part upon the continued adoption by our clients and potential clients of online education initiatives. Some academics and educators are opposed to online education in principle and have expressed concerns regarding the perceived loss of control over the education process that can result from offering courses online. Some of these critics, particularly college and university professors, have the capacity to influence the market for online education, and their opposition could reduce the demand for our products and services. In addition, the growth and development of the market for online education may prompt some members of the academic community to advocate more stringent protection of intellectual property associated with course content, which may impose additional burdens on clients and potential clients offering online education. This could require us to modify our products, or could cause these clients and potential clients to abandon their online education initiatives.

      Our expense levels are based, in significant part, on our estimates of future revenues and are largely fixed in the short term. As a result, we may be unable to adjust our spending in a timely manner if our revenues fall short of our expectations. Accordingly, any significant shortfall of revenues in relation to our expectations would have an immediate and material effect on our results of operations. In addition, as our business grows, we anticipate increasing our operating expenses to expand our product development, technical support, sales and marketing and administrative organizations. Any such expansion could cause material losses to the extent we do not generate additional revenues sufficient to cover the additional expenses.

      Our clients have no obligation to renew their licenses for our products after the expiration of the initial license period or subsequent license periods, which are typically one year, and some clients have elected not to do so. A decline in license renewal rates could cause our revenues to decline. Although we have experienced favorable license renewal rates in recent periods, we have limited historical data with respect to rates of renewals, so we cannot accurately predict future renewal rates. Our license renewal rates may decline or fluctuate as a result of a number of factors, including client dissatisfaction with our products and services, our failure to update our products to maintain their attractiveness in the market or budgetary constraints or changes in budget priorities faced by our clients.

      We introduced our newest software application, the Blackboard Content System,in March 2004. Our ability to grow our business will depend, in part, on client acceptance of this product, which is currently unproven. If we are not successful in gaining widespread market acceptance of this product, our revenues may fall below our expectations, which could cause our stock price to decline.

      We recognize most of our revenues from clients monthly over the terms of their agreements, which are typically 12 months, although terms can range from one month to 48 months. As a result, much of the revenue we report in each quarter is attributable to agreements entered into during previous quarters. Consequently, a decline in sales, client renewals, or market acceptance of our products in any one quarter will not necessarily be fully reflected in the revenues in that quarter, and will negatively affect our revenues and profitability in future quarters. This ratable revenue recognition also makes it difficult for us to rapidly increase our revenues through additional sales in any period, as revenues from new clients must be recognized over the applicable agreement term.

      Because our professional services revenues typically have lower gross margins than our product revenues, an increase in the percentage of total revenues represented by professional services revenues could have a detrimental impact on our overall gross margins, and could adversely affect our operating results. In addition, we sometimes subcontract professional services to third parties, which further reduces our gross margins on these professional services. As a result, an increase in the percentage of professional services provided by third-party consultants could lower our overall gross margins.

      Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. In the past, we have encountered product development delays and defects in our products. We would expect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products could lead to:

      Because our clients use our products to store and retrieve critical information, we may be subject to significant liability claims if our products do not work properly. We cannot be certain that the limitations of liability set forth in our licenses and agreements would be enforceable or would otherwise protect us from liability for damages. A material liability claim against us, regardless of its merit or its outcome, could result in substantial costs, significantly harming our business reputation and divert management’s attention from our operations.

      The sales cycle between our initial contact with a potential client and the signing of a license with that client typically ranges from 6 to 15 months. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of sales. A delay in or failure to complete license transactions could harm our business and financial results, and could cause our financial results to vary significantly from quarter to quarter. Our sales cycle varies widely, reflecting differences in our potential clients’ decision-making processes, procurement requirements and budget cycles, and is subject to significant risks over which we have little or no control, including:

      Potential clients typically conduct extensive and lengthy evaluations before committing to our products and services and generally require us to expend substantial time, effort and money educating them as to the value of our offerings.

      As we target more of our sales efforts at international postsecondary education providers and U.S. K-12 schools, we could face greater costs, longer sales cycles and less predictability in completing some of our sales, which may harm our business. In both of these markets, a potential client’s decision to use our products and services may be a decision involving multiple institutions and, if so, these types of sales would require us to provide greater levels of education to prospective clients regarding the use and benefits

of our products and services. In addition, we expect that potential clients in both of these markets may demand more customization, integration services and features. As a result of these factors, these sales opportunities may require us to devote greater sales support and professional services resources to individual sales, thereby increasing the costs and time required to complete sales and diverting sales and professional services resources to a smaller number of international and U.S. K-12 transactions.

      We may be unable to operate our business profitably if we fail to manage our growth. We have experienced significant expansion since our inception, which has sometimes strained our managerial, operational, financial and other resources. Future growth could continue to strain our resources. Our failure to successfully manage growth and to continue to refine our financial controls and accounting and reporting systems and to add and retain personnel that adequately support our growth would disrupt our business.

      Our future success depends upon the continued service of our key management, technical, sales and other critical personnel. Whether we are able to execute effectively on our business strategy will depend in large part on how well key management and other personnel perform in their positions and are integrated within our company. Key personnel have left our company over the years, and there may be additional departures of key personnel from time to time. In addition, as we seek to expand our global organization, the hiring of qualified sales, technical and support personnel has been difficult due to the limited number of qualified professionals. Failure to attract, integrate and retain key personnel would result in disruptions to our operations, including adversely affecting the timeliness of product releases, the successful implementation and completion of company initiatives and the results of our operations.

      Our future success and our ability to pursue our growth strategy will depend to a significant extent on the continued service of our key management personnel, including Michael L. Chasen, our chief executive officer and president, and Matthew L. Pittinsky, our chairman. Although we have employment agreements with several of our executive officers, including Mr. Chasen and Mr. Pittinsky, these agreements do not obligate them to remain employed by us. The loss of services of any key management personnel could make it more difficult to successfully pursue our business goals.

      Our software applications can be used with a variety of third-party applications used by our clients to extend the functionality of our products, which we believe contributes to the attractiveness of our products in the market. If we are not able to maintain the compatibility of our products with third-party applications, demand for our products could decline and we could lose sales. We may desire in the future to make our products compatible with new or existing third-party applications that achieve popularity within the education marketplace, and these third-party applications may not be compatible with our designs. Any failure on our part to modify our applications to ensure compatibility with such third-party applications would reduce demand for our products and services.

      If we are unable to protect our intellectual property, our competitors could use our intellectual property to market products similar to our products, which could decrease demand for our products. In addition, we may be unable to prevent the use of our products by persons who have not paid the required license fee, which could reduce our revenues. We rely on a combination of copyright, trademark and trade secret laws, as well as licensing agreements, third-party nondisclosure agreements and other contractual provisions and technical measures, to protect our intellectual property rights. These protections may not be

adequate to prevent our competitors from copying or reverse-engineering our products. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology. To protect our trade secrets and other proprietary information, we require employees, consultants, advisors and collaborators to enter into confidentiality agreements. These agreements may not provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. The protective mechanisms we include in our products may not be sufficient to prevent unauthorized copying. Existing copyright laws afford only limited protection for our intellectual property rights and may not protect such rights in the event competitors independently develop products similar to ours. In addition, the laws of some countries in which our products are or may be licensed do not protect our products and intellectual property rights to the same extent as do the laws of the United States.

      A third party may assert that our technology violates its intellectual property rights. As the number of software products in our markets increases and the functionality of these products further overlap, we believe that infringement claims will become more common. Any claims, regardless of their merit, could:

      One of our key growth strategies is to pursue international expansion. Expansion of our international operations may require significant expenditure of financial and management resources and result in increased administrative and compliance costs. As a result of such expansion, we will be increasingly subject to the risks inherent in conducting business internationally, including:

      Maintaining the security of online education and transaction networks is an issue of critical importance for our clients because these activities involve the storage and transmission of proprietary and confidential client and student information, including personal student information and consumer financial data, such as credit card numbers. Individuals and groups may develop and deploy viruses, worms and other malicious software programs that attack or attempt to infiltrate our products. If our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise, we could be subject to liability or our business could be interrupted. Penetration of our network security could have a negative impact on our reputation and could lead our present and potential clients to choose competitive offerings. Even if we do not encounter a security breach ourselves, a well-publicized breach of the consumer data security of any major consumer Web site could lead to a general public loss of confidence in the use of the Internet, which could significantly diminish the attractiveness of our products and services.

      During the course of our history, we have acquired several businesses, and a key element of our growth strategy is to pursue additional acquisitions in the future. Any acquisition could be expensive, disrupt our ongoing business and distract our management and employees. We may not be able to identify suitable acquisition candidates, and if we do identify suitable candidates, we may not be able to make these acquisitions on acceptable terms or at all. If we make an acquisition, we could have difficulty integrating the acquired technology, employees or operations. In addition, the key personnel of the acquired company may decide not to work for us. Acquisitions also involve the risk of potential unknown liabilities associated with the acquired business.

      As a result of these risks, we may not be able to achieve the expected benefits of any acquisition. If we are unsuccessful in completing or integrating acquisitions that we may pursue in the future, we would be required to reevaluate our growth strategy and we may have incurred substantial expenses and devoted significant management time and resources in seeking to complete and integrate the acquisitions.

      Future business combinations could involve the acquisition of significant intangible assets. We currently record in our statements of operations ongoing significant amortization of intangible assets acquired in connection with our historic acquisitions, and may need to recognize similar charges in connection with any future acquisitions. In addition, we may need to record write-downs from future impairments of identified intangible assets and goodwill. These accounting charges would reduce any future reported earnings, or increase a reported loss. In addition, we could use substantial portions of our available cash to pay the purchase price for acquisitions. We could also incur debt to pay for acquisitions, or issue additional equity securities as consideration for these acquisitions, which could cause our stockholders to suffer significant dilution.

      Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of the hosting service we provide to some of our clients. We provide remote hosting through computer hardware that is currently located in third-party co-location facilities in Virginia. We do not control the operation of these co-location facilities. Lengthy interruptions in our hosting service could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems at the co-location facilities or if these co-location facilities were to close without adequate notice. Although we have multiple transmission lines into the co-location facilities through two telecommunications service providers, we have experienced problems of this nature from time to time in the past, and we

will continue to be exposed to the risk of network failures in the future. We currently do not have adequate computer hardware and systems to provide alternative service for most of our hosted clients in the event of an extended loss of service at either co-location facility. Each co-location facility provides data backup redundancy for the other co-location facility, however, is not equipped to provide full disaster recovery to all of our hosted clients. If there are operational failures in our network infrastructure that cause interruptions, slower response times, loss of data or extended loss of service for our remotely hosted clients, we may be required to issue credits or pay penalties, current hosting clients may terminate their contracts or elect not to renew them, and we may lose sales to potential hosting clients.

      We are investing in establishing a new hosting facility in Europe. The completion of the facility may require more time or money than we anticipate and we may encounter technical difficulties that we do not foresee. If we have any unanticipated problems or delays in completing the facility, we may lose current clients or sales to new clients or need to incur additional expenses.

      We operate in highly competitive markets and generally encounter intense competition to win contracts. If we are unable to successfully compete for new business and license renewals, our revenue growth and operating margins may decline. The markets for online education, transactional, portal and content management products are intensely competitive and rapidly changing, and barriers to entry in such markets are relatively low. With the introduction of new technologies and market entrants, we expect competition to intensify in the future. Some of our principal competitors offer their products at a lower price, which has resulted in pricing pressures. Such pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of our product and service offerings to achieve or maintain more widespread market acceptance.

      Our primary competitors for the Blackboard Academic Suite are companies that provide course management systems, such as WebCT, Inc., eCollege.com, Desire2Learn Inc., ANGEL Learning, Inc. and Jenzabar, Inc. learning content management systems, such as HarvestRoad Ltd. and Concord USA, Inc., and education enterprise information portal technologies, such as SunGard SCT Inc., an operating unit of SunGard Data Systems Inc. We also face competition from clients and potential clients who develop their own applications internally, large diversified software vendors who offer products in numerous markets including the education market and open source software applications such as Moodle and Sakai. Our primary competitors for the Blackboard Commerce Suite are companies that provide university transaction systems, such as Diebold, Incorporated’s Card Systems division and The CBORD Group, Inc., as well as off-campus merchant relationship programs.

      We may also face competition from potential competitors that are substantially larger than we are and have significantly greater financial, technical and marketing resources, and established, extensive direct and indirect channels of distribution. As a result, they may be able to respond more quickly to new or emerging technologies and changes in client requirements, or to devote greater resources to the development, promotion and sale of their products than we can. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or prospective clients. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share to our detriment.

      The growing acceptance and prevalence of open source software may make it easier for competitors or potential competitors to develop software applications that compete with our products, or for clients and potential clients to internally develop software applications that they would otherwise have licensed from us. One of the aspects of open source software is that it can be modified or used to develop new software

that competes with proprietary software applications, such as ours. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies which may pose a challenge to our business model. As open source offerings become more prevalent, customers may defer or forego purchases of our products which could reduce our sales and lengthen the sales cycle for our products. If we are unable to differentiate our products from competitive products based on open source software, demand for our products and services may decline and we may face pressure to reduce the prices of our products.

      Most of our clients and potential clients are colleges, universities, schools and other education providers who depend substantially on government funding. Accordingly, any general decrease, delay or change in federal, state or local funding for colleges, universities, schools and other education providers could cause our current and potential clients to reduce their purchases of our products and services, to exercise their right to terminate licenses, or to decide not to renew licenses, any of which could cause us to lose revenues. In addition, a specific reduction in governmental funding support for products such as ours would also cause us to lose revenues.

      The application of existing laws and regulations potentially applicable to the Internet, including regulations relating to issues such as privacy, defamation, pricing, advertising, taxation, consumer protection, content regulation, quality of products and services and intellectual property ownership and infringement, can be unclear. It is possible that U.S., state and foreign governments might attempt to regulate Internet transmissions or prosecute us for violations of their laws. In addition, these laws may be modified and new laws may be enacted in the future, which could increase the costs of regulatory compliance for us or force us to change our business practices. Any existing or new legislation applicable to us could expose us to substantial liability, including significant expenses necessary to comply with such laws and regulations, and dampen the growth in use of the Internet.

      Specific federal laws that could also have an impact on our business include the following:

      Our clients’ use of our software as their central platform for online education initiatives may make us subject to any such laws or regulations, which could impose significant additional costs on our business or subject us to additional liabilities.

      Our transaction processing product and service offering could be subject to state and federal financial services regulation. The Blackboard Transaction System supports the creation and management of student debit accounts and the processing of payments against those accounts for both on-campus vendors and off-campus merchants. For example, one or more federal or state governmental agencies that regulate or monitor banks or other types of providers of electronic commerce services may conclude that we are engaged in banking or other financial services activities that are regulated by the Federal Reserve under

the U.S. Federal Electronic Funds Transfer Act or Regulation E thereunder or by state agencies under similar state statutes or regulations. Regulatory requirements may include, for example:

      A number of states have enacted legislation regulating check sellers, money transmitters or transaction settlement service providers as banks. If we were deemed to be in violation of any current or future regulations, we could be exposed to financial liability and adverse publicity or forced to change our business practices or stop selling some of our products and services. As a result, we could face significant legal fees, delays in extending our product and services offerings, and damage to our reputation that could harm our business and reduce demand for our products and services. Even if we are not required to change our business practices, we could be required to obtain licenses or regulatory approvals that could cause us to incur substantial costs.

      Our principal exposure to market risk relates to changes in interest rates. At December 31, 2004, we had no amounts outstanding under our line of credit, which bears interest at a floating rate equal to the prime rate (5.25% as of December 31, 2004). An increase in the interest rate on this line of credit would not affect our interest expense, assuming no change in our current outstanding borrowing balance.

      The interest rates on our equipment facility are fixed. The fair value of our fixed rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the fair value of our debt due to differences between market interest rates and rates in effect at the inception of our debt obligation. Changes in the fair value of our fixed rate debt have no impact on our cash flows or consolidated financial statements.

      Interest income on our cash and cash equivalents is subject to interest rate fluctuations, but we believe that the impact of such fluctuations does not have a material effect on our financial position because of the short-term nature of the relevant financial instruments. For the quarter ending December 31, 2004, a 100 basis-point adverse change in interest rates would have reduced our interest income for the quarter ended December 31, 2004 by approximately $230,000.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

Blackboard Inc.

      We have audited the accompanying consolidated balance sheets of Blackboard Inc. as of December 31, 2003 and 2004, and the related consolidated statements of operations, shareholders’ (deficit) equity, and cash flows for each of the three years in the period ended December 31, 2004. 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 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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.

      In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Blackboard Inc. at December 31, 2003 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

McLean, VA

January 27, 2005

BLACKBOARD INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes.

BLACKBOARD INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes.

BLACKBOARD INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY

See accompanying notes.

BLACKBOARD INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS