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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2004

Commission File No. 000-50570

ALPHASMART INC.

(Exact name of Registrant as specified in its charter)

973 University Avenue

Los Gatos, CA 95032

(408) 355-1000

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

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

None

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

Common Stock, par value $.0001 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 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  ¨

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 the 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.

Yes  þ    No  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  þ

Based on the closing sale price of the Common Stock on the NASDAQ National Market System on June 30, 2004, the aggregate market value of the voting Common Stock held by non-affiliates of the Registrant was approximately $15,260,000. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares outstanding of the Registrant’s Common Stock, $.0001 par value, was 14,897,549 on February 22, 2005.

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ALPHASMART, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

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PART I

Overview

AlphaSmart is a provider of affordable, portable personal learning solutions for the K-12 classroom. AlphaSmart’s portable personal learning solutions include computer-companion products that are designed to improve and assess students’ academic skills, increase teachers’ classroom productivity, and reduce administrators’ total cost of ownership for district-wide technology literacy and access. AlphaSmart’s computer-companion products are based on three rugged hardware platforms: the Neo by AlphaSmart, the Dana by AlphaSmart and the AlphaSmart 3000 platform that it sells to schools and school districts. An AlphaSmart solution consists of these devices with integrated keyboard, display, and proprietary or licensed operating system and basic application software. They are further enhanced with instructional and assessment software for specific educational subjects as well as management tools for teachers.

On January 24, 2005 AlphaSmart entered into an Agreement and Plan of Merger and Reorganization with Renaissance Learning, Inc. Under the terms of this agreement, Renaissance Learning, Inc. will acquire AlphaSmart in a two step-merger, and each AlphaSmart stockholder will be entitled to receive $3.75 for each share of AlphaSmart stock, with the option to be paid in cash, Renaissance Learning, Inc. common stock or some combination of the two, subject to pro-ration so that the total consideration paid will aggregate no more than 45% stock and no less than 55% cash. Renaissance Learning, Inc. intends to operate the AlphaSmart business in a wholly owned subsidiary, and the merger is expected to close sometime in the second quarter of 2005.

AlphaSmart’s Products

AlphaSmart’s platforms incorporate a number of supporting product categories, including management tools and proprietary, licensed and third party software applications. The device itself constitutes the core of each platform, and a series of products can be built upon each platform.

Neo by AlphaSmart and the AlphaSmart 3000 Platform.    The Neo by AlphaSmart platform, introduced in 2004, is AlphaSmart’s fifth generation AlphaSmart product. Neo is an easy to use, lightweight, affordable computer companion. Designed for use by multiple students, Neo’s long battery life, full-featured word processor, and expandable functions make it suitable for writing, keyboarding, and quizzing for the entire classroom. Neo provides a display that is 50% larger than the AlphaSmart 3000’s display. AlphaWord Plus, which comes standard on every Neo, is an enhanced word processor with spell check, thesaurus, writing tools, and Spanish-English word lookup. Neo has twice the memory of the AlphaSmart 3000, allowing users to add additional SmartApplets that increase Neo’s functionality in the classroom.

The AlphaSmart 3000 platform, introduced in 2000, is AlphaSmart’s fourth generation AlphaSmart product. The AlphaSmart 3000 system software, which provides the backbone for running AlphaSmart’s proprietary, licensed and third party software, or SmartApplets, is included with every AlphaSmart 3000. AlphaWord, a word processor, and a calculator are also included as standard software applications with every AlphaSmart 3000.

AlphaSmart expects that the Neo will eventually replace the AlphaSmart 3000 over the course of the remainder of 2005.

Device.    The Neo and the AlphaSmart 3000 are devices that include a full size keyboard with a display. They each weigh less than two pounds, are designed to withstand a drop from up to six feet without damage and are under warranty for three years. The devices run on three AA batteries with up to 700 hours of battery life and also include a rechargeable battery option. Other features include Instant-On, AutoSave and AutoOff capabilities and storage files with a total capacity of over 100 pages of text.

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SmartApplets.    AlphaSmart refers to its proprietary, licensed and third party application software that can be added to the Neo and AlphaSmart 3000’s system software as SmartApplets. The SmartApplets include:

Management Tools.    AlphaHub connects up to thirty devices (Neos or AlphaSmart 3000s) simultaneously to a teacher’s computer, allowing simultaneous transfer of files and software between each AlphaSmart 3000 and the teacher’s PC. The AlphaSmart Manager software included with the AlphaHub allows simple configuration of device settings, passwords and other aspects of the platform.

Dana by AlphaSmart Platform.

Dana.    AlphaSmart began shipping Dana devices in October 2002. Dana is a Palm OS-based computing device that weighs less than two pounds and includes a full size keyboard, with a wide, 7.5 inch by 2.25 inch touchscreen display with graphical capability. The Dana devices have expansion and communication options and include a rechargeable battery with runtime exceeding 25 hours, two USB ports and two industry-standard expansion slots. Dana is sold with a one-year warranty and is designed to withstand a drop from up to three feet without damage.

Dana Wireless.    AlphaSmart began shipping Dana Wireless devices in August 2003. Dana Wireless has the functionality of AlphaSmart’s standard Dana device, but also has built-in wireless network connectivity using IEEE Standard 802.11(b), commonly referred to as WiFi, which enables e-mail, web browsing and instant messaging. AlphaSmart believes that this connectivity, when combined with the Dana by AlphaSmart platform’s low total cost of ownership and targeted functionality and durability, will provide teachers with a valuable classroom tool and facilitate teacher-student communication and student collaboration. Dana Wireless is also well suited for research-based web browsing. Further, AlphaSmart believes Dana Wireless will help schools reduce the physical inconvenience and high infrastructure costs involved in delivering connectivity to each student’s desk.

Management Tools.    Dana Admin, AlphaSmart’s Dana platform management tool, allows teachers and administrators to restrict the Dana programs that students can use, and an AlphaHub provides recharging for up to 30 Dana devices at once in bundled configuration. Unlike the AlphaSmart 3000 platform, the Dana by AlphaSmart platform does not currently include software that allows a teacher to communicate with 30 devices simultaneously, although AlphaSmart expects to have this software available in the second quarter of 2005.

Standard Application Software.    All Dana devices include an extended version of the Palm OS 4.1 operating system and AlphaSmart’s proprietary word processing application. Several other third party software applications are included as standard, including the following:

Additional Application Software.    AlphaSmart’s customers can also include the following software applications in their Dana by AlphaSmart platforms:

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Customers can obtain these applications from AlphaSmart, or directly from third parties. Each of these applications is wide-screen enabled for the Dana by AlphaSmart platform.

Additional Application Software Available from Third Parties.    AlphaSmart’s customers can also obtain application software directly from third parties that create software for Palm OS-enabled devices, including more than 150 education-related commercially available applications.

Customers

AlphaSmart’s customers primarily consist of schools and school districts in the United States, Canada and Europe, and AlphaSmart has sold to over half of the school districts in the United States. During each of the years ended December 31, 2004 and 2003, AlphaSmart’s top 10 customers accounted for less than 10% of AlphaSmart’s net revenue.

Sales

AlphaSmart sells domestically and internationally through both direct and indirect channels. AlphaSmart also considers its presence at trade shows and conferences, its evaluation program, its training program and its customer care program to be important components of its sales process. As of December 31, 2004, AlphaSmart had thirty-three employees and three independent contractors in its sales function. AlphaSmart generally experiences higher revenue in its second and third quarters as a result of the U.S. K-12 budget cycle.

U.S. Sales.    U.S. sales were 87% of AlphaSmart’s net revenue for the year ended December 31, 2004, 89% of AlphaSmart’s net revenue for the year ended December 31, 2003, and 92% of AlphaSmart’s net revenue for the year ended December 31, 2002.

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Direct Sales.    As of December 31, 2004, AlphaSmart’s direct sales force consisted of ten company-employed regional sales representatives, two regional sales managers, one national sales director, one vice president of world wide sales, three independent sales representatives, four telemarketers and one telemarketing manager. AlphaSmart’s primary U.S. sales office is located in Los Gatos, California. Within their designated region, these direct sales people sell AlphaSmart’s platforms, identify new potential customers, locate potential private and public educational funding sources, attend trade shows, provide direction to the telemarketing group, forecast sales and build direct key customer relationships. AlphaSmart compensates its direct sales employees with salaries and quota-based commissions. In addition to the field sales force, the four telemarketers make telephone contact with potential customers and key education decision makers, follow-up on trade show leads from AlphaSmart’s direct sales force, promote AlphaSmart’s product evaluation program, convert the related evaluation trials to sales, handle referral sales calls from AlphaSmart’s customer care call center, manage their sales pipeline and forecast their sales on a quarterly basis. Also, any U.S. customer who wishes to order with a credit card may purchase an AlphaSmart 3000 or Dana by AlphaSmart platform and a variety of accessory items through AlphaSmart’s online store.

Indirect Sales.    Until June 30, 2003, AlphaSmart received a portion of its net revenue through its catalog-based channel. AlphaSmart discontinued these arrangements and is now conducting these sales through direct channels. Also, AlphaSmart has entered into an agreement with value-added reseller Don Johnston, Inc. under which Don Johnston is adding its software solutions to AlphaSmart’s devices and marketing and selling those devices. AlphaSmart generally offers its products to value-added resellers, or VARs, at a negotiated discount to its suggested retail price, which the VARs then integrate with additional software and other product offerings. AlphaSmart is continually seeking to expand its distribution channels and intends to enter into additional agreements with value-added resellers.

International Sales.    AlphaSmart’s international sales, the majority of which are in the United Kingdom, are primarily conducted through indirect channels. As of December 31, 2004, AlphaSmart’s international sales force consisted of four sales managers. International sales accounted for 13% of AlphaSmart’s total sales for the year ended December 31, 2004, 11% of AlphaSmart’s total sales for the year ended December 31, 2003, and 8% of AlphaSmart’s total sales for the year ended December 31, 2002.

Trade Shows and Conferences.    AlphaSmart believes that trade shows and conferences focused on technology in education provide an excellent opportunity to expose a large number of teachers, administrators, principals, technology coordinators and other decision-makers to its platforms and their potential benefits.

Evaluation Program.    AlphaSmart has developed an evaluation program that allows potential customers to evaluate its devices for a period of two to four weeks, providing them hands-on experience with the device. AlphaSmart markets this evaluation program through advertising and flyers and on its website.

Training.    AlphaSmart provides training workshops, or AlphaSmart Certified Training Academies, for professional trainers that certify them to conduct and charge for training sessions. AlphaSmart offers hands-on training for teachers, administrators and other trainers that help them integrate AlphaSmart’s products into the classroom. Each training session is conducted by AlphaSmart-trained and certified personnel and includes both hands-on training as well as workbooks. In addition to the basic operation of AlphaSmart’s platforms, the workshops cover specific applications and solutions that enable teachers to fully benefit from the features of AlphaSmart’s platforms. AlphaSmart believes that personal contact with its customers through training has a number of ancillary benefits, including reduction of customer support requirements following installation as well as additional sales, either within the specific school or within the district.

Customer Care.    A key component of AlphaSmart’s sales strategy is providing high-quality customer care. AlphaSmart believes that, because of the limitations of a daily class schedule and lack of on-site support, teachers need prompt customer care. AlphaSmart’s technical support and repair center, located in Red Bluff, California, as well as its customer service center in Irving, Texas, service the U.S. market. AlphaSmart’s

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European customer care is handled through AlphaSmart’s customer care and logistics center in Stockton-on-Tees, United Kingdom.

Marketing

As of December 31, 2004, AlphaSmart employed seven employees in its marketing department, which includes product management, product marketing and graphics design. Because AlphaSmart believes hands-on experience with AlphaSmart products is AlphaSmart’s best selling tool, AlphaSmart focuses its attention on exposing as many decision making educators as possible to its platforms. AlphaSmart employs a number of marketing tools in the sales cycle, all of which are designed to promote brand awareness and product exposure. Also, due to the growing number of AlphaSmart users, AlphaSmart established an online community that allows teachers from anywhere in the world to share their ideas and unique applications with other teachers who use its platforms. AlphaSmart’s marketing department also directs product management, which includes product positioning, pricing and interacting with the product development team.

Product Development and Technology

AlphaSmart believes it must continue to invest in product development and technology to remain competitive in the education technology market. AlphaSmart currently has nine employees dedicated to the design process. AlphaSmart’s product development staff has a high level of expertise in hardware design and software development for the educational market as well as testing, quality assurance, hardware/software integration and technical writing.

Intellectual Property

AlphaSmart’s devices include proprietary system software, and the Dana by AlphaSmart platform also includes the Palm OS operating system. AlphaSmart’s platforms include a number of additional applications and SmartApplets that expand functionality into different curricula.

The success of AlphaSmart’s Dana platform depends on AlphaSmart’s relationship with PalmSource. In June 2001 AlphaSmart entered into a software license agreement with PalmSource, Inc. permitting AlphaSmart to incorporate Palm OS software, technology and trademarks into AlphaSmart’s Dana platform. AlphaSmart’s Palm OS license requires the payment of royalties and maintenance and support fees to PalmSource. The license is non-exclusive, and PalmSource may continue to license the Palm OS to others, including AlphaSmart’s competitors. AlphaSmart’s license agreement with PalmSource extends until December 2008 and may be renewed if both parties agree. AlphaSmart’s license with PalmSource provides that PalmSource may allow AlphaSmart to examine or modify the source code to the Palm OS software. If an entity that develops, manufactures, markets and/or distributes handheld or mobile computing devices or related operating systems software acquires more than 20% of AlphaSmart’s outstanding stock or directly merges with AlphaSmart, AlphaSmart would be required to return any source code that AlphaSmart have obtained and AlphaSmart’s right to examine or modify source code would terminate. In addition, AlphaSmart must obtain PalmSource’s written consent to assign the agreement, which consent shall not be unreasonably withheld, except that AlphaSmart may assign the agreement one time without such consent to a wholly owned subsidiary.

For the AlphaSmart 3000 platform, SmartApplets include proprietary software as well as software and content developed by or licensed from third parties. AlphaSmart currently has relationships with a number of third party developers pursuant to which AlphaSmart licenses content for which AlphaSmart internally creates the software applications. One of the AlphaSmart 3000 applications that AlphaSmart has internally developed is KeyWords, which AlphaSmart licenses from Renaissance Learning, Inc. AlphaSmart also licenses the SmartApplet technology and brand to third party developers, who then develop technology for AlphaSmart’s platforms. For example, Don Johnston, Inc. is the third party developer of the Co: Writer SmartApplet. AlphaSmart has also internally developed and branded several applications for AlphaSmart’s platforms, including AlphaWord and AlphaQuiz. AlphaQuiz is a

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group of programs including QuizDesigner, QuizManager and the AlphaQuiz SmartApplet that can integrate third party content to help teachers expand their testing and assessment capabilities.

AlphaSmart licenses from a third party the right to use the one button send feature included in its AlphaSmart 3000 and Dana devices. The license requires the payment of royalty fees and is valid for the remaining life of the patent issued on the one button send feature, which expires in 2008. The license is non- exclusive and the licensor may continue licensing the technology to other parties, including AlphaSmart’s competitors. This license may be assigned in connection with the sale of all or substantially all of AlphaSmart’s assets or the sale of a controlling interest in AlphaSmart. If AlphaSmart loses the right to use this technology, AlphaSmart would be required to either license alternative methods of delivering the functionality currently provided by the one button send feature or design around the patent. However, AlphaSmart cannot provide assurances that such alternatives will be available, or that such alternatives will be as effective and cost efficient as the technology AlphaSmart currently uses.

To protect its intellectual property, AlphaSmart generally enters into confidentiality or license agreements with its employees, consultants and alliance members and controls access to and limits distribution of its proprietary technology. AlphaSmart also owns five trademark registrations and one application in the United States and a total of 17 trademark registrations and one application in other countries. AlphaSmart holds two U.S. patents and two foreign patents. Of the two U.S. patents, one expires in 2015, and the other expires in 2020. The two foreign patents expire in 2016. AlphaSmart does not currently use these patents to protect its core technology.

Competition

The education technology solutions market is highly competitive and AlphaSmart expects competition to increase in the future. The principal competitive factors in AlphaSmart’s market are specific purpose functionality, total cost of ownership, durability, reputation, brand awareness, service and support. AlphaSmart believes that it compares favorably to many current competitors with respect to some or all of these factors. Many of AlphaSmart’s direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than AlphaSmart does. These competitors may be able to respond more rapidly than AlphaSmart can to changes in preferences or requirements in the educational technology market or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their platforms than AlphaSmart does. Furthermore, there are a number of significantly larger companies with which AlphaSmart does not currently compete that do not presently offer the same or similar technology solutions for the education market but that could, with limited barriers to entry, compete directly with AlphaSmart in the future.

AlphaSmart’s competitors include sellers of the following:

PCs and Mobile Labs.    PCs are computing devices capable of several functions, from multimedia web browsing, financial modeling and graphic designing to simple tasks like word processing. Mobile labs generally consist of carts containing up to thirty wirelessly networked laptops that can be wheeled from classroom to classroom. Generally, however, laptops, including those that comprise mobile labs, have a significantly higher total cost of ownership and complexity, are less durable and have significantly shorter battery lives than AlphaSmart’s platforms. Competitors in this category include Apple Computer, Inc., Dell Computer Corporation and Hewlett-Packard Company.

PDAs.    These devices, based on Palm OS, Win CE or embedded Linux technology, are smaller, less expensive and more portable than PCs. They offer several similar features to PCs, but, due to their screen size and lack of an integrated keyboard, provide limited functionality. They are primarily used as computer companions that allow the user to have redundant data such as address books, task lists, memos and a few files while traveling. AlphaSmart believe these products are better suited for business users than educational users. Competitors in this category include Palm, Inc., Dell Computer Corporation and Hewlett-Packard Company.

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Manufacturing and Supply Chain

AlphaSmart currently uses All Quality & Services, Inc. in San Jose, California, to facilitate procurement, production and testing. AlphaSmart believes that, upon 90-days’ notice, All Quality & Services would be capable of meeting any reasonable increase in capacity that AlphaSmart could foresee. AlphaSmart takes title to inventory only when the units are completed, and the manufacturer purchases components and manages inventory. AlphaSmart takes physical delivery of the products in AlphaSmart’s facility in Fremont, California and conducts a final quality check and final configuration before shipping. This process has contributed to a low rate of product return and customer support calls per unit in the field. AlphaSmart handles all order processing, finished goods, inventory management, final configuration, and fulfillment and customer support internally utilizing Oracle’s online ERP system. Order processing, both directly from the customer and from an online order site, is managed from AlphaSmart’s primary offices in Los Gatos, California and is purchase-order based.

Employees

As of December 31, 2004, AlphaSmart had eighty-nine full time employees and three independent sales representatives covering various territories in the United States. Full time employees include nine in product development, fifty-seven in sales, marketing and customer support, eleven in operations and twelve in administration. AlphaSmart also employs several part time employees and, from time to time, AlphaSmart employs independent contractors to support these operational areas. None of AlphaSmart’s employees are represented by a union, and AlphaSmart believes its relationship with its employees is good.

As of December 31, 2004, AlphaSmart’s material facilities consisted of the following leased premises:

AlphaSmart believes that its facilities are adequate for its current operations.

On November 20, 2003, one of AlphaSmart’s contract manufacturers, Wolf Electronix, Inc., filed a lawsuit against the Company in United States District Court for the District of Utah, alleging that the Company breached their contract with Wolf and violated a U.S. federal anti-discrimination statute by no longer using Wolf for volume order manufacturing. Wolf is seeking an injunction and unspecified damages in connection with its complaint. On December 17, 2003, AlphaSmart answered the complaint and denied Wolf’s allegations. Discovery is in progress, and trial is currently scheduled for May 2005. AlphaSmart believes Wolf’s claims lack merit and that it has meritorious defenses to each claim.

From time to time AlphaSmart is involved in litigation arising out of claims in the normal course of business. Based on the information presently available, including discussion with outside legal counsel, AlphaSmart believes that there are no claims or actions pending or threatened against us, the ultimate resolution of which will have a material adverse effect on AlphaSmart’s financial position, liquidity or results of operations.

None

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PART II

Price Range of Common Stock

AlphaSmart’s common stock has been traded on the Nasdaq National Market under the symbol “ALSM” since AlphaSmart’s public offering on February 6, 2004. The following table sets forth, for the period indicated, the high and low sales price for the common stock as reported by the Nasdaq National Market. As of February 22, 2004 AlphaSmart had 69 stockholders of record.

Equity Compensation Plan Information

The following table provides information as of December 31, 2004 about AlphaSmart’s common stock that may be issued upon the exercise of options and rights granted to employees, consultants or members of AlphaSmart’s board of directors under the 1998 Stock Option Plan, the 2003 Stock Option Plan and the 2003 Stock Purchase Plan.

Dividend Policy

To date, AlphaSmart has paid no cash dividends on its common stock, and has no current intention to do so.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

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The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Annual Report on Form 10-K. The selected consolidated statement of operations and the consolidated balance sheet data for the years ended, and as of, December 31, 2004, 2003, 2002, 2001 and 2000 are derived from our audited consolidated financial statements.

The historical results presented below are not necessarily indicative of future results.

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The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Selected Financial Data” and AlphaSmart’s consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10K. In addition, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding the merger of AlphaSmart and Renaissance Learning, Inc.; expected seasonality of AlphaSmart’s net revenue; AlphaSmart’s intentions regarding international sales channels; AlphaSmart’s expectation that the trend toward increased international revenue will continue; AlphaSmart’s expectation regarding gross margin trends and inventory and accounts receivable reductions; AlphaSmart’s expectation regarding research and development expense, sales and marketing expense, general and administrative expense, other expense and AlphaSmart’s effective tax rate; AlphaSmart’s expectations regarding use of the remaining net proceeds of its initial public offering; expectations regarding AlphaSmart’s future capital and liquidity requirements; the disclosure included in AlphaSmart’s future minimum lease and royalty payment table; and AlphaSmart’s expectation that its cash and cash equivalents will be sufficient to meet its operating and capital requirements for the next 12 months. AlphaSmart’s actual results may be materially different from those anticipated by these forward-looking statements as a result of many factors, including those discussed under “Risk Factors” and elsewhere in this Annual Report on Form 10K.

Overview

AlphaSmart provides affordable, portable personal learning solutions for the kindergarten through 12th grade (K-12) classroom. AlphaSmart’s portable personal learning solutions include computer-companion products that are designed to improve and assess students’ academic skills, increase teachers’ classroom productivity, and reduce administrators’ total cost of ownership for district-wide technology literacy and access. AlphaSmart’s computer-companion products are based on three rugged hardware platforms: the Neo by AlphaSmart, the Dana by AlphaSmart and the AlphaSmart 3000 platforms that AlphaSmart sells to school and school districts. An AlphaSmart solution consists of these devices with integrated keyboard, display, and proprietary or licensed operating system and basic application software. They are further enhanced with instructional and assessment software for specific educational subjects as well as management tools for teachers.

AlphaSmart began shipping its first generation product, called the AlphaSmart, in 1993. AlphaSmart’s second-generation product, the AlphaSmart Pro, began shipping in 1995, followed by the AlphaSmart 2000 in 1997. Each of these products was a single purpose device designed to aid students in learning keyboarding and writing skills. In 2000, AlphaSmart introduced one of its current platforms, the AlphaSmart 3000, the first device that could be updated with additional proprietary, third party and licensed applications, which AlphaSmart calls SmartApplets. In 2001, AlphaSmart added management tools, which include administrative software, a mobile cart and a USB hub, called the AlphaHub. The AlphaHub enables teachers to configure a group of up to 30 AlphaSmart 3000s in the cart and to manage the devices from a single PC in the classroom. In 2001, AlphaSmart began selling SmartOption Bundles, which include up to 30 devices and related management tools. In October 2002, AlphaSmart began shipping its Palm OS-based platform, the Dana by AlphaSmart, directed at the higher grade levels in the K-12 market, while still continuing to ship the AlphaSmart 3000, which has been more successful at the lower grade levels. AlphaSmart began shipping the Dana Wireless in August 2003 and its newest product, Neo by AlphaSmart, in August 2004. Neo has a 50% larger screen, enhanced system software, new font technology and twice the memory, compared to its predecessor, the AlphaSmart 3000.

On January 24, 2005 AlphaSmart entered into an Agreement and Plan of Merger and Reorganization with Renaissance Learning, Inc. Under the terms of this agreement, which has been approved by AlphaSmart’s board of directors, Renaissance Learning, Inc. will acquire AlphaSmart in a two step-merger. If the merger closes, each AlphaSmart stockholder will be entitled to receive $3.75 for each share of AlphaSmart stock and will have the option to be paid in cash, Renaissance Learning, Inc. common stock or some combination of the two, subject to pro-ration so that the total consideration paid will aggregate no more than 45% stock and no less than 55% cash.

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The completion of the merger is contingent upon customary conditions of closing, including regulatory clearances and the approval of AlphaSmart’s stockholders. The acquisition is expected to close during the second quarter of 2005.

Renaissance Learning, Inc. filed a proxy statement/ prospectus on Form S-4 (File No. 333-122993) on February 25, 2005, and AlphaSmart stockholders are encouraged to read this proxy statement/ prospectus for a more thorough discussion of the proposed merger with Renaissance Learning, Inc.

Net Revenue.    AlphaSmart’s net revenue is derived primarily from the sale of the AlphaSmart 3000, Neo by AlphaSmart and Dana by AlphaSmart platforms, either on an individual device basis or as part of a bundle. AlphaSmart has sold its devices in over 8,000 of the approximately 15,000 U.S. school districts and, in the year ended December 31, 2004, more than 80% of its net revenue was from districts to which it had previously sold devices.

Because the U.S. K-12 budget cycle runs from July 1 through June 30 each year, AlphaSmart’s net revenue tends to be highest in the second calendar quarter of each year, as schools spend the remaining funds in the current year budget. AlphaSmart also generally sees a slow down in spending in July and early August of each year, followed by an increase in late August and early September as the new school year commences. As a result, AlphaSmart typically expects its net revenue to be higher in the second and third calendar quarters of each year than in the first and fourth calendar quarters.

Since AlphaSmart began shipments in 1993, its net revenue increased each year, with the exception of 2002 and 2004. During the second half of 2002, AlphaSmart believes that its customers were anticipating significant cutbacks in their technology budgets and, as a result, delayed technology-purchasing decisions. AlphaSmart believes this trend contributed to lower net revenue in the year ended December 31, 2002 than in the year ended December 31, 2001.

AlphaSmart believes that education technology budgets came under pressure during 2004, and that this pressure resulted in lower education technology spending overall during 2004, as compared to 2003. This reduction in education technology spending adversely affected AlphaSmart’s net revenue in 2004. Furthermore, during the second half 2004, AlphaSmart believes that its customers’ technology spending priorities changed due in part to recent government mandates focusing school districts more on implementing technology solutions that address specific student performance issues. Since failure to address those issues results in less federal funding for schools, both improved student performance and the ability to assess that performance and demonstrate improvement have become higher priorities. As a result, schools are making technology purchases based on integrated solutions that can directly address student skill development and then provide data on the assessment of that development. AlphaSmart believes this trend may have resulted in increased competitive pressure from PCs, particularly in connection with sales of AlphaSmart’s Dana platform. AlphaSmart also believes this trend toward more solutions-oriented purchases, including the lengthened decision cycle that resulted in part from this trend, contributed to lower net revenue in the year ended December 31, 2004 than in the year ended December 31, 2003.

AlphaSmart sells to schools and school districts, both directly and through value-added resellers, or VARs, and through international distribution channels. Direct sales were 85% of AlphaSmart’s net revenue in the year ended December 31, 2004 and 81% in the year ended December 31, 2003. As of June 30, 2003, AlphaSmart discontinued sales through domestic catalog-based resellers and added several new direct sales employees. International sales were 13% of AlphaSmart’s net revenue in the year ended December 31, 2004 and 11% of its net revenue in the year ended December 31, 2003. In the international markets AlphaSmart intends to continue to sell through reseller channels as well as direct sales employees.

Cost of Revenue; Gross Margin.    Cost of revenue consists of:

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A third party manufactures AlphaSmart’s devices. Accordingly, a significant portion of AlphaSmart’s cost of revenue consists of payments to this third party manufacturer. AlphaSmart also provides a limited three-year warranty on the AlphaSmart 3000 and Neo by AlphaSmart platforms and a limited one-year warranty on the Dana by AlphaSmart platform. AlphaSmart estimates and records the cost of the warranty at the time of sale.

AlphaSmart’s gross margin has been and will be affected by a variety of factors, including the mix and average selling price of its products, the cost of components and manufacturing labor, the cost of third party software, fluctuations in volume, competition, warranty and support costs, component shortages and the mix of distribution channels through which its products are sold. The Dana platform, which AlphaSmart began shipping in October 2002, carries a higher average selling price and a lower gross margin percentage than the AlphaSmart 3000 and Neo by AlphaSmart platforms.

Research and Development.    Research and development expense consists primarily of salaries and related overhead expense for development and engineering personnel, fees paid to consultants and outside contractors, and prototype costs related to the design, development, testing and enhancement of the AlphaSmart platforms. AlphaSmart expenses its research and development costs as they are incurred or capitalizes them under SFAS No. 86 where required.

Sales and Marketing.    Sales and marketing expense consists primarily of salaries, commissions and related overhead expense for personnel engaged in marketing and sales and costs associated with promotional and other marketing activities.

General and Administrative.    General and administrative expense consists primarily of salaries and related overhead expense for executive, finance, accounting, information technology and human resources personnel; accounting and legal fees; and other corporate expense.

Other Expense.    Other expense relates primarily to interest payments on outstanding balances on AlphaSmart’s term loan and revolving line of credit with a bank, as well as interest accretion, and premium, under its mandatorily redeemable preferred stock. For further discussion regarding these obligations, you should read “— Liquidity and Capital Resources.” AlphaSmart used a portion of the proceeds of its February 2004 public offering to repay the term loan in its entirety and to fully redeem the mandatorily redeemable preferred stock, including accrued dividends and a redemption premium.

Provision for Income Taxes.    Deferred tax assets and liabilities result primarily from temporary timing differences between book and tax valuation of assets and liabilities. The provision for income taxes reflects the estimated annualized effective tax rate applied to earnings including the effect of treating the nondeductible premium and interest expense on the mandatorily redeemable preferred stock as a discrete item in the first quarter of 2004. In addition, the calculation of AlphaSmart’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations. AlphaSmart records liabilities for anticipated tax audit issues based on its estimate of whether, and the extent to which, additional taxes may be due. Actual tax liabilities may be different than the recorded estimates and could result in an additional charge or benefit to the tax provision in the period when the ultimate tax assessment is determined.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of AlphaSmart’s financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting

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principles generally accepted in the United States of America. As such, AlphaSmart is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results may differ from these estimates under different assumptions or conditions. AlphaSmart believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:

Revenue Recognition.    Revenue is recognized when it is earned in accordance with applicable accounting standards, including Statement of Position No. 97-2, “Software Revenue Recognition,” as amended. AlphaSmart recognizes revenue from the sale of its devices and software upon shipment to the customer, provided at the time of shipment there is persuasive evidence of an arrangement with the customer, the fee is fixed or determinable, collection of the receivable is reasonably assured and there are no remaining unfulfilled obligations.

Revenue recognized is net of an estimated amount for the return of devices and software. AlphaSmart measures estimated future returns related to the current period by analyzing historical returns, current economic trends and changes in customer demand and acceptance of its devices and software. The balance of its allowance for sales returns was $47,000 as of December 31, 2004.

AlphaSmart does not provide free updates to its devices or software, however it does provide limited customer support, which includes email and phone support as well as software bug fixes which can be downloaded from the AlphaSmart website. AlphaSmart accrues for the costs associated with providing such customer support as a cost of revenue at the time the revenue is recognized.

Allowance for Doubtful Accounts.    AlphaSmart assesses collection risk based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. AlphaSmart does not request collateral from its customers. If AlphaSmart determines that collection of a fee is not reasonably assured, it defers the fee and recognizes net revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash. AlphaSmart also maintains allowances for doubtful accounts for estimated collection risk losses resulting from the inability of its customers to make required payments. If the financial condition of AlphaSmart’s customers was to deteriorate, resulting in an impairment of the customers’ ability to make payments, additional allowances may be required. The balance of the allowance for doubtful accounts was $77,000 as of December 31, 2004.

Obsolete or Slow-Moving Inventory.    AlphaSmart writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Prepaid Royalties.    In some cases where AlphaSmart pre-pays royalties relating to the licensing of third party software, amortization is recorded based on the number of units shipped times royalty cost per-unit basis. The royalty cost per unit is computed using estimates of expected sales over the life of the licensing contract. In the event of a significant decline in the estimated sales, AlphaSmart would have to accelerate the amortization of prepaid royalties by increasing the royalty cost per unit for future periods. For example, in the fourth quarter of 2004, AlphaSmart incurred a charge related to revisions of its estimates under its agreement with PalmSource, Inc.

Warranty Accrual.    AlphaSmart provides for the estimated cost of product warranties at the time net revenue is recognized. While it engages in product quality programs and processes, including monitoring and evaluating the quality of its component suppliers, AlphaSmart’s warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from AlphaSmart’s estimates, revisions to the estimated warranty liability would be required. The balance of the reserve for warranty obligations was $257,000 as of December 31, 2004.

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Valuation Allowance for Deferred Tax Assets.    AlphaSmart has not recorded a valuation allowance to reduce its deferred tax assets, as it believes those assets are more likely than not to be realized. While it has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event it were to determine that it would not be able to realize its deferred tax assets in the future in excess of its net recorded amount, a valuation allowance may be necessary and may decrease income in the period such a determination is made.

Results of Operations

The following table sets forth the percentage of consolidated net revenue represented by items in AlphaSmart’s consolidated income statements for the periods presented:

Years Ended December 31, 2004 and 2003

Net Revenue.    Net revenue from the sale of AlphaSmart products decreased 9% to $35.5 million for the year ended December 31, 2004, from $38.9 million for the year ended December 31, 2003. AlphaSmart believes the decrease in net revenue resulted from softness in technology spending in the K-12 education market generally, as well as increased customer demand for solutions that meet specific education needs, which increased competitive pressure on AlphaSmart’s platforms, particularly the Dana platform, which faced increased competitive pressure from PCs. Dana shipments accounted for approximately 28% of net revenue for the year ended December 31, 2004 compared to 29% for the year ended December 31, 2003. No single customer accounted for more than 10% of AlphaSmart’s net revenue in either year. U.S. sales accounted for 87% of its net revenue for the year ended December 31, 2004 and 89% of its revenue for the year ended December 31, 2003. Net revenue from AlphaSmart’s direct sales channels accounted for 85% of its net revenue for the year ended December 31, 2004 and 81% of its net revenue for the year ended December 31, 2003.

Gross Margin.    Gross margin was 51.6% for the year ended December 31, 2004, and the year ended December 31, 2003. Gross margin for the year ended December 31, 2004 was negatively impacted by 0.5% due to lower revenue spread across fixed overhead costs, offset by generally higher average selling prices. AlphaSmart expects gross margin to be lower in 2005 than during 2004, primarily as a result of an anticipated higher percentage of Dana Wireless shipments, which carry a lower gross margin than other products, higher royalty costs on the Dana platform related to a change in forecasted volume under AlphaSmart’s license agreement with PalmSource and an anticipated higher percentage of Neo shipments, which carry a lower gross margin than the AlphaSmart 3000.

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Research and Development.    Research and development expense decreased to $2.4 million, or 7% of net revenue, for the year ended December 31, 2004, from $3.2 million, or 8% of net revenue, for the year ended December 31, 2003. The decrease in absolute dollars was attributable primarily to a decrease in bonuses of $267,000 and a decrease of $462,000 in consulting and outside development expenses. AlphaSmart expects research and development expense to remain relatively flat in 2005.

Sales and Marketing.    Sales and marketing expense increased to $7.0 million, or 20% of net revenue, for the year ended December 31, 2004, from $6.0 million, or 15% of net revenue, for the year ended December 31, 2003. The increase in absolute dollars included $830,000 related to the expansion of its direct sales organizations in the United States, $87,000 related to increased marketing programs, and $113,000 related to increased travel costs. A portion of this increased expense related to AlphaSmart’s efforts to adapt to the changing educational technology spending market by focusing its sales organization on selling integrated solutions that address specific educational needs and on targeting sales efforts at the district level, where more education technology spending decisions are being made. AlphaSmart expects sales and marketing expense to increase slightly in 2005 as a result of AlphaSmart’s expectation that it will pay increased commissions and training and travel expenses. AlphaSmart also expects the opening of a new customer service center in late 2004 to increase sales and marketing expense in 2005.

General and Administrative.    General and administrative expense increased to $4.6 million, or 13% of net revenue, for the year ended December 31, 2004, from $4.2 million, or 11% of net revenue, for the year ended December 31, 2003. The increased general and administrative expense related primarily to additional personnel costs of $150,000 and additional professional service costs of $250,000 required to operate as a public company. AlphaSmart expects general and administrative expense to increase significantly in 2005, primarily as a result of transaction costs related to AlphaSmart’s proposed merger with Renaissance Learning, Inc.

Other Expense.    Other expense was approximately $580,000 for the year ended December 31, 2004 and $1.0 million for the year ended December 31, 2003. The decrease reflects the liquidation of all term debt and the redemption of AlphaSmart’s mandatorily redeemable preferred stock upon the completion of its initial public offering on February 11, 2004. With the redemption of AlphaSmart’s mandatorily redeemable preferred stock and repayment of AlphaSmart’s term loan in 2004 in connection with AlphaSmart’s initial public offering in February 2004, AlphaSmart expects other expense to consist primarily of net interest income and expense in 2005.

Provision for Income Taxes.    AlphaSmart accrued income taxes at an effective tax rate of 39% for the year ended December 31, 2004 and 40% for the year ended December 31, 2003. The differences between the federal rate of 34% and the effective rates indicated are primarily due to state income taxes and non-deductible interest accretion, partially offset by research and development credits. AlphaSmart expects the effective tax rate to fall slightly in 2005 due to the elimination of the non-deductible interest that AlphaSmart paid on its mandatorily redeemable preferred stock in 2004.

Years Ended December 31, 2003 and 2002

Net Revenue.    Net revenue from the sale of AlphaSmart products increased 9% to $38.9 million for the year ended December 31, 2003, from $35.6 million for the year ended December 31, 2002. This increase resulted primarily from a change in the mix of products shipped. While the total number of devices shipped in the year ended December 31, 2003 was substantially the same as the total number of devices shipped in the year ended December 31, 2002, the higher priced Dana devices accounted for 29% of net revenue in the year ended December 31, 2003 compared to 4% for the year ended December 31, 2002. AlphaSmart began shipping the Dana device in October 2002. No single customer accounted for more than 10% of AlphaSmart’s net revenue in either year. U.S. sales accounted for 89% of AlphaSmart’s net revenue for the year ended December 31, 2003 and 92% of its net revenue for the year ended December 31, 2002. Net revenue from its direct sales channels accounted for 81% of its net revenue for the year ended December 31, 2003 and 76% of its net revenue for the year ended December 31, 2002.

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Gross Margin.    Gross margin was 51.6% for the year ended December 31, 2003 and 52.4% for the year ended December 31, 2002. This decrease resulted primarily from the change in product mix to a higher proportion of the lower margin Dana product in the year ended December 31, 2003.

Research and Development.    Research and development expense increased to $3.2 million, or 8% of net revenue, for the year ended December 31, 2003, from $2.9 million, or 8% of net revenue, for the year ended December 31, 2002. The increase in absolute dollars was attributable primarily to an increase in personnel and related overhead expense.

Sales and Marketing.    Sales and marketing expense increased to $6.0 million, or 15% of net revenue, for the year ended December 31, 2003, from $5.3 million, or 15% of net revenue, for the year ended December 31, 2002. The increase in absolute dollars was related to expansion of AlphaSmart’s direct sales organization, both in the United States and internationally.

General and Administrative.    General and administrative expense decreased to $4.2 million, or 11% of net revenue, for the year ended December 31, 2003, from $4.4 million, or 12% of net revenue, for the year ended December 31, 2002. The decrease in absolute dollars was attributable primarily to the inclusion in 2002 of charges of approximately $300,000 each for relocation of the corporate headquarters and a financing which was subsequently delayed. This decrease was partially offset by an increase in personnel and related overhead expense in 2003.

Other Expense.    Other expense was approximately $1.0 million each for the years ended December 31, 2003 and 2002, primarily representing interest charges.

Provision for Income Taxes.    AlphaSmart accrued income taxes at an effective tax rate of 40% for the years ended December 31, 2003 and 2002. The difference between the federal rate of 34% and the effective rate of 40% is primarily due to state income taxes and non-deductible interest accretion, partially offset by research and development credits.

Liquidity and Capital Resources

As of December 31, 2004, cash and cash equivalents totaled $4.1 million, compared to $2.3 million as of December 31, 2003. Cash equivalents are short-term, interest-/bearing, investment-grade securities with original or remaining maturities of ninety days or less as of the date of purchase.

Net cash used in operating activities was $3.0 million for the year ended December 31, 2004 and consisted primarily of a net change in assets and liabilities of $6.6 million, partially offset by net income of $2.2 million, depreciation and amortization of $426,000 and premium and interest expense on mandatorily redeemable preferred stock of $588,000. The increase in inventory of $1.3 million relates primarily to a shortfall in AlphaSmart’s revenue compared to its forecast. The total increase in other current assets and other assets of $2.5 million relates primarily to prepaid royalties. The reduction in accounts payable of $1.1 million relates primarily to AlphaSmart’s reduced inventory purchases in the fourth quarter and the decrease in accrued liabilities of $1.8 million primarily reflects the payment of its accrued public offering costs of $1.5 million and accrued bonuses of $500,000. For the year ended December 31, 2003, net cash provided by operating activities was $3.8 million and consisted primarily of net income of $3.4 million, allowance for doubtful accounts and sales returns of $230,000, depreciation and amortization of $430,000 and interest on mandatorily redeemable preferred stock of $728,000, offset by a net change in assets and liabilities of $879,000. The net change in assets and liabilities consisted primarily of increases in inventory and other assets of $1.4 million and $1.5 million, respectively, offset by increases in accounts payable and accrued liabilities of $575,000 and $1.4 million, respectively. The increases in other assets and accrued liabilities related primarily to expenses incurred in connection with AlphaSmart’s initial public offering.

Net cash used in investing activities of $616,000 for the year ended December 31, 2004 resulted from purchases of property and equipment of $265,000 and purchases of capitalized software of $351,000. Net cash

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used in investing activities of $210,000 for the year ended December 31, 2003 resulted from purchases of property and equipment.

Net cash provided by financing activities was $5.4 million for the year ended December 31, 2004 and consisted of net proceeds from the sale of common stock in an initial public offering of $20.4 million, partially offset by the repayment of a loan facility of $4.0 million, repayment of a line of credit of $873,000 and the redemption of mandatorily redeemable preferred stock of $10.3 million. For the year ended December 31, 2003, net cash used in financing activities was $2.8 million and consisted primarily of net repayments under a loan facility.

On February 11, 2004, AlphaSmart completed an initial public offering of 4.0 million shares of its common stock at a price of $6.00 per share. The offering provided net proceeds to AlphaSmart of $20.4 million, which is net of underwriters’ discounts and commissions of $1.7 million and related legal, accounting, printing and other expenses totaling $1.9 million. AlphaSmart used $4.0 million of the proceeds to repay an outstanding term loan, $873,000 to pay down a line of credit, and $10.3 million to redeem 100,000 shares of mandatorily redeemable preferred stock. It has used and intends to continue to use the remaining net proceeds of the offering for working capital and general corporate purposes, including product research and development, marketing programs, further development of its sales force and capital expenditures. Pending these uses, AlphaSmart has invested the net proceeds of the offering in short-term, interest-bearing, investment-grade securities.

AlphaSmart currently has a revolving line of credit with a bank in the amount of $3.0 million, which expires on May 31, 2005. At December 31, 2004 AlphaSmart had no outstanding balance under this line of credit.

The following table describes AlphaSmart’s commitments to settle contractual obligations in cash as of December 31, 2004 (in thousands):

AlphaSmart’s future liquidity and capital requirements will depend on numerous factors, including

AlphaSmart believes that its cash and cash equivalents of $4.1 million as of December 31, 2004 will be sufficient to meet its operating and capital requirements through at least the next 12 months. However, it is possible that AlphaSmart may require additional financing within this period. In addition, even if it has sufficient funds to meet its anticipated cash needs in the next 12 months, it may need to raise additional funds beyond this time. AlphaSmart may be required to raise those funds through public or private financings, strategic

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relationships or other arrangements. AlphaSmart cannot assure that funding, if needed, will be available on terms attractive to it, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. If AlphaSmart fails to raise capital when needed, its failure could have a negative impact on its profitability and its ability to pursue its business strategy.

Recent Accounting Pronouncements

In April 2004, the Emerging Issues Task Force (“EITF”) reached final consensus on EITF 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128,” which requires companies that have participating securities to calculate earnings per share using the two-class method. This method requires the allocation of undistributed earnings to the common shares and participating securities based on the proportion of undistributed earnings that each would have been entitled to had all the period’s earnings been distributed. EITF 03-6 is effective for fiscal periods beginning after March 31, 2004 and earnings per share reported in prior periods presented must be retroactively adjusted in order to comply with EITF 03-6. AlphaSmart adopted EITF 03-6 on April 1, 2004. The adoption of EITF Issue 03-6 did not have a material impact on AlphaSmart’s financial position or results of operations.

In November 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 151, “Inventory Costs — an amendment of ARB No. 43 (“FAS 151”), which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. FAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. FAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. AlphaSmart does not believe that adoption of this standard will have a material impact on its consolidated financial statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” which requires companies to expense the fair value of employee stock options and other forms of share-based compensation. Accordingly, SFAS 123R eliminates the use of the intrinsic value method to account for share-based compensation transactions as provided under APB Opinion No. 25. Under SFAS 123R, AlphaSmart is required to determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. AlphaSmart currently uses the Black-Scholes option-pricing model to value options for financial statement disclosure purposes. The use of a different model to value options may result in a different fair value than the use of the Black-Scholes option-pricing model. AlphaSmart is required to adopt SFAS 123R in the third quarter of fiscal 2005. AlphaSmart is evaluating the requirements of SFAS 123R and expects its impact on AlphaSmart’s results of operations will not be materially different from the amount as calculated under FAS 123, depending on the plan and its terms, the valuation model used, and other factors.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (“FAS 109-1”), “Application of FASB Statement No. 109, “Accounting for Income Taxes,” to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (the “AJCA”).” The AJCA introduces a special 9% tax deduction on qualified production activities. FAS 109-1 clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with Statement 109. AlphaSmart is evaluating its impact on its consolidated financial statements.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-2 (“FAS 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. AlphaSmart does not expect the adoption of this new tax provision to have a material impact on its consolidated financial statements.

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In December 2004, the FASB issued SFAS Statement No. 153, “Exchanges of Non-monetary Assets.” The Statement is an amendment of APB Opinion No. 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges on non-monetary assets that do not have commercial substance. The effective date is for exchanges occurring in fiscal periods beginning after June 15, 2005. AlphaSmart believes that the adoption of this standard will have no material impact on its consolidated financial statements.

Factors That May Affect Future Results of Operations

There are numerous risks associated with the pending merger with Renaissance Learning, Inc.

On January 25, 2005, AlphaSmart announced that it had entered into a definitive agreement to be acquired by Renaissance Learning, Inc. in a merger transaction. The transaction is subject to a number of risks, including risks related to:

In addition, if the merger is not consummated for any reason, AlphaSmart may be subject to a number of risks, including:

In connection with the proposed merger, AlphaSmart and Renaissance Learning, Inc. filed a proxy statement/prospectus with the Securities and Exchange Commission on February 25, 2005 (File No. 333-122993). The proxy statement/prospectus contains important information about AlphaSmart, Renaissance Learning, Inc., the proposed merger, risks relating to the merger, and related matters. AlphaSmart urges all of its stockholders to read the proxy statement/prospectus.

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If fewer teachers and administrators adopt educational technology solutions and embrace one-to-one computing than AlphaSmart expects, or if AlphaSmart’s current and future platforms do not obtain broad market acceptance for other reasons, AlphaSmart may be unable to sustain or increase its net revenue and its business and financial results could be adversely affected.

AlphaSmart’s business depends on an increasing number of teachers and administrators adopting educational technology solutions and embracing the concept of one student to one computer, or one-to-one computing. There is the risk, however, that one-to-one computing may not produce the expected educational benefits or teachers and administrators may not recognize the benefits. As a result, fewer teachers and administrators may incorporate AlphaSmart’s platforms into their classrooms than AlphaSmart expects, which could result in AlphaSmart’s inability to increase or sustain its net revenue and materially adversely affect AlphaSmart’s business, financial condition and results of operations. Also, market acceptance of AlphaSmart’s platforms may be negatively influenced by a number of other factors, including:

Furthermore, the K-12 educational technology market in which AlphaSmart competes is characterized by new product introductions and, to a lesser extent, technological changes. These trends may reduce sales of AlphaSmart’s existing platforms. AlphaSmart’s success depends on its ability to respond to these trends by enhancing its existing platforms and developing and successfully introducing new platforms.

AlphaSmart’s sales are primarily to educational institutions. A decline of investment in, or loss or reduction of government funding for, educational technology could result in AlphaSmart being unable to sustain or increase its net revenue, which would negatively affect AlphaSmart’s business and financial results.

Substantially all of AlphaSmart’s net revenue is derived from sales to educational institutions, individual teachers and their suppliers. AlphaSmart cannot assure you that educational institutions and/or individual teachers will continue to invest in technology-based platforms. Due to AlphaSmart’s dependence on educational institutions, the funding of which depends largely on government support, a substantial decrease in funding for educational technology would have a material adverse effect on AlphaSmart’s business, financial condition and results of operations. The sources of funding for AlphaSmart’s platforms depend heavily on local, state and federal political bodies and, as a result, education budgets may vary from year to year. In this regard, government funding provided under Title II, Part D of the Elementary and Secondary Education Act, also know as the Enhancing Education Through Technology Act of 2001, was reduced from $700 million to $500 million for the 2005 school year (July 2004 to June 2005). The funding under this act may be further reduced or even completely eliminated for the coming school year. This reduction, as well as other significant reductions in education funding, particularly in states like California and Texas in which AlphaSmart has many customers, would likely result in reduced technology spending and materially adversely affect AlphaSmart’s financial results. For instance, AlphaSmart believes that the challenging spending environment AlphaSmart faced throughout 2004 resulted in part from reduced educational technology budgets, which adversely affected AlphaSmart’s net revenue in 2004.

AlphaSmart must adapt to a recent trend among its customers toward the purchase of products based on integrated solutions that address specific educational needs.

Partially as a result of recent government mandates, most notably the No Child Left Behind Act, school districts are much more focused on implementing technology solutions that address very specific student performance issues. As a result, particularly in the last 18 months, schools are making more technology purchase decisions based on their need for integrated solutions that can directly address student skill development and then

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provide data on the assessment of that development. Schools previously emphasized getting technology such as AlphaSmart’s into the classroom, rather than identifying technology solutions that can assess and address specific performance issues and needs. This trend has increased the importance of software applications to AlphaSmart’s platforms, which AlphaSmart believes are becoming an increasingly important component of its ability to access the K-12 classroom market. Accordingly, AlphaSmart will need to develop software solutions internally to complement its platforms or enter into additional agreements with third parties with respect to these software solutions. For instance, AlphaSmart believes that developing management software for its Dana by AlphaSmart platform is essential for the success of that platform. Although AlphaSmart believes it can develop and market these kinds of solutions, AlphaSmart believes this trend has been partially responsible for the challenging spending climate AlphaSmart encountered in the last 18 months.

Unless AlphaSmart maintains a strong brand identity, develops the Dana by AlphaSmart and Neo by AlphaSmart brands and protects its brands, AlphaSmart’s business may not grow and its financial results may suffer.

AlphaSmart believes that building and enhancing the value of its brands is critical to attracting purchasers of its platforms. One of AlphaSmart’s strategies is to leverage the strength of the AlphaSmart brand. For example, in 2002 AlphaSmart introduced its Dana by AlphaSmart brand, in 2004 AlphaSmart introduced its Neo by AlphaSmart brand, and in the future AlphaSmart may introduce new brands. AlphaSmart’s success in developing brand awareness will depend on its ability to provide educational technology that meets the needs of students, teachers and administrators. AlphaSmart cannot assure you that it will be successful in promoting its existing or new brands. AlphaSmart will need to increase spending on brand-building strategies, which include advertising, promotional programs and sales force efforts. Net revenue from these activities may not be sufficient to offset associated costs.

AlphaSmart seeks to protect its brands, trademarks and logos through a variety of strategies, including domestic and foreign trademark registrations. However, AlphaSmart may be unable to stop third parties from adopting similar names, trademarks and logos, especially in international markets where intellectual property rights may be less protected or more difficult to enforce. In addition, it is possible that the brands, logos and trademarks AlphaSmart uses may infringe on the rights of others or may be challenged as infringing, and AlphaSmart may have to devote time and money to defending such claims.

AlphaSmart’s platforms compete against PCs, which have greater functionality. If AlphaSmart’s customers and potential customers decide that the benefits of greater functionality outweigh the advantages of AlphaSmart’s platforms, AlphaSmart may suffer competitive losses and its business and financial results would suffer.

AlphaSmart’s indirect competitors include sellers of desktop, laptop, tablet and notebook personal computers, or PCs, which typically have more functionality than AlphaSmart’s platforms. AlphaSmart also competes against providers of PC-based solutions referred to as mobile labs, which generally consist of carts containing thirty or fewer wirelessly networked laptops that can be wheeled from classroom to classroom. AlphaSmart believes that its business depends, in part, on teachers and administrators preferring the lower total cost of ownership, greater durability and targeted functionality associated with AlphaSmart’s platforms to the greater functionality of PCs. However, because of the greater functionality and memory that most PCs have compared to AlphaSmart’s platforms, the recent trend among AlphaSmart’s customers toward demand for integrated solutions may cause customers seeking such integrated solutions to choose PCs over AlphaSmart’s platforms. Furthermore, AlphaSmart expects the price of PCs to continue to decrease, and their durability may increase or PC makers may develop technology that allows teachers to target the functionality of PCs in a classroom environment. As a result of these factors, customers or prospective customers may choose to purchase PCs instead of AlphaSmart’s platforms. For instance, the success of AlphaSmart’s Dana platform, which is targeted at higher grade levels, has been adversely affected by competition from sellers of laptop computers.

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AlphaSmart’s sales cycle can be long and unpredictable, and this can lead to fluctuating financial results.

Most of AlphaSmart’s customers are public institutions, such as public school districts, that depend on public funding sources. Funding sources can be found at all levels of government through a wide variety of programs. Identifying the decision maker and a potential funding source is often time consuming. Larger orders, in particular, can take months or years to complete. Other variables also complicate the purchasing process, including the timing of disbursement of funds from funding sources and the person-to-person sales contact process. Sales may take much longer than anticipated, may fall outside the approved budget cycle and, therefore, may not occur due to the loss of funding. As a result of these factors, AlphaSmart’s sales cycle is unpredictable and typically lasts six to 18 months. This unpredictability could cause AlphaSmart’s net revenue and financial results to vary significantly from quarter to quarter. The recent trend towards schools demanding integrated technology solutions that can assess and address specific student performance issues has, AlphaSmart believes, lengthened the sales cycle.

AlphaSmart must manage risks associated with its reliance on third parties to develop software applications for its platforms.

To augment AlphaSmart’s software development activities, AlphaSmart relies on third parties to help develop software applications for its platforms. For instance, AlphaSmart licenses technology included in its KeyWords SmartApplet from Renaissance, and Don Johnston, Incorporated developed the Co:Writer SmartApplet. To increase the attractiveness of its technology platforms, AlphaSmart intends to enter into additional third party relationships for the development of additional software applications for its platforms. AlphaSmart also outsources a portion of AlphaSmart’s internal software development function. Some of these third parties have limited operating histories and limited access to capital. Furthermore, AlphaSmart relies on these third parties to protect their intellectual property rights and to not infringe the rights of others. As a result, AlphaSmart has less control over software development and engineering processes, and associated intellectual property protection and infringement risks, than if AlphaSmart developed software internally. AlphaSmart relies on these third parties to deliver software or other technology that meet AlphaSmart’s specifications in a timely and cost-effective manner, and delays or cost overruns in software developments or intellectual property infringement claims could negatively affect customer relations and AlphaSmart’s competitive position.

The failure of government sponsored education initiatives to endorse, or be complementary to, AlphaSmart’s platforms could adversely affect AlphaSmart’s ability to access some education technology markets.

Substantially all of AlphaSmart’s net revenue is derived from sales to educational institutions, individual educators and their suppliers, the funding of which depends largely on government support. A decrease in government sponsorship of education initiatives that endorse, or are complementary to, the principles and methodologies underlying and associated with AlphaSmart’s platforms, could result in a reduction of funding available to educational institutions to acquire AlphaSmart’s platforms. In the event of such reduction, AlphaSmart may be unable to increase or sustain its net revenue and its business, financial condition and results of operations would be adversely affected. For example, in 2003 the State of Michigan mandated that all seventh grade students have access to laptop computers. The state specifications for what constitutes a laptop computer include larger screen sizes and video and audio features that AlphaSmart’s platforms do not support. If other jurisdictions adopt similar policies, AlphaSmart’s ability to sell its platforms in these jurisdictions would be adversely affected.

Because AlphaSmart’s product offering is not diversified, a decrease in sales of its platforms may seriously harm its business.

AlphaSmart’s three platforms, AlphaSmart 3000, Neo by AlphaSmart and Dana by AlphaSmart, are in a narrow category of products, namely computing devices for use in the K-12 classroom. AlphaSmart does not

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offer a diversified product line or services, as some of its competitors do. Consequently, if sales of AlphaSmart’s platforms decline precipitously, its business would be seriously harmed, and it may be difficult for it to recover because AlphaSmart does not have the breadth of products that would enable it to sustain its business while seeking to develop new types of products or services or other markets for its platforms. In addition, because AlphaSmart’s technical know-how and intellectual property have limited application, AlphaSmart may be unable to leverage AlphaSmart’s technical know-how and intellectual property to diversify AlphaSmart’s product line or develop other products or sources of revenue outside AlphaSmart’s current niche market.

The success of the Dana by AlphaSmart platform depends substantially on PalmSource, AlphaSmart’s license from PalmSource and the success of the Palm OS operating system. If the Palm OS operating system is unsuccessful or if AlphaSmart’s relationship with PalmSource terminates, AlphaSmart would have to design-in or license an alternative operating system, which could take a long period of time, and AlphaSmart’s net revenue, business and financial condition would be materially and adversely affected.

AlphaSmart currently licenses the Palm OS operating system from PalmSource for use in AlphaSmart’s Dana by AlphaSmart platform. The use of, and interoperability with, the Palm OS operating system is an important part of the Dana by AlphaSmart platform. As a result, the success of AlphaSmart’s Dana by AlphaSmart platform substantially depends on AlphaSmart’s relationship with PalmSource and the success of PalmSource and the Palm OS. If the Palm OS business is unsuccessful, or if PalmSource encounters financial or other difficulties that affect its operations or the popularity of the Palm OS, the success of AlphaSmart’s Dana by AlphaSmart platform would be adversely affected. Also, unless extended by mutual agreement, AlphaSmart’s license agreement with PalmSource will terminate in December 2008.

AlphaSmart’s license with PalmSource also provides that PalmSource may allow AlphaSmart to examine or modify the source code to the Palm OS software. If an entity that develops, manufactures, markets and/or distributes handheld or mobile computing devices or related operating systems software acquires more than 20% of AlphaSmart’s outstanding stock or directly merges with AlphaSmart, AlphaSmart would be required to return any PalmSource code that AlphaSmart may have and AlphaSmart’s right to examine or modify PalmSource’s code would terminate. If this license is terminated, or if PalmSource encounters financial or other difficulties that affect the Palm OS popularity, AlphaSmart may be required to license a substitute operating system, which could be less desirable, time consuming and more costly in terms of cash and other resources. Alternatively, AlphaSmart could develop AlphaSmart’s own operating system, but this would take considerable time, resources and expense, would likely divert AlphaSmart’s engineers’ attention from platform innovations and may not have the advantages of the Palm OS applications compatibility.

Shipments of platforms could be delayed and AlphaSmart’s business may be seriously harmed if AlphaSmart’s suppliers, particularly single source suppliers, do not satisfy AlphaSmart’s requirements and alternative sources are not available.

AlphaSmart relies on its suppliers to deliver necessary components to its contract manufacturer in a timely manner based on AlphaSmart’s forecasts. AlphaSmart does not, and AlphaSmart’s contract manufacturer does not, carry a significant inventory of these components. At various times, some of AlphaSmart’s platforms’ key components, including display components and flash memory, have been in short supply. Delays in AlphaSmart’s supply chain would harm AlphaSmart’s ability to deliver AlphaSmart’s platforms on a timely basis. The cost, quality and availability of components are essential to the successful production and timely sale of AlphaSmart’s platforms. If AlphaSmart’s suppliers are unable to meet AlphaSmart’s demand for these components, AlphaSmart will be required to work around these shortages, which may have a material adverse effect on AlphaSmart’s manufacturing costs and AlphaSmart’s business, financial condition and results of operations. Each of AlphaSmart’s platforms contains certain components, including the following, that have a single source supplier:

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If any supplier of these components were unable or unwilling to meet AlphaSmart’s needs, qualifying new suppliers would likely be time-consuming and cause production delays.

In addition, although AlphaSmart is evaluating other manufactures, All Quality & Services, Inc. is currently the only manufacturer of their platforms. AlphaSmart does business with All Quality & Services essentially on a purchase order basis and does not have a long term contract with them. Should All Quality & Services ever become unable or unwilling to manufacture AlphaSmart’s platforms, it could take AlphaSmart between 8 to 10 weeks to obtain a new manufacturer and begin to resume shipments of their platforms.

AlphaSmart must maintain customer loyalty, or the net revenue it derives from repeat customers will decrease.

In 2004, more than 80% of AlphaSmart’s net revenue came from districts to which AlphaSmart had previously sold units. If AlphaSmart’s current and repeat customers decide to purchase technology other than AlphaSmart’s, or if they decide to allocate funding away from educational technology, AlphaSmart’s net revenue would decline.

The loss of AlphaSmart’s senior management could have a material adverse effect on AlphaSmart’s business.

AlphaSmart depends on the continued service of its senior management. AlphaSmart’s management team, Ketan D. Kothari, Manish D. Kothari and Joseph Barrus, has a substantial role in AlphaSmart’s product development, AlphaSmart’s reputation and contacts with customers and third party developers and AlphaSmart’s business culture. AlphaSmart does not have employment agreements with any of these persons, and AlphaSmart has no current intention of entering into any such employment agreements. The loss of services of any of these persons could harm AlphaSmart’s business.

AlphaSmart does not know whether additional financing will be available when needed, on favorable terms or at all.

AlphaSmart believes that its cash and cash equivalents of $4.1 million as of December 31, 2004 will be sufficient to meet its operating and capital requirements through at least the next 12 months. However, it is possible that AlphaSmart may require additional financing within this period. In addition, even if AlphaSmart has sufficient funds to meet its anticipated cash needs in the next 12 months, AlphaSmart may need to raise additional funds beyond this time. AlphaSmart may be required to raise those funds through public or private financings, strategic relationships or other arrangements. AlphaSmart cannot assure that such funding, if needed, will be available on favorable terms, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. To the extent that AlphaSmart raises additional funds through strategic relationships, AlphaSmart may be required to relinquish some rights to technologies or products, or grant licenses on unfavorable terms. If AlphaSmart fails to raise capital when needed, AlphaSmart’s failure could have a negative impact on AlphaSmart’s profitability and AlphaSmart’s ability to pursue its business strategy.

If AlphaSmart’s customers delay purchases to evaluate new products and platforms it may introduce in the future, AlphaSmart’s financial results could be adversely affected.

AlphaSmart intends to continue to introduce new products and platforms. In response to these introductions, AlphaSmart’s customers may delay purchases of AlphaSmart’s existing platforms and products, which could adversely affect AlphaSmart’s financial results. For example, AlphaSmart believes that the introduction of Neo

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in the second quarter of 2004 may have adversely affected net revenue during that period as a result of school districts delaying their purchasing decision to evaluate the Neo product.

Loss of the right to use the one-button-send feature included in the AlphaSmart 3000, Neo and Dana devices could adversely affect AlphaSmart’s business.

AlphaSmart licenses from a third party the right to use the one button send feature in AlphaSmart’s AlphaSmart 3000, Neo and Dana devices. If AlphaSmart loses the right to use this technology, AlphaSmart would be required to either license alternative methods of delivering the functionality that is currently provided by the one button send feature or design around the patent. AlphaSmart could experience production delays while it attempts to secure suitable technology alternatives. Such delays could adversely affect its business. Also, if AlphaSmart is successful in obtaining technology alternatives, such technology may not be as effective as, and may be more costly than, the technology AlphaSmart currently uses.

AlphaSmart’s quarterly operating results are likely to fluctuate, which could cause it to miss expectations about these results and cause the trading price of AlphaSmart’s common stock to decline.

AlphaSmart’s operating results are likely to fluctuate substantially from quarter to quarter for a variety of reasons, many of which are beyond its control. As a result, AlphaSmart believes that you should not rely on period-to-period comparisons of its financial results as an indication of its future performance. Factors that are likely to cause AlphaSmart’s quarterly net revenue and operating results to fluctuate include those disclosed in these risk factors and others such as:

If AlphaSmart’s quarterly net revenue or operating results fall below the expectations of market analysts or investors, its stock price could decline substantially. For instance, in the third quarter of 2004 AlphaSmart failed to meet analyst’s expectations for its financial results, and its stock price declined.

AlphaSmart’s quarterly results have fluctuated in the past due in part to school funding calendars, and these seasonal fluctuations make predicting its sequential quarterly results difficult.

AlphaSmart’s sales are typically substantially higher in its second quarter, when districts use end of year funds, and in AlphaSmart’s third quarter, when districts use beginning of year funds. As a result of these

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fluctuations and other risks AlphaSmart has described in these risk factors, financial results for a quarter are not indicative of any subsequent quarter. This can make predicting AlphaSmart’s financial results difficult.

AlphaSmart’s platforms compete with other solutions. If AlphaSmart’s customers and potential customers choose these other solutions, AlphaSmart may suffer competitive losses and its financial results would suffer.

In addition to competing with PC manufacturers, AlphaSmart also competes against sellers of other technology solutions, such as personal digital assistants, or PDAs, based on operating systems such as the Palm OS, Win CE or embedded Linux. Although PDAs generally have a smaller screen than AlphaSmart’s platforms and generally do not include integrated keyboards, they offer some of the same benefits to students, teachers and administrators as AlphaSmart’s platforms. For instance, PDAs generally have a lower initial cost and are more portable than PCs. As such, customers or prospective customers may choose to purchase PDAs instead of AlphaSmart’s platforms. Also, historical competitors have in the past attempted to replicate AlphaSmart’s technology and market it to the U.S. K-12 market. Although AlphaSmart believe these competitors currently have little or no market share, they have at times caused AlphaSmart to reduce prices in order to obtain customer sales. This type of competition could in the future cause AlphaSmart to lower prices in some markets, or any of such companies could emerge as more significant competitors. Furthermore, there are a number of significantly larger companies with which AlphaSmart does not currently compete that do not currently offer the same or similar technology solutions for the education market but that could, with limited barriers to entry, compete directly in the future.

AlphaSmart expects its competitors, including providers of PCs, to continue to reduce their prices; to improve the performance of their current platforms; and to introduce new platforms, services and technologies. Successful new platform introductions or enhancements by AlphaSmart’s competitors could reduce the sales and market acceptance of AlphaSmart’s platforms, cause intense price competition or make AlphaSmart’s platforms obsolete. Many of AlphaSmart’s direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than AlphaSmart does. These competitors may be able to respond more rapidly than AlphaSmart can to changes in preferences or requirements in the educational technology market or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their platforms than AlphaSmart does. To be competitive, AlphaSmart must continue to invest resources in research and development, sales and marketing and customer support. AlphaSmart cannot be sure that it will have sufficient resources to make these investments or that it will be able to make the technological advances necessary to be competitive. Increased competition could result in price reductions, fewer customer orders, reduced margins and loss of market share. AlphaSmart’s failure to compete successfully against current or future competitors could seriously harm its business.

If AlphaSmart’s third party manufacturers are unable to perform, or if AlphaSmart does not provide its manufacturers with accurate demand forecasts, AlphaSmart could experience production delays or increased expenditures, which could adversely affect its net revenue or operating results.

AlphaSmart relies on third party manufacturers for a substantial portion of the procurement, production and testing of AlphaSmart’s platforms. Although AlphaSmart believes it could find alternate manufacturers, if these manufacturers are unable to perform their functions, AlphaSmart could experience disruptions in its operations and delays in its shipments. Furthermore, AlphaSmart must provide these manufacturers with accurate rolling demand forecasts. If AlphaSmart’s actual requirements exceed its forecasts, these manufacturers may be unable to manufacture its products in a timely manner to meet customer demand. If AlphaSmart’s forecasts are more than its actual requirements, AlphaSmart could be required to reimburse its manufacturers for their component purchases on its behalf if they are unable to use those components in AlphaSmart’s products.

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Dana by AlphaSmart, AlphaSmart’s platform based on the Palm OS operating system, is targeted in part at the higher education market, a market in which AlphaSmart has little experience. AlphaSmart’s lack of experience in the higher education market could adversely affect its ability to penetrate that market.

Historically, almost all of AlphaSmart’s net revenue has come from the K-12 market. AlphaSmart has not yet been successful selling Dana by AlphaSmart to the higher education market in significant quantities. AlphaSmart believes that its Dana by AlphaSmart platform, which began shipping in October 2002, will be useful in the higher education market. However, AlphaSmart does not have the experience and customer contacts in the higher education market that it has in the K-12 market. As a result, AlphaSmart may be unable to market its Dana devices successfully to the higher education market or other markets in which they would otherwise be useful. Furthermore, AlphaSmart could incur costs related to its efforts to penetrate the higher education market that are not offset by related net revenue.

Failure to manage growth of its direct and indirect sales force effectively could increase costs that are not offset by increased net revenue, result in reduced net revenue and harm its operating results.

AlphaSmart intends to expand its international presence, market and sell its Dana devices in selected markets, such as journalism and higher education, and continue to adapt its focus in the U.S. K-12 markets by focusing its sales efforts at the district level and by adapting to the recent trend toward customer demand for integrated solutions. These strategies require AlphaSmart to manage its direct and indirect sales force teams effectively. Internationally, almost all of AlphaSmart’s historical sales have been conducted through resellers. To increase its international presence, AlphaSmart must enter into reseller agreements in its existing international markets and in the additional markets it enters or it must hire and train direct international sales employees in these markets. In the U.S. K-12 markets, AlphaSmart intends to hire additional direct sales employees within the next year. In hiring these employees, AlphaSmart needs to select the proper markets in which to focus the new employees and assess the start-up costs associated with establishing a customer base and contacts in the selected markets. Furthermore, to be successful selling its platforms in the United States, AlphaSmart must continue to adapt its sales strategy to its customers’ focus on integrated solutions and also must focus its sales efforts at the district level, where more education technology purchase decisions are being made. Also, as AlphaSmart increases its installed base and introduces new products, it will need to manage the training and staffing of AlphaSmart’s customer care services. For instance, AlphaSmart recently opened a customer care center in Irving, Texas. If AlphaSmart does not manage these challenges effectively, AlphaSmart may be unable to capitalize on available opportunities or it may expend costs that are not justified by related net revenue.

The loss of key employees, or the inability to attract key employees, could limit AlphaSmart’s ability to develop new platforms and result in lost sales and diversion of management.

AlphaSmart’s success depends in part on its ability to attract and retain qualified management, sales and marketing and engineering personnel. As AlphaSmart enters new markets, such as higher education, vertical markets and international markets, AlphaSmart will need to hire sales and other personnel with familiarity with these markets.

AlphaSmart may be unable to protect its intellectual property adequately or cost-effectively, which may cause it to lose market share or reduce its prices.

AlphaSmart’s success depends to a significant degree on its ability to protect and preserve the proprietary aspects of AlphaSmart’s technology. However, AlphaSmart may be unable to prevent third parties from using its technology without its authorization. Although AlphaSmart has been issued patents in the United States and Europe, it does not currently rely on patents to protect its core intellectual property. To protect its intellectual property, AlphaSmart generally enters into confidentiality or license agreements with its employees, consultants and third party developers and controls access to and limits distribution of AlphaSmart’s proprietary technology. However, these measures afford only limited protection and may be inadequate. Enforcing these or other rights

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AlphaSmart has related to its technology could be costly, time-consuming and distracting. Others may develop non-infringing technologies that are similar or superior to AlphaSmart’s. If competitors are able to develop such technology, they may be able to market and sell products that compete with AlphaSmart’s, and this competition could adversely affect AlphaSmart’s business.

AlphaSmart’s future results could be harmed by economic, political, regulatory and other risks associated with international sales and operations.

To date, AlphaSmart has generated substantially all of its net revenue from sales in the United States. In 2004, approximately 13% of AlphaSmart’s net revenue was generated from international sales. AlphaSmart intends to continue to expand its presence in such markets and enter additional international markets in the near future, and these expansion efforts will be subject to economic, political, regulatory, and other risks generally associated with international sales and operations. To the extent that AlphaSmart’s net revenue from international operations represents an increasing portion of its net revenue, AlphaSmart will be subject to increased exposure to international risks, including changes in a specific country’s or region’s political or economic conditions and difficulty in managing widespread sales and support operations.

Future changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect AlphaSmart’s reported results of operations.

For example, recent changes requiring that AlphaSmart record compensation expense in the statement of operations for employee stock options using the fair value method or changes in existing taxation rules related to stock options could have a significant negative effect on its reported results.

AlphaSmart’s business could be harmed by lawsuits that have been filed, or may in the future be filed, against PalmSource involving the Palm OS operating system.

Suits against PalmSource involving the Palm OS operating system, which AlphaSmart licenses from PalmSource, could adversely affect AlphaSmart. A disruption in PalmSource’s business because of these suits could disrupt AlphaSmart’s operations and result in higher costs. PalmSource is or has been a defendant in several patent infringement lawsuits involving the Palm OS operating system. Although AlphaSmart has not been a party to these cases, AlphaSmart could be adversely affected by a determination adverse to PalmSource as a result of market uncertainty or platform changes that could arise from such a determination.

AlphaSmart could become subject to litigation regarding intellectual property, which could divert management attention, be costly to defend and prevent it from using or selling the challenged technology.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. This litigation is particularly prevalent in the technology industry. In addition, in recent years, there has been an increase in the filing of suits alleging infringement of intellectual property rights, which pressure defendants into entering settlement arrangements quickly to dispose of such suits, regardless of their merits. Other companies or individuals may pursue litigation against AlphaSmart with respect to intellectual property-based claims, including any such claims related to use of AlphaSmart’s existing brands, trademarks and logos. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to AlphaSmart’s platforms that could arise in the future, AlphaSmart could be required to obtain licenses to the infringing technology; begin using other brands, trademarks and logos; pay substantial damages under applicable law; cease the manufacture, use and sale of platforms found to be infringing; or expend significant resources to develop non-infringing technology. AlphaSmart’s insurance may not cover potential claims or may not be adequate to indemnify it for damages it incurs. Also, litigation frequently involves substantial expenditures and can require significant management attention, even if AlphaSmart ultimately prevails.

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AlphaSmart recently became a public company. Being a public company has increased AlphaSmart’s administrative costs and could make it more difficult to attract and retain key personnel.

AlphaSmart became a public company in February 2004. As a public company, AlphaSmart is incurring significant legal, accounting and other expenses that it did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC, has required changes in corporate governance practices of public companies. In addition to final rules and rule proposals already made by the SEC, The Nasdaq Stock Market revised its requirements for companies that are Nasdaq-listed. These new rules and regulations have increased AlphaSmart’s legal and financial compliance costs and made some activities more time consuming and/or costly. For example, partially in connection with becoming a public company AlphaSmart has added additional independent directors, created several board committees, implemented additional internal controls and disclosure controls and procedures, retained a transfer agent, a bank note company, and a financial printer, adopted an insider trading policy and has all of the internal and external costs of preparing and distributing periodic public reports in compliance with AlphaSmart’s obligations under the securities laws. These new rules and regulations could also make it more difficult to attract and retain qualified members of AlphaSmart’s board of directors, particularly to serve on AlphaSmart’s audit committee, and qualified executive officers.

Any errors or defects contained in AlphaSmart’s platforms, or failure to comply with applicable safety standards, could result in delayed shipments or rejection or recall of AlphaSmart’s platforms, damage to AlphaSmart’s reputation and exposure to regulatory or other legal action.

AlphaSmart has experienced, and in the future may experience, delays in releasing some of its platforms, and recalls of existing platforms, due to defects or errors in its platforms. For instance, in May 2003 AlphaSmart issued a recall on approximately 9,000 Dana devices as a result of a defect in the display screens that in some cases resulted in the backlight to the screen malfunctioning. Although the recall is complete, AlphaSmart cannot assure you that AlphaSmart’s platforms in the future will not contain other errors or defects that are discovered after commercial shipments have begun. Children could sustain injuries from AlphaSmart’s platforms, and AlphaSmart may be subject to claims or lawsuits resulting from such injuries. Any such injuries or recalls could result in the rejection of AlphaSmart’s platforms by AlphaSmart’s customers, damage to AlphaSmart’s reputation, lost sales, diverted development resources and increased customer service and support costs and warranty claims, any of which could harm AlphaSmart’s business.

AlphaSmart has limited exposure to financial market risks, including changes in interest rates and foreign currency exchange rates.

Interest Rate Risk

AlphaSmart’s exposure to interest rate risk relates primarily to its investment portfolio and credit facilities. All investments are classified as cash equivalents carried at cost and are deposited with financial institutions that approximate market value. AlphaSmart does not plan to use derivative financial instruments in its investment portfolio. If market rates were to increase immediately and uniformly by 10% from levels at December 31, 2004, the decline in fair value of the portfolio would not be material. AlphaSmart plans to ensure the safety and preservation of its invested principal funds by limiting default risks, market risk and reinvestment risk. It plans to mitigate default risk by investing in high-credit quality securities.

AlphaSmart’s exposure to market risk also relates to the increase or decrease in the amount of interest expense it must pay on its revolving line of credit with a bank. At December 31, 2004, AlphaSmart had no outstanding balance under this line of credit. Amounts owed under its revolving line of credit accrue interest at a rate equal to a bank rate that was 5.25% per annum at December 31, 2004.

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The risk associated with fluctuating interest expense is limited to these debt instruments, and AlphaSmart does not believe that a 10% change in the interest rate would have a significant impact on its interest expense.

AlphaSmart did not have any off-balance sheet arrangements at December 31, 2004.

Foreign Currency Risk

Although AlphaSmart pays salaries that are fixed in British pounds to its European employees, to date, its exposure to foreign currency rate fluctuations has not been significant. Substantially all of its international sales are transacted in U.S. dollars. To date, AlphaSmart does not use derivative financial instruments for speculative trading purposes, nor does it hedge any foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates.

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Quarterly Results of Operations

The following table presents AlphaSmart’s unaudited quarterly consolidated results of operations for its most recent eight quarters including the quarter ended December 31, 2004. You should read the following table in conjunction with the consolidated financial statements and the related notes, listed in the index appearing under Item 15(a)(1), contained elsewhere in this Annual Report on Form 10-K. AlphaSmart has prepared the data on the same basis as its audited consolidated financial statements. This table includes all adjustments, consisting only of normal recurring adjustments, that it considers necessary for a fair statement of its financial position and operating results for the quarters presented. Operating results for any quarter are not indicative of results for any future quarters or for a full year.

The following table sets forth the statements of operations data for each of the periods indicated (in thousands, except per share data):

Net Revenue.    AlphaSmart generally experiences higher revenue in its second and third quarters as a result of the U.S. K-12 budget cycle that runs from July 1 through June 30 each year. Increased spending in the second quarter is a result of schools spending the remaining funds in the current year and increased spending in the third quarter is a result of the new school year commencing. AlphaSmart expects this seasonality to continue.

Gross Margin.    The decrease in gross margin percentage from the third quarter of 2004 to the fourth quarter of 2004 was due primarily to a combination of higher costs for the AlphaSmart 3000 solution bundles,

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Dana related incentives, increased royalty costs on the Dana, product mix, and lower revenue on fixed overhead costs.

Research and Development.    The decrease in research and development expense from the fourth quarter of 2003 to the first quarter of 2004 was primarily the result of capitalizing outside development costs of $126,000 in the first quarter of 2004.

Sales and Marketing.    The increase in sales and marketing expense from the fourth quarter of 2003 to the first quarter of 2004 was primarily $173,000 related to increased headcount and $114,000 related to the acceleration of marketing programs.

General and Administrative.    The increase in general and administrative expense from the first quarter of 2004 to the second quarter of 2004 was primarily the result of increased costs to operate as a public company. The increase in general and administrative expense from the third quarter of 2004 to the fourth quarter of 2004 was primarily the result of $100,000 of increased legal costs related to litigation.

AlphaSmart’s quarterly operating results have varied on a quarterly basis and are likely to fluctuate in the future. Some of the important factors that could cause its net revenue and operating results to fluctuate from quarter-to-quarter include: