Rosetta Stone Inc
Annual Report 2009

Plain-text annual report

Use these links to rapidly review the documentTABLE OF CONTENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTSTable of ContentsUNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-KANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2009Commission file number: 1-34283Rosetta Stone Inc.(Exact name of registrant as specified in its charter)Delaware(State of incorporation) 043837082(I.R.S. Employer Identification No.)1919 North Lynn St., 7th Fl,Arlington, Virginia(Address of principal executiveoffices) 22209(Zip Code)Registrant's telephone number, including area code:800-788-0822Securities Registered Pursuant to Section 12(b) of the Act:Title of Each Class Name of Each Exchange on Which RegisteredCommon Stock, par value $0.00005 pershare New York Stock ExchangeSecurities Registered Pursuant to Section 12(g) of the Act:None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No  Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No  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 of1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to suchfiling requirements for the past 90 days. Yes  No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for suchshorter period that the registrant was required to submit and post such files). Yes o No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained,to the best of 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.  Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Checkone): Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No  The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $300 million as of June 30, 2009(based on the last sale price of such stock as quoted on the New York Stock Exchange). As of March 2, 2010, there were 20,251,027 shares of common stock outstanding. Documents incorporated by reference: Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the 2010Annual Meeting of Stockholders to be held on May 26, 2010 are incorporated by reference into Part III.Large Accelerated filer o Accelerated filer o Non-accelerated filer (Do not check if asmaller reporting company) Smaller reporting company oTable of ContentsTABLE OF CONTENTS 2 PagePART IItem 1. Business 3Item 1A. Risk Factors 18Item 2. Properties 38Item 3. Legal Proceedings 38PART IIItem 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities 39Item 6. Selected Financial Data 41Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 43Item 7A. Quantitative and Qualitative Disclosures About Market Risk 66Item 8. Financial Statements and Supplementary Data 66Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 66Item 9A Controls and Procedures 67Item 9B Other Information 67PART IIIItem 10. Directors, Executive Officers and Corporate Governance 67Item 11. Executive Compensation 68Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 68Item 13. Certain Relationships and Related Transactions, and Director Independence 68Item 14. Principal Accounting Fees and Services 68PART IVItem 15. Exhibits and Financial Statement Schedules 68Table of ContentsPART I Item 1. Business Overview We are a leading provider of technology-based language learning solutions. We develop, market and sell language learning solutions consisting ofsoftware, online services and audio practice tools primarily under our Rosetta Stone brand. Our teaching method, which we call Dynamic Immersion, isdesigned to leverage the innate, natural language learning ability that children use to learn their native language. Our courses are based on ourproprietary interactive technologies and pedagogical content, and utilize a sophisticated sequencing of images, text and sounds to teach a new languagewithout translation or grammar explanation. We believe our award-winning solutions provide an effective, convenient and fun way to learn languages.We currently offer our self-study language learning solutions in 31 languages. Our customers include individuals, educational institutions, armed forces,government agencies and corporations. People throughout the world seek to learn foreign languages for a variety of reasons, including to learn about other cultures, to communicate withfriends and family, to enhance their career prospects, to travel internationally and to obtain personal enjoyment and enrichment. According to aDecember 2007 industry analysis we commissioned from The Nielsen Company, a market research firm, which we refer to as the Nielsen survey, thelanguage learning industry worldwide represented over $83 billion in consumer spending in 2007, of which more than $32 billion was for self-study.According to the Nielsen survey, the language learning industry in the United States, where we generated 92% of our revenue in 2009, represented over$5 billion in consumer spending in 2007, of which over $2 billion was for self-study. The strength and breadth of our solutions have allowed us to develop a business model that we believe distinguishes us from other languagelearning companies. Our scalable technology platform and our proprietary content can be deployed across many languages. This has enabled us to cost-effectively develop a broad product portfolio. We have a multi-channel marketing and distribution strategy that directly targets customers, utilizing print,online, television and radio advertising, public relations initiatives and our branded kiosks. Approximately 82% of our revenue in 2009 was generatedthrough our direct sales channels, which include our call centers, websites, institutional sales force and kiosks. We also distribute our solutions throughselect retailers such as Amazon.com, Apple, Barnes & Noble, Office Depot and Borders. According to an August 2008 survey we commissioned fromGlobal Market Insite Inc., or GMI, a market research services firm, which we refer to as the GMI survey, Rosetta Stone is the most recognizedlanguage learning brand in the United States. Additionally, of those surveyed who had an opinion of our brand, over 80% associated it with high qualityand effective products and services for teaching foreign languages. January and February 2009 internal studies showed aided brand awareness forRosetta Stone in the US was approximately 74-79%, based on general population surveys and confirmed that Rosetta Stone is the most recognizedlanguage learning brand in the United States. We grew our revenue from $25.4 million in 2004 to $252.3 million in 2009, representing a 58% compound annual growth rate.Our Industry Market Size. According to the Nielsen survey, the worldwide language learning industry represented more than $83 billion in consumerspending in 2007, of which more than $32 billion was for self-study. The Nielsen survey also estimated that the language learning industry in theUnited States, where we generated 92% of our revenue in 2009, represented more than $5 billion in consumer spending in 2007, of which more than$2 billion was for self-study. In a more recent study in 2009 we3Table of Contentsestimated the language learning industry represented more than $4.5 billion in consumer spending, of which $2.4 billion was for self-study. The language learning market is highly fragmented and consists of the following primary models: classroom instruction utilizing the traditionalapproach of memorization, grammar and translation; immersion-based classroom instruction; self-study books, audio tapes and software that rely ongrammar and translation; and free online offerings that provide basic content and opportunities to practice writing and speaking. Key Drivers of Demand in Language Learning Market. We believe that language learning is becoming more important and valued by individualsand institutions in the United States and throughout the world. The demand for language learning is driven in part by:•individuals seeking the enjoyment and enrichment brought by learning a language; •professionals conducting business in a global economy; •schools seeking to educate their students in local and foreign languages; •companies training their employees; •leisure travelers seeking language proficiency for independent international travel; •armed forces training soldiers to communicate in foreign languages; •immigrants and expatriates seeking to successfully function in their new environments; •individuals connecting with their ethnic and family roots; and •parents supplementing their children's education. Limitations of Traditional Methods for Language Learning. The human brain has a natural capacity to learn languages. Children learn theirnative language without using rote memorization or adult analytical abilities for grammatical understanding. They learn at their own pace through theirimmersion in the language spoken around them and using trial and error. They do not rely on translation. By contrast, foreign languages havetraditionally been taught by focusing on memorization, grammar translation and word translation, typically in an academic classroom setting. Thistraditional method involves learning complex grammar rules, conjugating verbs and memorizing vocabulary lists. Students have little practice speakingor listening in the classroom, and practice outside the classroom typically involves rote listening to audio recordings and pronunciation exercises, withlittle or no feedback on pronunciation accuracy. Many students who were taught languages using the traditional method regard it as ineffective andboring. Emergence of Immersion Language Learning. To address some of the shortcomings of traditional language learning methods, language learningspecialists have developed an alternative method for teaching language known as immersion learning, in which only the target language is spoken. Webelieve that immersion learning is more effective than the traditional translation and grammar method in helping learners move towards conversationalfluency. Immersion learning provides a more natural, direct learning environment, where the learner deduces meaning and develops an intuition oflanguage structure. This is similar to the manner in which children learn their native language, without an awareness of formal grammar rules or thenecessity to translate. Most immersion learning programs, however, require either one-on-one teaching, a small group course or travel to a foreigncountry. These programs can cost several thousand dollars and are less convenient than self-study alternatives. Use of Interactive Technologies. There has been a rapid adoption of interactive technologies and software tools to help learning in both consumerand institutional markets, supported by the rapid increase in computing technologies and internet use. According to a 2008 report by Euromonitor4Table of ContentsInternational, Inc., a market research firm, there will be more than one billion personal computers in use, and 1.7 billion internet users, by 2009. Givenbusy lifestyles, adult language learners seek solutions that work flexibly and do not require physical classroom attendance. Educators are interested indeploying learning tools that are relevant to their students, who have had extensive exposure to computer software and interactive games. Corporationsare recognizing the value and effectiveness of using their technology investment to help increase the skills of their workforce. According to a July 2007report by Global Industry Analysts, Inc., a market research firm, the global demand for the delivery of instructional content through the use of electronictechnology, or eLearning, will grow an average of 21% annually between 2007 and 2010, reaching a total estimated value of $53 billion by 2010. The Need for a High-Quality, Trusted Solution. Consumers and institutions face a confusing array of alternatives when choosing a languagecourse due to the fragmented nature of the language learning market. Most providers of language learning offer little information to potential customersabout their teaching methods and do not have well known brands. The few major internationally known language learning providers generally offeronly classroom instruction, which is not convenient for all prospective language learners. In addition, there are numerous self-study courses in themarket available at a variety of price points, most of which are offered as audio and books and do not provide an interactive, immersion learningexperience. There are also many community websites that provide free opportunities to practice. We believe that language learners seek a trusted name-brand solution that is more convenient and affordable than classroom alternatives, and moreeffective, interactive and engaging than other self-study options. We believe the combination of these elements is not offered by traditional providers oflanguage instruction.The Rosetta Stone Solution Our mission is to change the way people learn languages. We believe our solutions provide an effective way to learn languages in a convenient andengaging manner. Our approach, called Dynamic Immersion, eliminates translation and grammar explanation and is designed to leverage the innate,natural language learning ability that children use to learn their native language. We consider traditional translation and grammar methods as obstaclesthat delay and impede the successful acquisition of language proficiency, and our solutions avoid those elements. Our computer-based self-studycourses allow our customers to learn using the immersion method on their own schedule and for a price that is significantly lower than most classroom-based or one-on-one alternatives. Although other audio and software publishers claim to teach with immersion methods, we believe that we are the onlyself-study solution that teaches strictly without any translation or explicit grammar explanations. Our proprietary solutions have been developed over thepast 16 years by professionals with extensive linguistic, educational and instructional technology expertise. We estimate that our content library consistsof more than 25,000 individual photographic images and more than 400,000 professionally recorded sound files. We design the sequencing of ourcontent to optimize learning. The result is a rigorous and complete language learning curriculum that is also designed to be flexible, fun and convenient. Our language learning solutions are built upon a flexible software platform that supports multiple languages and is deployable on personalcomputers, on local networks and online. The platform incorporates a number of proprietary technologies that are key to enabling language learning,including:•speech recognition that is focused on the unique challenges of language learners; •Adaptive Recall algorithms that repeat content at scheduled intervals to promote long-term retention;5Table of Contents•reporting features and curriculum options designed to enhance the effectiveness and administration of classroom, enterprise and homeschool learning; and •an intuitive user interface that assists the learner's transition from listening comprehension to speaking. Rosetta Stone offers a broad product suite, with courses currently available in 31 languages. Our courses are available in up to five levels ofproficiency per language, with each level providing approximately 40 hours of instruction and containing multiple units, lessons and activities. In July 2009, we introduced Rosetta Stone TOTALe, an online language learning solution that integrates our online courses with coach-led practicesessions, fun and engaging language games, interaction with native speakers and live support from customer service agents. We also provide an online peer-to-peer practice environment called SharedTalk, at www.sharedtalk.com, where registered language learners meetfor language exchange to practice their foreign language skills. During 2009, we had more than 125,000 active SharedTalk users. Our innovative solutions have received numerous awards and recognitions, including our placing #14 on the 2009 Inc. 5000 list for the educationindustry, the 2009 National Parenting Publications Awards (NAPPA) Honors Award for Rosetta Stone Version 3 Personal Edition, four classroomspecific awards in 2009 for Classroom Version 3, two enterprise specific awards in 2009, the 2008 CODiE awards for best corporate learning solutionand best instructional solution in other curriculum areas sponsored by the Software & Information Industry Association, the 2008 education product ofthe year awarded by MacWorld, the 2008 BESSIE multilevel foreign language award for Spanish Levels 1, 2, and 3 awarded by ComputED Gazette in2008, the 2008 EDDIE Award for our classroom edition as the best foreign language website awarded by ComputED Gazette, the 2007 EDDIEmultilevel foreign language award for Chinese levels 1 and 2 and a 2007 multilevel English-as-a-second-language, or ESL, award for English levels 1,2, and 3 awarded by ComputED Gazette.Competitive Strengths We consider the foundations of our success to be the quality and breadth of our solutions, the strength of our brand and our direct distributionmodel. Together, we believe these elements represent a business model with attractive economics that differentiates us from other language learningproviders. The quality of our solutions supports our price point, which in turn allows us to deploy a multi-channel marketing effort and a broad-baseddirect distribution network. We focus on educating consumers about the benefits of our solutions by leveraging our advertising and our kiosk networkto drive customers to our call centers and websites, where they can learn about our solutions, try product demonstrations and then transact directly withus. We believe our competitive strengths include: Advanced Technology-Enabled Language Learning System. Our proprietary solutions combine effective immersion learning with the benefits offlexibility and interactivity to provide for an efficient and engaging language learning experience. We intend to remain at the forefront of technologicaland pedagogical advances in language learning. Scalable and Adaptable Platform and Content. Our solutions are designed to be efficiently delivered across multiple languages, systems andgeographic markets. For example, we deploy many of the same images and image combinations across multiple languages, which accelerates our abilityto add new languages. Because our solutions do not rely upon translation from the target language into the learner's native language, they require onlymodest localization to be used by learners from other native language backgrounds. This facilitates our ability to sell our existing language courses innew international markets. In addition, our software platform is engineered to work in the same way both6Table of Contentsonline and locally installed, allowing for multiple delivery methods. We also use the same platform for all editions of our solutions: personal, enterprise,classroom and home school. Effective Multi-Channel Marketing and Distribution Model. We believe that our multi-channel marketing and distribution strategy is acompetitive strength because it enables us to market and serve our diverse customer base more broadly and make marketing impressions with a highfrequency and at a relatively low cost per impression. As compared to competitors that rely primarily on retailers or online vendors to sell their products,our direct marketing and distribution strategy enables us to exert more control over our own growth and the customer experience. Our marketing, salesand distribution efforts are highly integrated and focused on direct interaction with consumers. As a result, we are able to present a tightly controlled andunified message to the marketplace. Our television, online, print and radio advertising includes a "call to action" that drives customers directly to ourwebsites and call centers, where we seek to convert them to sales. Our marketing tools and techniques allow us to attribute sales results to specificmarketing initiatives. We utilize this data to continuously improve the efficiency of our websites, call centers, advertising and media planning andbuying. We also operated 242 kiosks as of December 31, 2009, which extend our direct interaction with customers and allow them to experience oursolutions with the guidance of one of our product specialists. Our kiosks are located in airports, malls and other strategic, high-traffic locations. In ourinstitutional markets, sales efforts are led by our direct sales force. We conduct our institutional marketing primarily through tradeshows and customervisits. Our marketing campaigns also support this channel. We augment our direct distribution network with select retailers, including Amazon.com,Apple, Barnes & Noble and Borders. We also offer our products in a limited number of ZoomShop unmanned automated kiosks. During the year endedDecember 31, 2009, approximately 82% of our revenue came from our direct channels, including our websites, call centers, kiosks and institutionalsales force, and the remainder was attributable to sales through retailers. Leading and Trusted Brand, with a Differentiated, High-Quality Positioning. According to the GMI survey, Rosetta Stone is the mostrecognized brand of language learning solutions in the United States. Additionally, of those surveyed who had an opinion of our brand, over 80%associated the brand with high-quality and effective products and services for teaching foreign languages. We believe we have positioned Rosetta Stoneas a premium brand and a trusted choice for learning languages. Our marketing message centers on key points of differentiation from our competitors'traditional language offerings by focusing on our learners' own intrinsic competence. We believe that continued marketing and brand building will drivebroader demand for our products and help us pursue our goal of making Rosetta Stone the preeminent language learning brand. Enthusiastic and Loyal Customer Base. Our customers exhibit loyalty and enthusiasm for our products and many promote sales of our productsthrough word-of-mouth referrals. Our latest survey of our individual customers in the United States, completed in August 2009, revealed that 90% ofrespondents expressed satisfaction with our solutions, with a satisfaction rating of 6 or higher on a 10-point scale, and 88% would recommend oursolutions to friends or colleagues. Our latest survey of our institutional customers in the United States, completed in February 2010, revealed that 85%of respondents expressed satisfaction with our solutions, with a satisfaction rating of 6 or higher on a 10-point scale, and 83% said that they wouldrecommend our solution to other organizations. Effective Products. We believe our solutions are effective. According to a January 2009 study we commissioned from Roumen Vesselinov,Ph.D, visiting assistant professor, Queens College, City University of New York, after 55 hours of study using our Spanish program the averageWebCAPE score will be at a level sufficient to fulfill the requirements for one semester of study in a college that offers six semesters of Spanish.Statistically, the study concluded that such an outcome would occur with 95% confidence. WebCAPE, which stands for Web-based Computer AdaptivePlacement Exam, is a standardized test which, according to their website, is used by over 500 colleges and universities for7Table of Contentsplacement. In addition, approximately 64% of the students participating in the study increased their oral proficiency by at least one level on a seven-levelscale based on the American Council on the Teaching of Foreign Languages (ACTFL) OPIc test, which is used worldwide by academic institutions,government agencies, and private corporations for evaluating oral language proficiency. In May 2009, we commissioned Rockman et al, an independent evaluation research and consulting firm, to conduct a quantitative study to measurethe effectiveness of the Rosetta Stone solution including new Rosetta Stone TOTALe, and product features such as Rosetta Studio, our live onlinelanguage learning practice sessions with dedicated conversation coaches. According to the study, after 64 hours of study with Rosetta Stone Spanish(Latin American) and six hours of Rosetta Studio sessions, 78% of the students participating in the study increased their oral proficiency by at least onelevel on the seven-level scaled developed by ACTFL. Based on the overall results from the research study, the researchers from Rockman et alconcluded that the Rosetta Stone solution is both an effective and efficient means of learning foreign languages.Our Strategy Our goal is to strengthen our position as a leading provider of language learning solutions through the following strategies: Extend Our Technological and Product Leadership. We intend to apply new technologies to maintain our product leadership. We currently areworking on a variety of product development initiatives. For example, in July 2009, we introduced Rosetta Stone TOTALe, a new web-based servicethat extends our existing language courses by offering opportunities for practice with dedicated language conversation coaches and other languagelearners to increase language socialization, offering online learning games and interaction with native speakers and offering live support from customerservice agents. We provide Rosetta Stone TOTALe primarily as a bundle with our software and audio offerings. At the same time, we expect to provideaugmented free peer-to-peer language practice, building on our existing success with www.sharedtalk.com. In addition, we are evaluating opportunitiesto extend our learning solutions to hand-held devices, and we intend to continue to advance our proprietary software platform and our speechrecognition technology. Expand Our Core Product Portfolio. We plan to expand our product portfolio by adding more advanced course levels for our existinglanguages. We give learners the option to purchase our solutions at a single level of difficulty, or as a bundle of all available levels. Currently, six of ourlanguages are offered in all five levels of proficiency and another 19 of our languages are offered in the first three levels of proficiency. Our other sixlanguages are available in only one level of proficiency. We also plan to add new languages and new skill development and remediation courses foradvanced language learners. We believe that there is an opportunity to increase our revenue as we introduce additional levels of proficiency to ourexisting languages. In addition, we believe that there may be opportunities for us to introduce additional language learning solutions containing industry-specific content. Increase U.S. Market Share. To increase our penetration of the U.S. market and expand our brand awareness, we intend to increase ourmarketing campaigns through the purchase of additional television, print, radio and online advertising, and to explore new media channels. We believethat our multi-channel marketing model helps to build greater brand awareness, which over time will further increase our marketing efficiency. We alsointend to continue to add select retail relationships and kiosks. For example, a selection of our solutions has become available in Office Depot, Books-A-Million and London Drugs retail outlets. For our institutional business, we expect to expand our direct sales force along with our institutionalmarketing activities. During the third quarter of 2010 we plan to introduce a new version of our core offering called Rosetta Stone Version 4 TOTALe,which integrates our current Version 3 language learning software solution with our Rosetta Stone TOTALe8Table of Contentsweb-based service offering that includes socialization features and dedicated language conversation coaches. Increase Our Focus on Sizeable Non-U.S. Markets. We generated approximately 8% of our revenue in 2009 from sales outside the UnitedStates. According to the Nielsen survey, over 90% of the $83 billion spent in 2007 on consumer language learning products and services was spentoutside the United States. We therefore believe that there is a significant opportunity for us to expand our business internationally utilizing many of thesuccessful marketing and distribution strategies we have used in the United States. We have established subsidiaries in the United Kingdom, Japan andGermany as well as a branch office in South Korea to develop our international business. In addition, we are exploring opportunities to expand ourpresence in Asia, Europe and South America. Because our solutions do not rely upon translation from the target language into the learner's nativelanguage, they require only modest localization to be used by learners from other native language backgrounds, and thus we believe that we canefficiently scale our business internationally.Products and Services We offer language learning solutions in 31 languages under the Rosetta Stone brand. Each language currently has up to five levels, with eachconsecutive level representing a higher level of proficiency. We sell each level as a standalone unit, although we offer a price incentive to customers topurchase all available levels of a language as a bundle, where that option is available. In August 2007, we released our Version 3 solution for ten of ourbest selling languages. We released an additional four languages in Version 3 in March 2008 and we released an additional seven languages inVersion 3 in September 2008. In May 2009, we released Levels 4 and 5 in English (US) and Spanish (Latin America) as well as an additional fourlanguages in Version 3. In July 2009, we released Rosetta Stone TOTALe, our new web-based service offering that includes a component of dedicatedlanguage conversation coaching. In November 2009, we released Levels 4 and 5 in 4 additional languages in Version 3. As of December 31, 2009, allVersion 3 languages are sold with Audio Companion and all Version 3 languages, except for Latin, are available with Rosetta Stone TOTALe web-based services. We have four different editions: personal, enterprise, classroom and home school. Each edition utilizes the same core software product, butincludes different ancillary features as follows:•Personal Edition—This edition is targeted to individual consumers and contains the core software product we use for all editions. •Enterprise Edition—This edition is targeted to businesses, armed forces, government organizations and not-for-profit entities and canaccommodate organizations of any size, from individual learners to entire global organizations. This edition includes management toolsthat provide easy-to-use administrative and reporting functionality. These tools deliver easy-to-read reports and graphs that track learneractivity, progress and scores, thereby providing organizations with key information they need to measure return on their languagelearning investment. •Classroom Edition—This edition is targeted to language programs in primary, secondary and higher education settings and is scalable toaccommodate a variety of implementations, from individual schools to district-wide programs and universities. The classroom edition isdesigned to be incorporated into a teacher's overall language-learning curriculum, complementing in-class teaching and enablingindividualized self-paced learning outside the classroom. The classroom edition includes a learner management tool, the Rosetta StoneManager, which provides easy-to-use administrative and reporting functionality. This tool enables teachers to plan lessons and generatereports and graphs that track student and classroom activity, progress and scores.9Table of Contents•Home School Edition—This edition is targeted to families with home school students and is designed to provide parents the tools andresources they need to manage student progress without extensive planning or supervision. The home school edition includesadministrative tools that permit parents to follow student progress and access specific information about student performance, such ascompleted exercises, test scores, and time spent learning, and to generate printable progress reports. In addition, parents have the abilityto enroll their students in predefined curriculum paths designed to assist in lesson planning and in achieving learning objectives. With our personal edition, we offer a compact disc audio practice tool, the Audio Companion, in all 25 Version 3 languages. Audio Companion is aseries of digital audio files that contain lessons directly aligned to the Rosetta Stone curriculum, allowing users to practice and carry on their immersiveexperience when they are away from a computer. The lessons on the Audio Companion can be transferred to MP3 players. The Audio Companionprovides a convenient opportunity for practicing material that was previously learned through the software program. Unlike other common audioproducts, Rosetta Stone does not rely solely on an audio environment to teach, so we can create an immersive audio environment, using only the targetlanguage, which reinforces material learned from our software program. Our solutions are available both pre-packaged and by subscription online through our language learning portal. For the year ended December 31,2009, approximately 87% of our revenue was from CD-ROM sales to both consumers and institutions, while approximately 13% was from onlinesubscriptions. We currently offer the following languages: Level 1 Level 2 Level 3 Level 4 Level 5 AudioCompanion TOTALe Version2 Version3 Arabic • • • • • • Chinese(Mandarin) • • • • • • Danish • • Dutch • • • • • • English(U.K.) • • • • • • English(U.S.) • • • • • • • • Farsi(Persian) • • • • • • French • • • • • • • • German • • • • • • • • Greek • • • • • • Hebrew • • • • • • Hindi • • • • • • Indonesian • • Irish • • • • • • Italian • • • • • • • • Japanese • • • • • • Korean • • • • • • Latin • • • • • Pashto • • Polish • • • • • • Portuguese(Brazil) • • • • • • Russian • • • • • • Spanish(LatinAmerica) • • • • • • • • Spanish(Spain) • • • • • • • • Swahili • • Swedish • • • • • • Tagalog • • • • • • Thai • • Turkish • • • • • • 10Vietnamese • • • • • • Welsh • • Table of Contents We also provide an online peer-to-peer practice environment called SharedTalk, at www.sharedtalk.com, where registered language learners meetfor language exchange and to practice their foreign language skills. During 2009, we had more than 125,000 active SharedTalk users. In July 2009, we introduced Rosetta Stone TOTALe, an online language learning solution that integrates our online courses with coach-led practicesessions, fun and engaging language games, interaction with native speakers and live support from customer service agents. In addition, we have developed Rosetta Stone products for the exclusive use of Native American communities to help to save their endangeredlanguages, including Mohawk, Chitimacha, Innutitut and Iñupiaq.Technology We develop most of our own technology, including our proprietary unified language learning software platform. Our newest application,Version 3, currently supports up to five levels of proficiency and is available in 25 languages. Version 2, our legacy application, is available for ourother 6 languages. We intend to offer additional languages on Version 3. The technology underlying both Version 2 and Version 3 is designed tohandle the complexities of a wide variety of languages, including languages written from right-to-left such as Arabic and Hebrew and languages withcharacters such as Chinese and Japanese. Our Version 3 platform is flexible and capable of meeting a wide range of market requirements, including:•enabling reporting features and additional curriculum options for our home school edition; •providing our solutions in a local networked environment to enable a class management tool in the classroom edition; •offering our solutions online through a commercial learning management system for our enterprise customers; and •providing localized interfaces and help files in the user's native language, which are currently available in eight languages.In each of these cases, the learner receives the same engaging language learning experience and content. We have developed a speech recognition technology focused on the unique challenges of language learners, stressing non-native speechunderstanding and pronunciation feedback. This technology, which is included in Version 3, is available for 25 of our languages and runs on all widelyavailable operating systems and on local and online applications. Our speech recognition models include languages traditionally not supported bygeneral-purpose speech recognition software, such as Irish. We have developed proprietary algorithms we call Adaptive Recall, which are designed to enhance the learner's experience by reintroducing contentat longer and longer intervals in order to improve long-term retention. Adaptive Recall, available in Version 3, is designed to be efficient with a learner'stime, bringing material back in the program less and less frequently as the learner remembers over extended periods of time. We have developed a proprietary student management system, which is designed to allow teachers and administrators to configure their ownlesson plans using our content and exercises and to review reports for evaluation of student progress. We have developed an intuitive user interface that assists in the learner's transition from listening comprehension to speaking, making languageskill development an integrated experience.11Table of Contents We have also created proprietary content development tools that allow our curriculum specialists to write, edit, manage and publish our coursematerials. These tools allow authors, translators, voicers, photographers and editors to work efficiently and cooperatively across multiple locations.Content and Curriculum The foundation of Dynamic Immersion is our proprietary content, consisting of a total of more than 25,000 individual photographic images andmore than 400,000 professionally recorded sound files. Each Version 3 language contains approximately 10,000 individual photographic images and15,000 professionally recorded sound files. We believe these photographic images and recorded sound files are a competitive strength, as we havecreated many of the pictures and all of the sound files ourselves. We believe that our images and their juxtaposition convey a universal meaning, whichmakes it possible for us to broadly deploy the same images across multiple languages. In addition, we have developed a sophisticated method forsequencing the images, which is designed to build a rich curriculum that incrementally teaches the user the most important and relevant language skillsnecessary to achieve fluency. We believe that our sequence of images is as effective for someone learning Arabic or Mandarin Chinese as it is forsomeone learning Spanish or English. To supplement our core content, we incorporate specific nuances for each language, such as dual forms for partsof speech in Arabic. Our ability to tailor our content also enables us to develop customized versions of our language learning solutions to address thespecific needs of various industries. For example, we created a customized version of our Arabic learning solution for the U.S. Army, which includesmilitary-specific content, such as vocabulary, images and curriculum sequencing. In the future, we may develop customized versions for otherindustries, such as healthcare, business, real estate and retail. In addition to visual learning experiences, our Version 3 solutions incorporate an integrated speech program utilizing our voice recognitionapplication, which works in languages that are traditionally not supported by general-purpose speech recognition software. As an integral component ofthe program, this voice recognition feature works with our learners to promote the appropriate pronunciation of the words and concepts included in thelesson. Throughout the curriculum sequence, our program combines the introduction of new concepts, practice of recent material and production of keyphrases. As learners progress along our curriculum, they transition from seeing and recognizing to speaking as our program prompts them to pronouncethe words they are being taught. Our solution covers all aspects necessary for fluency within a completely immersive environment without requiringtranslation or explanation, including alphabet, vocabulary, intuitive grammar, reading, writing, listening, pronunciation and conversation. While rigorousand complete, the curriculum is designed to remain flexible, allowing learners to alter their individual pace and focus of instruction to meet theirparticular goals and abilities. The language content for our respective courses is organized into up to five levels of proficiency, with each level providingapproximately 40 hours of instruction and containing multiple units, lessons and activities.12Table of ContentsCustomers Our customers include individuals, home school parents, educational institutions, armed forces, government agencies, corporations and not-for-profit institutions. We sell to our customers through a direct-to-consumer and institutional marketing and distribution strategy.Marketing and Distribution Channels Our multi-channel marketing and distribution model consists of print, online, television and radio direct-response advertising, kiosks, ourinstitutional sales force and retail resellers. We believe that this marketing and distribution model, through which each channel complements andsupports the others, provides:•greater brand awareness across channels; •cost-effective consumer acquisition and education; •premium brand building; and •improved convenience for consumers.Consumer Consumer sales accounted for approximately 79% of our revenue for the year ended December 31, 2009. Our consumer distribution modelcomprises a mix of our call centers, websites, network of kiosks and select retail resellers, such as Amazon.com, Apple, Barnes & Noble and Borders.We also offer our products in a limited number of ZoomShop unmanned automated kiosks. We believe these channels complement each other, asconsumers that have seen our direct-to-consumer advertising may purchase13Channel Customer Type Representative CustomersConsumer Individual Based on our internal studies, 60% annually earn more than $75,000 and 44% earn more than $100,000 Retailers Amazon.com, Apple, Barnes & Noble, Borders, Office Depot, Books-A-Million, London DrugsInstitutional EducationalInstitutions Primary and Secondary Schools: New York City Department of Education (NY), DeKalb County Schools (GA),Cherokee County Board of Education (GA), Yonkers Public Schools (NY), Oakland Unified School District (CA),Manatee County Schools (FL) Universities: James Madison University, University of Wisconsin, West Chester University, VirginiaCommonwealth University, Clark Atlanta University, Jackson State University Government,Armed Forcesand Not-for-ProfitOrganizations U.S. Department of Homeland Security, U.S. Immigration and Customs Enforcement, Foreign Service Institute,Defense Intelligence Agency, U.S. Department of the Air Force, U.S. Army, U.S. Marines, The Church of JesusChrist of Latter-Day Saints, Council for Adult and Experiential Learning, Pacific Training Institute Clinic, AARP,Neighborhood House of St. Paul, Seattle Goodwill Corporations Reuters Group Plc, General Motors Corp., Pride International Inc., Res-Care, Inc., Cerner Corp., Tyco ElectronicsCorp., Molex Inc., Experian Information Solutions, Inc., Marriott International, Inc., Whole Foods Market Inc.Table of Contentsat our kiosks or retailers, and those who have seen our solutions demonstrated at our kiosks may purchase solutions through our retailers, websites orcall centers. Direct to Consumer. Our direct-to-consumer channel, which we define as sales generated through either our websites or call centers, accountedfor approximately 57% of our consumer revenue for the year ended December 31, 2009. We utilize several forms of advertising to drive our direct-to-consumer sales, including print, online, television and radio. We advertise in a variety of national publications, such as Time, The Economist, The NewYorker and National Geographic. Our online media strategy encompasses banner and paid search advertising, as well as affiliate relationships. Wework with various online agencies to buy both impression-based and performance-based traffic. All our advertisements include a "call to action," whichencourages potential customers to visit our websites or contact a call center to order a product or a CD-ROM demo. Our advertisements includepromotional codes that encourage customers to indicate which television or radio spot or publication they are responding to in order for us to trackperformance of each discrete media buy. By using different codes for different advertising media and campaigns, we can track the link between ourmedia buying and the demand it generates. This gives us insight into the effectiveness of each form of advertising we purchase, which enables us tomore closely tie our advertising spending to the results achieved. We receive our orders in the direct-to-consumer channel through our websites and callcenters. Our marketing to this channel also supports the kiosk and retail channels. Rosetta Stone Kiosks. As of December 31, 2009, we operated 242 retail kiosks, including 3 full service retail outlets, in airports, malls and otherstrategic high-traffic locations in 39 states and the District of Columbia. This does not include the ZoomShop unmanned automated kiosks in which weoffer our products. As of December 31, 2009, we also operated 9 kiosks in the United Kingdom, 12 in Japan and 20 in South Korea. Some of ourinternational kiosks are inside the stores of other retailers. These company-operated kiosks accounted for approximately 20% of our consumer revenuefor the year ended December 31, 2009. With bright and colorful displays, efficient use of retail space and limited capital investment, we believe that ourcompany-operated kiosks are an effective outlet for selling our solutions and reinforcing our brand image. We believe that our kiosks enhance ourability to build strong consumer relationships and promote additional customer interest through the provision of personal demonstrations by our salesassociates. Most of our kiosk site licenses range between three to six months with renewal options. Our policy is to close under-performing kiosksexpeditiously. We also offer our products in a limited number of unmanned ZoomShop automated kiosks. Although these devices do not offer the one-on-oneexperience that the kiosks provide, there are interactive demonstrations on their touch screens with audio that helps illustrate our teaching techniques.These devices allow us to quickly establish a presence in retail locations for a very low capital commitment. Retailers. Sales to retailers accounted for approximately 23% of our consumer revenue for the year ended December 31, 2009. Our retailersenable us to provide additional points of contact to educate consumers about our solutions, expand our presence beyond our own kiosks and websites,and further strengthen and enhance our brand image. Our retail relationships include Amazon.com, Apple, Barnes & Noble, Books-A-Million, Borders,Office Depot and London Drugs. Sales in the retail channel are highly correlated with our media expenditures in the direct-to-consumer channel.Institutional Institutional sales accounted for approximately 21% of our revenue for the year ended December 31, 2009. Our institutional distribution model isfocused on targeted sales activity primarily through a direct sales force in four markets: schools, colleges and universities; the U.S. armed forces14Table of Contentsand federal government agencies; corporations; and not-for-profit organizations. Regional sales managers are responsible for sales of our solutions intheir territories and supervise account managers who are responsible for maintaining our customer base. Educational Institutions. These customers include primary and secondary schools and represented approximately 44% of our institutional salesfor the year ended December 31, 2009. In our experience, colleges, universities and schools frequently rely on references from peer institutions and anofficial request-for-proposal, or RFP, process when selecting a vendor. We generate sales leads from sources such as visiting potential customer sites toprovide briefings on our solutions and the industry, interacting with attendees at trade shows and conferences, responding to inbound calls based onrecommendations from existing customers and monitoring and responding to RFPs. Federal Government Agencies and Armed Forces, Not-for-Profit. These customers include governmental agencies and armed forces andorganizations developing workforces to serve non-native speaking populations, offering literacy programs and preparing members for overseasmissions and accounted for approximately 25% of our institutional sales for the year ended December 31, 2009. Many customers in this market licenseour products through online subscriptions. We have recently been adding sales representatives to this group to allow greater focus by senior salesexecutives on expanding some of our key relationships. Corporations. We promote interest in this market with onsite visits, trade show and seminar attendance, speaking engagements and directmailings. Many of our customers in the market prefer online subscription delivery. Corporations represented 12% of our institutional revenue for theyear ended December 31, 2009. Home Schools. We promote interest in this market through advertising in publications focused on home schooling, attending local trade showsand seminars and direct mailings. Home school sales accounted for approximately 19% of our institutional revenue for the year ended December 31,2009.International International sales accounted for approximately 8% of our revenue for the year ended December 31, 2009. In the near term, our internationalactivity is primarily focused on successfully growing our business in the United Kingdom, Germany, South Korea and Japan, where we are utilizingmany of the same direct-to-consumer and channel strategies that we developed in the domestic market. We opened our United Kingdom office in 2005,our Japan office in 2007, and our Korean office in 2009. Over time, we believe that we will be able to develop a similar business model in other marketsin Europe, Asia and Latin America.Product Development Our product portfolio is a result of significant investment in product development over 16 years. Our product development focuses on bothsoftware and content development. Our development efforts include both creating new solutions and adding new languages to existing solutions. Ourdevelopment team has specific expertise in speech recognition, interface design, immersion learning and instructional design. In 2006, we licensed speech recognition technology for language learning from the Regents of the University of Colorado. We subsequently hiredseveral of the original developers of this technology to begin building our expertise in speech recognition. Since 2006, we have made significantimprovements to the original technology. We believe that this technology and expertise distinguishes us from other companies in our industry.15Table of Contents In August 2007, we launched a new product platform, Version 3, in ten languages in our consumer channels. This product launch was theculmination of over three years of research and development. Version 3 provides a significant set of new features and benefits, including our proprietaryspeech recognition technology. We subsequently introduced four additional Version 3 languages in March 2008 and seven more Version 3 languages inSeptember 2008. We also introduced the Audio Companion compact disc practice tool in all 14 of our then-available Version 3 languages in June 2008and introduced the Audio Companion in the seven new Version 3 languages in September 2008. In May 2009, we released Levels 4 and 5 in English(US) and Spanish (Latin America) as well as an additional four languages in Version 3. In July 2009, we released Rosetta Stone TOTALe, our newweb-based service offering that includes a component of dedicated language conversation coaching. In November 2009, we released Levels 4 and 5 in 4additional languages in Version 3. As of December 31, 2009, all Version 3 languages are sold with Audio Companion and all Version 3 languages,except for Latin, are available with Rosetta Stone TOTALe web-based services. Our research and development expenses were $26.2 million in the year ended December 31, 2009.Sourcing and Fulfillment Our strategy is to maintain a flexible, diversified and low-cost manufacturing base. We use third-party contract manufacturers and suppliers toobtain substantially all our product and packaging components and to manufacture finished products. We believe that we have good relationships withour manufacturers and suppliers and that there are alternative sources in the event that one or more of these manufacturers or suppliers is not available.We continually review our manufacturing and supply needs against the capacity of our contract manufacturers and suppliers with a view to ensuring thatwe are able to meet our production goals, reduce costs and operate more efficiently. We package and distribute our products primarily from our fulfillment facility in Harrisonburg, Virginia. We also contract with third-partyfulfillment vendors in Munich, Netherlands and Tokyo, Japan. From Tokyo, we distribute products for consumer orders in Japan. From Munich, wedistribute products for consumer orders in Europe. We distribute products for the remainder of our orders from Harrisonburg, Virginia.Competition The language learning industry is highly fragmented and subject to rapidly changing consumer preferences and industry trends. We expectcompetition in the markets that we serve to persist and intensify. We face varying degrees of competition from a wide variety of companies providinglanguage learning solutions including:•language learning center operators; •audio CD and MP3 download providers; •pre-packaged software producers; •textbook publishers; •online tutoring service providers; and •online peer-to-peer practice providers.Our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), Random House Ventures LLC (Living Language), DisneyPublishing Worldwide and McGraw-Hill Education. We believe that the principal competitive factors in our industry include:•product differentiation, including:16Table of Contents•teaching method, •effectiveness, •accessibility and convenience, •availability and quality of speech recognition, and •fun and likelihood of continued engagement, •brand recognition and reputation; •price; and •effective advertising.We believe that we compete favorably on the basis of these factors.Intellectual Property Our ability to protect our core technology and intellectual property is critical to our success. We rely on a combination of measures to protect ourintellectual property, including patents, trade secrets, trademarks, trade dress, copyrights and non-disclosure and other contractual arrangements. We have one U.S. patent that has been granted and several international and U.S. patents pending. Many of these pending patents relate to ourlanguage teaching methods. We hold a perpetual, irrevocable and worldwide license from the University of Colorado allowing us to use speech recognition technology forlanguage learning solutions. We entered into the license agreement in December 2006, and paid the University of Colorado an up-front license fee. We have registered a variety of trademarks, including Rosetta Stone, Rosetta World, Rosetta Stone Language Learning Success & global design,Audio Companion, Dynamic Immersion, The Fastest Way to Learn a Language. Guaranteed., Adaptive Recall, Contextual Formation, the RosettaStone blue stone logo and design, the Rosetta Stone blue stone logo and design/Language Learning Success, Rosettastone.com, and SharedTalk. Wehave applied to register our TOTALe, rWorld, Rosetta Studio, Rosetta Course, Rosetta Stone Totale and Simbio trademarks. All these trademarks arethe subject of either registrations or pending applications in the United States, as well as numerous countries worldwide where we do business. Weintend to continue to strategically register, both domestically and internationally, trademarks we utilize today and those we develop in the future. We own the copyright on our Version 2 English editions. We are registering or have registered in the United States our Version 2 non-Englisheditions and all editions of our Version 3 languages. We believe that the distinctive marks that we use in connection with our solutions are important in building our brand image and distinguishing oursolutions from those of our competitors. These marks are among our most valuable assets. In addition to our distinctive marks, we own severalcopyrights and trade dress rights to our solutions, product packaging and user manuals. We also place significant value on our trade dress, which is theoverall image and appearance of our solutions, and we believe that our trade dress helps to distinguish our solutions in the marketplace. Furthermore, our employees, contractors and other parties with access to our confidential information sign agreements that prohibit theunauthorized disclosure of our proprietary rights, information and technology.Employees As of December 31, 2009, we had 1,738 total employees, consisting of 922 full-time and 816 part-time employees. Our personnel consisted of266 employees in sales and marketing, 333 employees17Table of Contentsin research and development, 190 in general and administrative and 894 kiosk sales employees. None of our employees is represented by a collectivebargaining agreement. We believe our employee relations are good.Other Information Our Internet address is www.rosettastone.com. We make available free of charge through our Internet website our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to the Securities Act of 1934as soon as reasonably practicable after we electronically file such material with, or furnish it to, the United States Securities and Exchange Commission(SEC).Item 1A. Risk Factors In addition to the other information set forth in this annual report on Form 10-K, you should carefully consider the risk factors discussed belowand in other documents we file with the Securities and Exchange Commission, which could materially affect our business, financial condition or futureresults. These are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financial condition and/or operating results.Our actual operating results may differ significantly from our guidance. From time to time, we may release guidance in our quarterly earnings releases, quarterly earnings conference call, or otherwise, regarding ourfuture performance that represent our management's estimates as of the date of release. This guidance, which includes forward-looking statements, isbased on projections prepared by our management. These projections are not prepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside partycompiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto. Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject tosignificant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specificassumptions with respect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges whichare intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of thesuggested ranges. The principal reason that we release guidance is to provide a basis for our management to discuss our business outlook with analystsand investors. We do not accept any responsibility for any projections or reports published by any such persons. Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions of the guidance furnished by us will notmaterialize or will vary significantly from actual results. Accordingly, our guidance is only an estimate of what management believes is realizable as ofthe date of release. Actual results will vary from our guidance and the variations may be material. In light of the foregoing, investors are urged not torely upon, or otherwise consider, our guidance in making an investment decision in respect of our common stock. Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in our "Risk Factors"and in this annual report on Form 10-K could result in the actual operating results being different from our guidance, and such differences may beadverse and material.18Table of ContentsRisks Related to Our BusinessBecause we generate all of our revenue from language learning solutions, a decline in demand for our language learning solutions or forlanguage learning solutions in general could cause our revenue to decline. We generate substantially all of our revenue from our language learning solutions, and we expect that we will continue to depend upon languagelearning solutions for substantially all of our revenue in the foreseeable future. Because we are dependent on our language learning solutions, factorssuch as changes in consumer preferences for these products may have a disproportionately greater impact on us than if we offered multiple productcategories. If consumer interest in our language learning software products declines, or if consumer interest in learning foreign languages in generaldeclines, we would likely experience a significant loss of sales. Some of the potential developments that could negatively affect interest in and demandfor language learning software products include:•a decline in international travel; •changes in U.S. laws or policies making it more difficult for foreign persons to visit or take up residence in the United States; and •a reduction in the roles of the U.S. armed forces or other governmental agencies in foreign countries.Because a substantial portion of our revenue is generated from our consumer business, if we fail to accurately forecast consumer demand andtrends in consumer preferences, our Rosetta Stone brand, sales and customer relationships may be harmed. Demand for our language learning software products and related services, and for consumer products and services in general, is subject to rapidlychanging consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:•identify, anticipate, understand and respond to these trends in a timely manner; •introduce appealing new products and performance features on a timely basis; •anticipate and meet consumer demand for additional languages and learning levels; •effectively position and market our products and services; •identify and secure cost-effective means of marketing our products to reach the appropriate consumers; •identify cost-effective sales distribution channels, kiosk locations and other sales outlets where interested consumers will buy ourproducts; •anticipate and respond to consumer price sensitivity and pricing changes of competitive products; and •identify and successfully implement ways of building brand loyalty and reputation. A decline in consumer demand for our solutions, or any failure on our part to satisfy changing consumer preferences, could harm our business andprofitability.We depend on discretionary consumer spending in the consumer segment of our business. Adverse trends in general economic conditions,including retail shopping patterns, airport traffic or consumer confidence, may compromise our ability to generate revenue. The success of our business depends to a significant extent upon discretionary consumer spending, which is subject to a number of factors,including general economic conditions, consumer confidence, employment levels, business conditions, interest rates, availability of credit, inflation andtaxation. Adverse trends in any of these economic indicators may cause consumer spending to decline further,19Table of Contentswhich could hurt our sales and profitability. We depend on the continued popularity of malls as shopping destinations and the ability of mall anchortenants and other attractions to generate customer traffic for our retail mall-based kiosks. We also depend on continued airline travel to generate trafficfor our retail kiosks located in airports. Decreases in mall or airport traffic adversely affect the sales from our kiosks and our profitability and financialcondition. In addition, an increase in the taxation of online sales could result in reduced online purchases or reduced margins on such sales.Furthermore, consumers may defer purchases of our solutions in anticipation of new products or new versions from us or our competitors.Intense competition in our industry may hinder our ability to generate revenue and may diminish our margins. The market for foreign language learning solutions is rapidly evolving, highly fragmented and intensely competitive, and we expect both productand pricing competition to persist and intensify. Increased competition could cause reduced revenue, price reductions, reduced gross margins and loss ofmarket share. Our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), a subsidiary of CBS Corporation, Random HouseVentures LLC (Living Language), Disney Publishing Worldwide, a subsidiary of Walt Disney Company, and McGraw-Hill Education, a subsidiary ofThe McGraw-Hill Companies. Many of our current and potential competitors have longer operating histories and substantially greater financial,technical, sales, marketing and other resources than we do, as well as greater name recognition worldwide. The resources of these competitors also mayenable them to respond more rapidly to new or emerging technologies and changes in customer requirements, reduce prices to win new customers andoffer free language learning software or online services. We may not be able to compete successfully against current or future competitors. As the market for foreign language solutions continues to develop, a number of other companies with greater resources than ours could attempt toenter the market or increase their presence by acquiring or forming strategic alliances with our competitors or our distributors or by introducing theirown competing products. These companies and their products may be superior to any of our current competition. We may not have the financialresources, technical expertise, marketing, distribution or support capabilities to compete effectively with any of these new entrants to the market. As we continue to expand into foreign markets, we expect that we will experience competition from local foreign language learning companies thathave strong brand recognition and more experience in selling to local consumers and a better understanding of local marketing, sales channels andconsumer preferences. Our success will depend on our ability to adapt to these competitive forces, to adapt to technological advances, to develop more advanced productsmore rapidly and less expensively than our competitors, to continue to develop an international sales network, to adapt to changing consumerpreferences and to educate potential customers about the benefits of using our solutions rather than our competitors' products and services. Existing ornew competitors could introduce new products and services with superior features and functionality at lower prices. This could impair our ability to sellour products and services.Demand for paid language learning solutions such as ours could decline if effective language learning solutions become available for free. Presently there are a number of free online language websites offering limited vocabulary lists and grammar explanations and tips. In addition,there are some online services offering limited free lessons and learning tools, including one sponsored by the U.S. Department of Education to helpimmigrants learn English. Many of these websites offer free language practice opportunities with other language learners. If these free products becomemore sophisticated and competitive or gain widespread acceptance by the public, demand for our solutions could decline.20Table of ContentsOur future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures. Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures, including ourability to:•create greater awareness of our brands and our language learning solutions; •select the right market, media and specific media vehicle in which to advertise; •identify the most effective and efficient level of spending in each market, media and specific media vehicle; •determine the appropriate creative message and media mix for advertising, marketing and promotional expenditures; •effectively manage marketing costs, including creative and media expenses, in order to maintain acceptable customer acquisition costs; •drive traffic to our websites, call centers, kiosks and distribution channels; and •convert customer inquiries into actual orders. Our planned marketing expenditures may not result in increased revenue or generate sufficient levels of product and brand name awareness, andwe may not be able to increase our net sales at the same rate as we increase our advertising expenditures. Much of our radio, television and print advertising has been through the purchase of "remnant" advertising segments. These segments are randomtime slots and publication dates that have remained unsold and are offered at discounts to advertisers who are willing to be flexible with respect to timeslots. There is a limited supply of this type of advertising and the availability of such advertising may decline or the cost of such advertising mayincrease. In addition, if we increase our marketing budget we cannot assure you that we can increase the amount of remnant advertising at thediscounted prices we have obtained in the past. If any of these events occur, we may be forced to purchase time slots and publication dates at higherprices, which will increase our costs.Our business depends on our Rosetta Stone brand, and if we are not able to maintain and enhance our brand, our business and operatingresults may be harmed. We believe that market awareness of our Rosetta Stone brand in the United States has contributed significantly to the success of our business. Wealso believe that maintaining and enhancing the Rosetta Stone brand is critical to maintaining our competitive advantage. As we continue to grow in size,expand our products and services and extend our geographic reach, maintaining the quality and consistency of our language learning solutions, and thusthe quality of our brand, may be more difficult. In addition, software piracy and trademark infringement may harm our Rosetta Stone brand byundermining our reputation for quality software programs.We depend on search engines and other online sources to attract visitors to our websites, and if we are unable to attract these visitors and convertthem into customers in a cost-effective manner, our business and financial results may be harmed. Our success depends on our ability to attract online consumers to our websites and convert them into customers in a cost-effective manner. Wedepend, in part, on search engines and other online sources for our website traffic. We are included in search results as a result of both paid searchlistings, where we purchase specific search terms that will result in the inclusion of our listing, and algorithmic searches that depend upon the searchablecontent on our sites. Search engines and other online sources revise their algorithms from time to time in an attempt to optimize their search results.21Table of Contents If one or more of the search engines or other online sources on which we rely for website traffic were to modify its general methodology for howit displays our websites, resulting in fewer consumers clicking through to our websites, our sales could suffer. If any free search engine on which werely begins charging fees for listing or placement, or if one or more of the search engines or other online sources on which we rely for purchasedlistings, modifies or terminates its relationship with us, our expenses could rise, we could lose customers and traffic to our websites could decrease.Our expansion into international markets may not succeed and imposes special risks. Our business strategy contemplates continued expansion into international markets. We are currently expanding our direct sales channels in Europeand Asia. In addition, we are expanding our indirect sales channels in Europe, Asia and Latin America through retailer and distributor arrangementswith third parties. If we are unable to expand our international operations successfully and in a timely manner, our ability to pursue our growth strategywill be impaired. Such expansion may be more difficult or take longer than we anticipate, and we may not be able to successfully market, sell, deliverand support our products and services internationally. Our international operations and our efforts to increase sales in international markets are subject to a number of risks that are in addition to ordifferent than those affecting our U.S. operations, including:•difficulty in staffing and managing geographically dispersed operations and culturally diverse work forces and increased travel,infrastructure and legal compliance costs associated with multiple international locations; •difficulty in establishing and maintaining financial and other internal controls over geographically dispersed operations; •competition from local foreign language software providers and preferences for local products in some regions; •expenses associated with customizing products, support services and websites for foreign countries; •inability to identify an effective and efficient level of advertising, marketing and promotional expenditures in order to maintain acceptablecustomer acquisition costs; •difficulties with providing appropriate and appealing products to suit consumer preferences and capabilities in these markets, such as thepotential need to customize English language software solutions for local markets; •difficulties with establishing successful kiosk sales channels; •inability to successfully develop relationships with significant retailers and distributors; •potential political and economic instability in some regions; •potential unpredictable changes in foreign government regulations; •legal and cultural differences in the conduct of business; •import and export license requirements, tariffs, taxes and other trade barriers; •inflation and fluctuations in currency exchange rates; •potentially adverse tax consequences; •difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets;22Table of Contents•the burden and difficulties of complying with a wide variety of U.S. and foreign laws, regulations, trade standards, treaties and technicalstandards, including the Foreign Corrupt Practices Act; •difficulty in protecting our intellectual property and the high incidence of software piracy in some regions; •costs and delays in downsizing foreign work forces as a result of differing employment and other laws; •protectionist laws and business practices that favor local competitors; and •uncertainty regarding liability for information retrieved and replicated in foreign countries. The effects of any of the risks described above could reduce our future revenue from our international operations and could harm our overallbusiness, revenue and financial results.Our introduction of Rosetta Stone Version 4 TOTALe will increase our costs as a percentage of revenue, may not succeed and may harm ourbusiness, financial results and reputation. We have publicly announced plans to introduce Rosetta Stone Version 4 TOTALe in the third quarter of 2010. Rosetta Stone Version 4 TOTALeintegrates our existing language learning software solutions with web-based services, which will provide opportunities for practice with dedicatedlanguage conversation coaches and other language learners to increase language socialization. These web-based services will have a much higher cost asa percentage of revenue than our software solutions. We expect to offer Rosetta Stone Version 4 TOTALe primarily by bundling the web-basedservices of TOTALe with our software and audio offerings. At the same time, we expect to provide augmented, free peer-to-peer language practice. Wewill devote significant capital, personnel and management attention to develop and launch Rosetta Stone Version 4 TOTALe, including replacing ourexisting product packaging with Version 4 TOTALe packaging, expanding our staff of conversational coaches and customer support employees,incurring related research and development expenses, and incurring significant marketing expenses relating to the launch of the new offering. Theservices associated with Rosetta Stone Version 4 TOTALe will decrease our margins. Rosetta Stone Version 4 TOTALe will also present newmanagement and marketing challenges that differ from the challenges we face in our existing business. In addition, we will be required to deferrecognition of a portion of each sale of Version 4 TOTALe in connection with the subscription terms of our on-line socialization services. We cannotassure you that Rosetta Stone Version 4 TOTALe will be introduced on the timetable publicly announced or that it will be successful or profitable, or ifit is profitable, that it will provide an adequate return on capital expended. If we are not successful in our launch of Rosetta Stone Version 4 TOTALe,our business, financial results and reputation may be harmed.Our introduction of the "Rosetta Stone Mini" and/or an introductory language learning software offering may not succeed and may harm ourbusiness, financial results and reputation. We have publicly announced plans to introduce an iPhone/iPod Touch/Mobile application, with the project name of Rosetta Stone Mini" to bereleased in the second half of 2010 that will provide a sub-2 hour learning experience in a new language. In addition, we have publicly announced plansto release an introductory offering at a sub-$200 price point, which we refer to as the introductory offering, with our launch of the full Rosetta StoneVersion 4 TOTALe language learning solution. Both the Rosetta Stone Mini and the introductory offering will carry lower price points than our fullRosetta Stone Version 4 TOTALe language learning solution and may cannibalize sales of our more expensive solutions. We will devote significantcapital, personnel and management attention to develop and launch the Rosetta Stone Mini and the introductory offering, including related research anddevelopment expenses, and incurring significant marketing expenses relating to the launch. These new products will present new management andmarketing challenges that differ from the challenges we23Table of Contentsface in our existing business. We cannot assure you that the Rosetta Stone Mini or the introductory offering will be successful or that either offeringwill be profitable, or if it is profitable, that it will provide an adequate return on capital expended. If we are not successful in our launch of the RosettaStone Mini or the introductory offering, our business, financial results and reputation may be harmed.Product returns could exceed our estimates, which would diminish our reported revenue. We offer consumers who purchase our packaged software and audio practice products directly from us an unconditional full money-back six-month guarantee. We also permit some of our retailers and distributors to return packaged products, subject to limitations. We establish revenue reservesfor packaged product returns based on historical experience, estimated channel inventory levels and the timing of new product introductions and otherfactors. If packaged product returns exceed our reserve estimates, the excess would offset reported revenue, which could hurt our reported financialresults.If the recognition by schools and other institutions of the value of technology-based education does not continue to grow, our ability to generaterevenue from institutions could be impaired. Our success depends in part upon the continued adoption by institutions and potential customers of technology-based education initiatives. Someacademics and educators oppose online education in principle and have expressed concerns regarding the perceived loss of control over the educationprocess that can result from offering courses online. If the acceptance of technology-based education does not grow our ability to continue to grow ourinstitutional business could be impaired.If there are changes in the spending policies or budget priorities for government funding of colleges, universities, schools, other educationproviders, armed forces or government agencies, we could lose revenue. Many of our institutional customers are colleges, universities, primary and secondary schools, other education providers, armed forces andgovernment agencies who depend substantially on government funding. Accordingly, any general decrease, delay or change in federal, state or localfunding for colleges, universities, primary and secondary schools, or other education providers or for armed forces or government agencies that use ourproducts and services could cause our current and potential customers to reduce their purchases of our products and services, to exercise their right toterminate licenses, or to decide not to renew licenses, any of which could cause us to lose revenue. In addition, a specific reduction in governmentalfunding support for products such as ours would also cause us to lose revenue and could hurt our overall gross margins.Some of our institutional business faces a lengthy and unpredictable sales cycle for our solutions, which could delay new sales. We face a lengthy sales cycle between our initial contact with some potential institutional customers and the signing of license agreements withthese customers. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of such institutional sales. A delay in orfailure to complete license transactions could cause us to lose revenue, and could cause our financial results to vary significantly from quarter to quarter.Our sales cycle varies widely, reflecting differences in our potential institutional customers' decision-making processes, procurement requirements andbudget cycles, and is subject to significant risks over which we have little or no control, including:•customers' budgetary constraints and priorities; •the timing of our customers' budget cycles; •the need by some customers for lengthy evaluations that often include both their administrators and faculties; and •the length and timing of customers' approval processes.24Table of ContentsIf we are unable to continually enhance our products and services and adapt them to technological changes and customer needs, including theemergence of new computing devices and more sophisticated online services, we may lose market share and revenue and our business couldsuffer. We need to anticipate, develop and introduce new products, services and applications on a timely and cost-effective basis that keeps pace withtechnological developments and changing customer needs. For example, the number of individuals who access the internet through devices other than apersonal computer, such as personal digital assistants, mobile telephones, televisions and set-top box devices, has increased dramatically, and this trendis likely to continue. Our products and services were designed for high resolution, graphical environments such as those available on desktop and laptopcomputers. The lower resolution, functionality and memory associated with alternative devices currently available may make the use of our products andservices through such devices difficult. Because each manufacturer or distributor may establish unique technical standards for its devices, our productsand services may not work or be viewable on these devices. We have no experience to date in operating versions of our products and servicesdeveloped or optimized for users of alternative devices, and new devices and new platforms are continually being released. Accordingly, it is difficult topredict the problems we may encounter in developing versions of our products and services for use on these alternative devices, and we may need todevote significant resources to the creation, support and maintenance of such versions. If we fail to develop or sell products and services that respond tothese or other technological developments and changing customer needs cost effectively, we may lose market share and revenue and our business couldsuffer.If we fail to manage our growth effectively, we may experience difficulty in filling purchase orders, declines in product and service quality andcustomer satisfaction, increased costs or disruption in our operations. We have experienced rapid growth in our business in recent periods, which has strained our managerial, operational, financial and other resources. We anticipate that continued growth of our operations will be required to satisfy increasing consumer and institutional demand and to availourselves of new market opportunities. The expanding scope of our business and growth in the number of our employees, customers and saleslocations will continue to place a significant strain on our management team, information technology systems and other resources. To properly manageour growth, we need to hire and retain personnel, upgrade our existing operational, management and financial and reporting systems, includingwarehouse management and inventory control, improve our business processes and controls and identify and develop relationships with additionalretailers and distributors. We may also be required to expand our distribution facilities and our operational facilities or add new facilities, which couldrequire significant capital expenditures. Failure to effectively manage our growth in a cost-effective manner could result in difficulty in filling purchaseorders, declines in product and service quality and customer satisfaction, increased costs or disruption of our operations. Our rapid growth also makes it difficult for us to adequately predict the expenditures we will need to make in the future. If we do not make thenecessary overhead expenditures to accommodate our future growth, we may not be successful in executing our growth strategy.Our revenue is subject to seasonal and quarterly variations, which could cause our financial results to fluctuate significantly. We have experienced, and we believe we will continue to experience, substantial seasonal and quarterly variations in our revenue and net income.These variations are primarily related to increased sales of our products and services to consumers in the fourth quarter during the holiday selling seasonas well as higher sales to governmental and educational institutions in the second and third quarters. We sell to a significant number of our retailers,distributors and institutional customers on a purchase25Table of Contentsorder basis and we receive orders when these customers need products and services. As a result, their orders are typically not evenly distributedthroughout the year. Our quarterly results of operations also may fluctuate significantly as a result of a variety of other factors, including the timing ofholidays and advertising initiatives, changes in our products, services and advertising initiatives and changes in those of our competitors. Budgetaryconstraints of our institutional customers may also cause our quarterly results to fluctuate. As a result of these seasonal and quarterly fluctuations, we believe that comparisons of our results of operations between different quarters are notnecessarily meaningful and that these comparisons are not reliable as indicators of our future performance. In addition, these fluctuations could result involatility and adversely affect our cash flows. As our business grows, these seasonal fluctuations may become more pronounced. Any seasonal orquarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors. This could cause the price of ourcommon stock to fluctuate significantly.Because a significant portion of our sales are made to or through retailers and distributors, none of which have any obligation to sell ourproducts, the failure or inability of these parties to sell our products effectively could hurt our revenue growth and profitability. We rely on retailers and distributors, together with our direct sales force, to sell our products. Our sales to retailers are highly concentrated on asmall group, including Amazon.com, Apple, Barnes & Noble, Borders and Office Depot. We expect that our arrangements with these retailers anddistributors will continue to generate significant revenue for us. Sales to or through our retailers and distributors accounted for approximately 18% ofour revenue for the year ended December 31, 2009. We have no control over the amount of products that these retailers purchase from us or sell on our behalf, we do not have long-term contractswith any of them, and they have no obligation to offer or sell our products or to give us any particular shelf space or product placement within theirstores. Thus, there is no guarantee that this source of revenue will continue at the same level as it has in the past or that these retailers will not promotecompetitors' products over our products or enter into exclusive relationships with competitors. Any material adverse change in the principal commercialterms, material decrease in the volume of sales generated by our larger retailers or distributors or major disruption or termination of a relationship withthese retailers and distributors could result in a potentially significant decline in our revenue and profitability. Furthermore, product display locations andpromotional activities that retailers undertake can affect the sales of our products. The fact that we also sell our products directly could cause retailers ordistributors to reduce their efforts to promote our products or stop selling our products altogether. In addition, if one or more of such retailers ordistributors were unable to meet their obligations with respect to accounts payable to us, we could be forced to write off such accounts. In addition, anybankruptcy, liquidation, insolvency or other failure of any of these retailers or distributors could result in significant financial loss and cause us to loserevenue in future periods.Substantially all of our inventory is located in one warehouse facility. Any damage or disruption at this facility could cause significant financialloss, including loss of revenue and harm to our reputation. Substantially all of our inventory is located in one warehouse facility. We could experience significant interruption in the operation of this facilityor damage or destruction of our inventory due to natural disasters, accidents, failures of the inventory locator or automated packing and shippingsystems or other events. If a material portion of our inventory were to be damaged or destroyed, we might be unable to meet our contractual obligationswhich could cause us significant financial loss, including loss of revenue and harm to our reputation.26Table of ContentsThe loss of key personnel or the failure to attract and retain highly qualified personnel could compromise our ability to effectively manage ourbusiness and pursue our growth strategy. Our future performance depends on the continued service of our key technical, development, sales, services and management personnel. We relyon our executive officers and senior management to execute our existing business plans and to identify and pursue new opportunities. We rely on ourtechnical and development personnel for product innovation. We generally do not have employment agreements with our personnel and, therefore, theycould terminate their employment with us at any time. The loss of key employees could result in significant disruptions to our business, and theintegration of replacement personnel could be costly and time consuming, could cause additional disruptions to our business, and could be unsuccessful.We do not carry key person life insurance covering any of our employees. Our future success also depends on our continued ability to attract and retain highly qualified technical, development, sales, services andmanagement personnel. Competition for such personnel is intense, and we may fail to retain our key employees or attract or retain other highly qualifiedpersonnel in the future. Many of our employees are located in Harrisonburg, Virginia, a city that does not have a large pool of qualified replacementpersonnel. The lack of qualified local replacement personnel may make it more difficult to quickly find replacement personnel and may increase the costsof identifying and relocating replacement personnel to Harrisonburg, Virginia. In addition, wage inflation and the cost of retaining our key personnel in the face of competition for such personnel may increase our costs fasterthan we can offset these costs with increased prices or increased sales volume.If we are unable to hire, train, motivate and retain sales personnel to staff our kiosks, or to identify suitable locations and negotiate site licenseson acceptable terms, we could lose revenue, our costs could increase and our profitability could decline. In order to successfully grow our kiosk sales channel we must be able to hire, train, motivate and retain sales personnel to staff these kiosks. Ourkiosks are small and widely dispersed, and, as such, are operated without substantial hands-on management or oversight by us. As a result, we dependon our kiosk sales personnel to effectively manage sales, customer issues and reporting of financial transactions from these kiosks. The opening andsuccess of new kiosks will depend upon various additional factors, including our ability to identify suitable locations and our ability to negotiate sitelicenses on acceptable terms and labor costs. Specifically, we must identify and negotiate cost-effective site licenses for kiosk locations that will generatesufficient consumer demand. Many of these site licenses contain terms and conditions that are highly favorable to licensors including allowing licensorsto cancel them on short notice, sometimes as little as thirty days, and broad indemnification terms in favor of licensors. If competition for kiosk spaceincreases, license rates may increase and other terms may become even less favorable to us, resulting in lower profitability. Our failure to properlymanage the expansion of this sales channel could cause us to lose revenue and increase our expenses.Failure to maintain the availability of the systems, networks, databases and software required to operate and deliver our internet-based productsand services could damage our reputation and cause us to lose revenue. We rely on internal systems and external systems, networks and databases maintained by us and third-party providers to process customer orders,handle customer service requests, and host and deliver our internet-based language learning solutions, including our online language courses andRosetta Stone TOTALe, and our SharedTalk online peer-to-peer collaborative and interactive community. Any damage, interruption or failure of oursystems, networks and databases could prevent us from processing customer orders and result in degradation or interruptions in delivery of ourproducts and services. Notwithstanding our efforts to protect against interruptions in the availability of our e-commerce27Table of Contentswebsites and internet-based products and services, we do occasionally experience unplanned outages or technical difficulties. In addition, we do nothave complete redundancy for all of our systems. We do not maintain real-time back-up of all of our data, and in the event of system disruptions, wecould experience loss of data which could cause us to lose customers and could harm our reputation and cause us to face unexpected liabilities andexpenses. If we continue to expand our business, we will put additional strains on these systems. We may also need to grow, reconfigure or relocate ourdata centers in response to changing business needs, which may be costly and lead to unplanned disruptions of service.We are subject to U.S. and foreign government regulation of online services which could subject us to claims, judgments, and remedies includingmonetary liabilities and limitations on our business practices. We are subject to regulations and laws directly applicable to providers of online services. The application of existing domestic and internationallaws and regulations to us relating to issues such as user privacy and data protection, defamation, promotions, billing, consumer protection,accessibility, content regulation, quality of services, and intellectual property ownership and infringement in many instances is unclear or unsettled. Inaddition, we will also be subject to any new laws and regulations directly applicable to our domestic and international activities. Internationally, we mayalso be subject to laws regulating our activities in foreign countries and to foreign laws and regulations that are inconsistent from country to country. Wemay incur substantial liabilities for expenses necessary to defend litigation in connection with such regulations and laws or to comply with these lawsand regulations, as well as potential substantial penalties for any failure to comply.We may be subject to legal liability for new web-based online services. Rosetta Stone TOTALe enables individuals to exchange information and engage in various online activities on a domestic and an internationalbasis. The law relating to the liability of providers of online services for activities of their users is currently unsettled both within the U.S. andinternationally. Claims may be brought against us for defamation, negligence, copyright or trademark infringement, unlawful activity, tort, includingpersonal injury, fraud, or other theories based on the nature and content of information that may be posted online or generated by our users. Defense ofany such actions could be costly and involve significant time and attention of our management and other resources and may require us to change ourbusiness in an adverse manner. In addition, the amount of data we store for our users on our servers (including personal information) will increase as we increase our web basedservices. Any systems failure or compromise of our security that results in the release of our users' data could seriously limit the adoption of ourproducts and services as well as harm our reputation and brand and, therefore, our business. We may also need to expend significant resources toprotect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number ofweb based products and services we offer as well as increase the number of countries where we operate. Further, failure or perceived failure by us to comply with our policies, applicable requirements, or industry self-regulatory principles related to thecollection, use, sharing or security of personal information, or other privacy, data-retention or data-protection matters could result in a loss of userconfidence in us, damage to our brands, and ultimately in a loss of users, advertising partners, or affiliates which could adversely affect our business.28Table of ContentsOur possession and use of personal information presents risks and expenses that could harm our business. Unauthorized disclosure ormanipulation of such data, whether through breach of our network security or otherwise, could expose us to costly litigation and damage ourreputation. Maintaining our network security is of critical importance because our online e-commerce systems and our online administration tools for ourinstitutional business store proprietary and confidential customer, employee and other sensitive data, such as names, addresses, other personalinformation and credit card numbers. We and our vendors use commercially available encryption technology to transmit personal information whentaking orders. We use security and business controls to limit access and use of personal information. However, third parties may be able to circumventthese security and business measures by developing and deploying viruses, worms and other malicious software programs that are designed to attack orattempt to infiltrate our systems and networks. In addition, employee error, malfeasance or other errors in the storage, use or transmission of personalinformation could result in a breach of customer or employee privacy. We employ contractors and temporary and part-time employees who may haveaccess to the personal information of customers and employees. It is possible such individuals could circumvent our controls, which could result in abreach of customer or employee privacy. Possession and use of personal information in conducting our business subjects us to legislative and regulatory burdens that could requirenotification of data breach, restrict our use of personal information and hinder our ability to acquire new customers or market to existing customers. Wehave incurred, and will continue to incur, expenses to comply with privacy and security standards and protocols imposed by law, regulation, industrystandards or contractual obligations. If third parties improperly obtain and use the personal information of our customers or employees, we may be required to expend significantresources to resolve these problems. A major breach of our network security and systems could have serious negative consequences for our businesses,including possible fines, penalties and damages, reduced customer demand for our products and services, harm to our reputation and brand and loss ofour ability to accept and process customer credit card orders.We are exposed to risks associated with credit card and payment fraud and with credit card processing, which could cause us to lose revenue. Many of our customers use credit cards or automated payment systems to pay for our products and services. We have suffered losses, and maycontinue to suffer losses, as a result of orders placed with fraudulent credit cards or other fraudulent payment data. For example, under current creditcard practices, we may be liable for fraudulent credit card transactions if we do not obtain a cardholder's signature, a frequent practice in internet sales.We employ technology solutions to help us detect fraudulent transactions. However, the failure to detect or control payment fraud could cause us to losesales and revenue.Any significant interruptions in the operations of our call center or third-party call centers could cause us to lose sales and disrupt our ability toprocess orders and deliver our solutions in a timely manner. We rely on both an in-house call center and third-party call centers to sell our solutions, respond to customer service and technical support requestsand process orders. Any significant interruption in the operation of these facilities, including an interruption caused by our failure to successfullyexpand or upgrade our systems or to manage these expansions or upgrades, could reduce our ability to receive and process orders and provide productsand services, which could result in lost and cancelled sales and damage to our brand and reputation. As we grow, we will need more capacity from those existing call centers or we will need to identify and contract with new call centers. We maynot be able to continue to locate and contract for call29Table of Contentscenter capacity on favorable terms, or at all. Additionally, the rates those call centers charge us may increase or those call centers may not continue toprovide service at the current levels. We structure our marketing and advertising to drive potential customers to our call centers and websites to purchase our solutions. If our call centeroperators do not convert inquiries into sales at expected rates, our ability to generate revenue could be impaired. Training and retaining qualified callcenter operators is challenging due to the expansion of our product and service offerings and the seasonality of our business. If we do not adequatelytrain our call center operators, they will not convert inquiries into sales at an acceptable rate. Our call center employs a large number of personnel and historically has been subject to a high turnover rate among employees. We may have toterminate employees from time to time as our business changes and labor demands shift among our facilities. Any significant increase in labor costs,deterioration of employee relations, slowdowns or work stoppages at any of our locations, employee turnover or otherwise, could harm our businessand profitability. In addition, high employee turnover could increase our exposure to employee-related litigation. Likewise, the third-party call centerswe utilize face similar issues.If any of our products contain defects or errors or if new product releases or services are delayed, our reputation could be harmed, resulting insignificant costs to us and impairing our ability to sell our solutions. If our products contain defects, errors or security vulnerabilities, our reputation could be harmed, which could result in significant costs to us andimpair our ability to sell our products in the future. In the past, we have encountered product development delays due to errors or defects. We wouldexpect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products orservices could lead to, among other things:•delays in or loss of market acceptance of our products and services; •diversion of our resources; •a lower rate of license renewals or upgrades for consumer and institutional customers; •injury to our reputation; or •increased service expenses or payment of damages. In addition, we could face claims for product liability, tort or breach of warranty. Our contracts with customers contain provisions relating towarranty disclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divertmanagement's attention and adversely affect the market's perception of us and our products and services. In addition, if our business liability insurancecoverage proves inadequate or future coverage is unavailable on acceptable terms, or at all, we could face significant financial losses.Our sales to U.S. government agencies and armed forces subject us to special risks that could adversely affect our business. Government sales entail a variety of risks including:•government contracts are subject to the approval of appropriations by the United States Congress to fund the expenditures by theagencies under these contracts. Congress often appropriates funds for government agencies on a yearly basis, even though their contractsmay call for performance over a number of years; •our products and services are included on a General Services Administration, or GSA, schedule. The loss of the GSA schedule coveringour software products and related services could cause us to lose our ability to sell our products and services to U.S. governmentcustomers;30Table of Contents•we must comply with complex federal procurement laws and regulations in connection with government contracts, which may imposeadded costs on our business; and •federal government contracts contain provisions and are subject to laws and regulations that provide government customers with rightsand remedies not typically found in commercial contracts. These rights and remedies allow government clients, among other things, toterminate existing contracts, with short notice, for convenience without cause, reduce or modify contracts or subcontracts, and claimrights in products, systems, and technology produced by us.If we fail to effectively upgrade our information technology systems, we may not be able to accurately report our financial results or prevent fraud. As part of our efforts to continue improving our internal control over financial reporting, we plan to continue to upgrade our existing financialinformation technology systems in order to automate several controls that are currently performed manually. We may experience difficulties intransitioning to these upgraded systems, including loss of data and decreases in productivity, as personnel become familiar with these new systems. Inaddition, our management information systems will require modification and refinement as we grow and as our business needs change, which couldprolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If weexperience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable tosuccessfully modify our management information systems or respond to changes in our business needs, we may not be able to effectively manage ourbusiness and we may fail to meet our reporting obligations. In addition, as a result of the automation of these manual processes, the data produced maycause us to question the accuracy of previously reported financial results.Our software products must interoperate with computer operating systems of our customers. If we are unable to ensure that our productsinteroperate properly with customer systems, our business could be harmed. Our products must interoperate with our customers' computer systems, including student learning management systems of our institutionalcustomers. As a result, we must continually ensure that our products interoperate properly with these systems. Changes in operating systems, thetechnologies we incorporate into our products or the computer systems our customers use may damage our business. For example, our online Version 2software subscriptions, which we offer in six languages, does not currently operate properly with the newly released Microsoft Windows 7 and MacOS X operating systems.As our product and service offerings become more complex, our reported revenue may become less predictable. Our planned expansion of products and services will generate more varied sources of revenue than our existing business. The accounting policiesthat apply to these sources of revenue may be more complex than those that apply to our traditional products and services. In addition, we may changethe manner in which we sell our software licenses, and such change could cause delays in revenue recognition in accordance with accounting standards.Under these accounting standards, even if we deliver products and services to, and collect cash from, a customer in a given fiscal period, we may berequired to defer recognizing revenue from the sale of such product or service until a future period when all the conditions necessary for revenuerecognition have been satisfied. Conditions that can cause delays in revenue recognition include software arrangements that have undelivered elementsfor which we have not yet established vendor specific objective evidence of fair value, requirements that we deliver services for significantenhancements or modifications to customize our software for a particular customer or material customer acceptance criteria.31Table of ContentsMany of our expenses are fixed and many are based, in significant part, on our expectations of our future revenue and are incurred prior to thesale of our products and services. Therefore, any significant decline in revenue for any period could have an immediate negative impact on ourmargins, net income and financial results for the period. Our expense levels are based, in significant part, on our estimates of future revenue and many of these expenses are fixed in the short term. As aresult, we may be unable to adjust our spending in a timely manner if our revenue falls short of our expectations. Accordingly, any significant shortfallof revenue in relation to our estimates could have an immediate negative effect on our profitability. In addition, as our business grows, we anticipateincreasing our operating expenses to expand our product development, technical support, sales and marketing and administrative organizations. Anysuch expansion could cause material losses to the extent we do not generate additional revenue sufficient to cover the additional expenses.We may need to raise additional funds to pursue our growth strategy or continue our operations, and we may be unable to raise capital whenneeded. From time to time, we may seek additional equity or debt financing to provide for the capital expenditures required to finance working capitalrequirements, continue our expansion, develop new products and services or make acquisitions or other investments. In addition, if our business planschange, general economic, financial or political conditions in our markets change, or other circumstances arise that have a material effect on our cashflow, the anticipated cash needs of our business as well as our conclusions as to the adequacy of our available sources of capital could changesignificantly. Any of these events or circumstances could result in significant additional funding needs, requiring us to raise additional capital. Wecannot predict the timing or amount of any such capital requirements at this time. If financing is not available on satisfactory terms, or at all, we may beunable to expand our business or to develop new business at the rate desired and our results of operations may suffer.Risks Related to Intellectual Property RightsProtection of our intellectual property is limited, and any misuse of our intellectual property by others, including software piracy, could harm ourbusiness, reputation and competitive position. Our intellectual property is important to our success. We believe our trademarks, copyrights, trade secrets, pending patents, trade dress and designsare valuable and integral to our success and competitive position. To protect our proprietary rights, we rely on a combination of copyrights, trademarks,trade secret laws, confidentiality procedures, contractual provisions and technical measures. We have several patent applications on file. However, we do not know whether any of our pending patent applications will result in the issuance ofpatents or whether the examination process will require us to narrow our claims. Even if patents are issued from our patent applications, which is notcertain, they may be contested, circumvented or invalidated in the future. Moreover, the rights granted under any issued patents may not provide us withproprietary protection or competitive advantages, and, as with any technology, competitors may be able to develop similar or superior technologies nowor in the future. In addition, we have not emphasized patents as a source of significant competitive advantage and have instead sought to primarilyprotect our proprietary rights under laws affording protection for trade secrets, copyright and trademark protection of our products, brands, trademarksand other intellectual property where available and appropriate. However, all of these measures afford only limited protection and may be challenged,invalidated or circumvented by third parties. In addition, these protections may not be adequate to prevent our competitors or customers from copying orreverse-engineering our products. Third parties could copy all or portions of our products or otherwise obtain, use, distribute and sell our proprietaryinformation without authorization. Third parties may32Table of Contentsalso develop similar or superior technology independently by designing around our intellectual property, which would decrease demand for ourproducts. In addition, our patents may not provide us with any competitive advantages and the patents of others may seriously impede our ability toconduct our business. We protect our products, trade secrets and proprietary information, in part, by requiring all of our employees to enter into agreements providing forthe maintenance of confidentiality and the assignment of rights to inventions made by them while employed by us. We also enter into non-disclosureagreements with our technical consultants, customers, vendors and resellers to protect our confidential and proprietary information. We cannot assureyou that our confidentiality agreements with our employees, consultants and other third parties will not be breached, that we will be able to effectivelyenforce these agreements, that we will have adequate remedies for any breach, or that our trade secrets and other proprietary information will not bedisclosed or will otherwise be protected. We rely on contractual and license agreements with third parties in connection with their use of our products and technology. There is no guaranteethat such parties will abide by the terms of such agreements or that we will be able to adequately enforce our rights, in part because we rely, in manyinstances, on "click-wrap" and "shrink-wrap" licenses, which are not negotiated or signed by individual licensees. Accordingly, some provisions of ourlicenses, including provisions protecting against unauthorized use, copying, transfer, resale and disclosure of the licensed software program, may beunenforceable under the laws of several jurisdictions. Protection of trade secret and other intellectual property rights in the markets in which we operate and compete is highly uncertain and may involvecomplex legal questions. The laws of countries in which we operate may afford little or no protection to our trade secrets and other intellectual propertyrights. Although we defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through avariety of techniques, preventing unauthorized use or infringement of our intellectual property rights is inherently difficult. Despite our enforcementefforts against software piracy, we lose significant revenue due to illegal use of our software. If piracy activities increase, it may further harm ourbusiness. We also expect that the more successful we are, the more likely that competitors will try to illegally use our proprietary information and developproducts that are similar to ours, which may infringe on our proprietary rights. In addition, we could potentially lose future trade secret protection forour source code if any unauthorized disclosure of such code occurs. The loss of future trade secret protection could make it easier for third parties tocompete with our products by copying functionality. In addition, any changes in, or unexpected interpretations of, the trade secret and other intellectualproperty laws in any country in which we operate may compromise our ability to enforce our trade secret and intellectual property rights. Costly andtime-consuming litigation could be necessary to enforce and determine the scope of our confidential information and trade secret protection. If we areunable to protect our proprietary rights or if third parties independently develop or gain access to our or similar technologies, our business, revenue,reputation and competitive position could be harmed.Third-party use of our trademarks as keywords in internet search engine advertising programs may direct potential customers to competitors'websites, which could harm our reputation and cause us to lose sales. Competitors and other third parties purchase our trademarks and confusingly similar terms as keywords in internet search engine advertisingprograms and in the header and text of the resulting sponsored link advertisements in order to divert potential customers to their websites. Preventingsuch unauthorized use is inherently difficult. If we are unable to protect our trademarks and confusingly similar terms from such unauthorized use,competitors and other third parties may continue to drive potential online customers away from our websites to competing websites, which could harmour reputation and cause us to lose sales.33Table of ContentsOur trademarks are limited in scope and geographic coverage and may not significantly distinguish us from our competition. We own several federal trademark registrations, including the Rosetta Stone mark, hold common law trademark rights and have federal trademarkapplications pending in the United States and abroad for additional trademarks. Even if federal registrations are granted to us, our trademark rights maybe challenged. It is also possible that our competitors will adopt trademarks similar to ours, thus impeding our ability to build brand identity andpossibly leading to customer confusion. In fact, various third parties have registered trademarks that are similar to ours in the United States andoverseas. We could incur substantial costs in prosecuting or defending trademark infringement suits. If we fail to effectively enforce our trademarkrights, our competitive position and brand recognition may be diminished.We have not registered copyrights for all our products, which may limit our ability to enforce them. We have not registered our copyrights in all of our software, written materials, website information, designs or other copyrightable works. TheUnited States Copyright Act automatically protects all of our copyrightable works, but without a registration we cannot enforce those copyrights againstinfringers or seek certain statutory remedies for any such infringement. Preventing others from copying our products, written materials and othercopyrightable works is important to our overall success in the marketplace. In the event we decide to enforce any of our copyrights against infringers,we will first be required to register the relevant copyrights, and we cannot be sure that all of the material for which we seek copyright registration wouldbe registrable in whole or in part, or that once registered, we would be successful in bringing a copyright claim against any such infringers.We must monitor and protect our internet domain names to preserve their value. We may be unable to prevent third parties from acquiringdomain names that are similar to, infringe on or otherwise decrease the value of our trademarks. We own several domain names that include the terms Rosetta Stone and Rosetta World. Third parties may acquire substantially similar domainnames that decrease the value of our domain names and trademarks and other proprietary rights which may hurt our business. Moreover, the regulationof domain names in the United States and foreign countries is subject to change. Governing bodies could appoint additional domain name registrars ormodify the requirements for holding domain names. Governing bodies could also establish additional "top-level" domains, which are the portion of theWeb address that appears to the right of the "dot," such as "com," "gov" or "org." As a result, we may not maintain exclusive rights to all potentiallyrelevant domain names in the United States or in other countries in which we conduct business, which could harm our business or reputation.Claims that we misuse the intellectual property of others could subject us to significant liability and disrupt our business. We may become subject to material claims of infringement by competitors and other third parties with respect to current or future products, e-commerce and other web-related technologies, online business methods, trademarks or other proprietary rights. Our competitors, some of which mayhave substantially greater resources than us and have made significant investments in competing products and technologies, may have, or seek to applyfor and obtain, patents, copyrights or trademarks that will prevent, limit or interfere with our ability to make, use and sell our current and future productsand technologies, and we may not be successful in defending allegations of infringement of these patents, copyrights or trademarks. Further, we maynot be aware of all of the patents and other intellectual property rights owned by third parties that may be potentially adverse to our interests. We mayneed to resort to litigation to enforce our proprietary rights or to determine the scope and validity of a third-party's patents or other proprietary rights,including whether any of our products, technologies or processes infringe the patents or other proprietary rights of third parties. We may incursubstantial34Table of Contentsexpenses in defending against third-party infringement claims regardless of the merit of such claims. The outcome of any such proceedings is uncertainand, if unfavorable, could force us to discontinue sales of the affected products or impose significant penalties or restrictions on our business. We donot conduct comprehensive patent searches to determine whether the technologies used in our products infringe upon patents held by others. In addition,product development is inherently uncertain in a rapidly evolving technological environment in which there may be numerous patent applicationspending, many of which are confidential when filed, with regard to similar technologies.We do not own all of the software, other technologies and content used in our products and services. Some of our products and services include intellectual property owned by third parties, including software that is integrated with internallydeveloped software and a portion of our voice recognition software, which we license from the University of Colorado. From time to time we may berequired to renegotiate with these third parties or negotiate with new third parties to include their technology or content in our existing products, in newversions of our existing products or in wholly new products. We may not be able to negotiate or renegotiate licenses on commercially reasonable terms,or at all, and the third-party software may not be appropriately supported, maintained or enhanced by the licensors. If we are unable to obtain the rightsnecessary to use or continue to use third-party technology or content in our products and services, the inability to support, maintain and enhance anysoftware could result in increased costs, or in delays or reductions in product shipments until equivalent software could be developed, identified,licensed and integrated.Our use of open source software could impose limitations on our ability to commercialize our products. We incorporate open source software into our products and may use more open source software in the future. The use of open source software isgoverned by license agreements. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that these licensescould be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In such event,we could be required to seek licenses from third parties in order to continue offering our products, make generally available, in source code form,proprietary code that links to certain open source modules, re-engineer our products, discontinue the sale of our products if re-engineering could not beaccomplished on a cost-effective and timely basis, or become subject to other consequences. In addition, open source licenses generally do not providewarranties or other contractual protections regarding infringement claims or the quality of the code. Thus, we may have little or no recourse if webecome subject to infringement claims relating to the open source software or if the open source software is defective in any manner.Risks Related to Owning Our Common StockSome of our stockholders could together exert significant influence over our company. As of December 31, 2009, funds affiliated with ABS Capital Partners beneficially owned in the aggregate shares representing approximately 25%of our outstanding voting power. Two managing members of the general partner of ABS Capital Partners currently serve on our board of directors.Additionally, as of December 31, 2009, Norwest Equity Partners VIII, LP, or Norwest, beneficially owned in the aggregate shares representingapproximately 16% of our outstanding voting power. One managing member of the general partner of Norwest currently serves on our board ofdirectors. As a result, these stockholders could together potentially have significant influence over all matters presented to our stockholders for approval,including election and removal of our directors and change of control transactions. The interests of these stockholders may not always coincide with theinterests of the other holders of our common stock.35Table of ContentsAs a public company we incur additional cost and face increased demands on our management and key employees. We have operated as a public company only since April 15, 2009. As a public company, we incur significant legal, accounting and other expensesthat we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as rules implemented by the Securities and ExchangeCommission, or SEC, and the New York Stock Exchange, impose various requirements on public companies. Our management and other personneldevote substantial amounts of time to these requirements. Moreover, these requirements have significantly increased our legal and financial compliancecosts and have made some activities more time-consuming and costly. In addition, we incur additional costs associated with our public companyreporting requirements. These rules and regulations also make it more difficult and more expensive for us to obtain director and officer liabilityinsurance. We estimate that the incremental annual public company costs will be between $1.5 million and $2.0 million in fiscal 2010, which willprimarily be reflected in general and administrative costs. However, these estimates may prove to be inaccurate as many of these costs are beyond ourcontrol, and the actual incremental costs associated with our public company status could materially exceed our estimates. If our profitability is harmedby these additional costs, it could have a negative effect on the trading price of our common stock.In prior periods, we identified material weaknesses in our internal controls that could result in material misstatements in our financial statements.Although we have remediated the weaknesses, if we do not maintain adequate internal controls over financial reporting, it could impair our abilityto comply with the accounting and reporting requirements applicable to public companies. In relation to our consolidated financial statements for the year ended December 31, 2007, we identified material weaknesses in our internalcontrols over financial reporting in accounting for inventory, income taxes and stock-based compensation, our general computer controls and controlswithin our enterprise resources planning system. In addition, we identified a significant deficiency in our financial closing process. No materialweaknesses or significant deficiencies in our internal controls were identified in relation to our consolidated financial statements for the years endedDecember 31, 2008 and 2009. A material weakness is defined as a significant deficiency or combination of significant deficiencies that result in areasonable possibility that a material misstatement of our financial statements will not be prevented by our internal control over financial reporting. Asignificant deficiency means a control deficiency, or combination of control deficiencies, that adversely affects our ability to initiate, record, process orreport financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that amisstatement of our financial statements that is more than inconsequential will not be prevented or detected by our internal control over financialreporting. Our independent registered public accounting firm's audit for the years ended December 31, 2008 and 2009 included consideration of internalcontrol over financial reporting as a basis for designing their audit procedures, but not for the purpose of expressing an opinion on the effectiveness ofour internal controls over financial reporting. If such an evaluation had been performed or when we are required to have them perform such anevaluation, additional material weaknesses, significant deficiencies and other control deficiencies may have been or may be identified. Ensuring that wehave adequate internal financial and accounting controls and procedures in place to help produce accurate financial statements on a timely basis is acostly and time-consuming effort that needs to be evaluated frequently. We incur increased costs and demands upon management as a result ofcomplying with the laws and regulations affecting public companies relating to internal controls, which could materially adversely affect our results ofoperations. Because of these material weaknesses, there is heightened risk that a material misstatement of our annual or quarterly financial statements relatingto the periods that these material weaknesses existed36Table of Contentswas not prevented or detected. We have taken steps to remediate our material weaknesses, including hiring additional accounting and finance personneland engaging consultants. Although we believe we have remediated these material weaknesses and significant deficiencies and did not identify any newmaterial weaknesses or significant deficiencies in relation to our consolidated financial statements for the years ended December 31, 2008 or 2009, wecannot be certain that our efforts to remediate these internal control weaknesses were successful or that similar material weaknesses will not recur. Our internal growth plans will also put additional strains on our internal controls if we do not augment our resources and adapt our procedures inresponse to this growth. As a public company, we are required to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002regarding internal controls beginning with our fiscal year ending December 31, 2010. In the event that we have not adequately remedied these materialweaknesses, and if we fail to maintain proper and effective internal controls in future periods, we could become subject to potential review by the NewYork Stock Exchange, the SEC or other regulatory authorities, which could require additional financial and management resources, could result in ourdelisting by the New York Stock Exchange, could compromise our ability to run our business effectively and could cause investors to lose confidencein our financial reporting.If securities analysts do not publish research or reports about our business or if they publish negative evaluations of our stock, the price of ourstock could decline. The trading market for our common stock depends in part on the research and reports that industry or financial analysts publish about us or ourbusiness. If one or more of the analysts covering our business downgrade their evaluations of or recommendations regarding our stock, or if one ormore of the analysts cease providing research coverage on our stock, the price of our stock could decline. If one or more of these analysts ceaseproviding research coverage on our stock, we could lose visibility in the market for our stock, which in turn could cause our stock price to decline.Provisions in our organizational documents and in the Delaware General Corporation Law may prevent takeover attempts that could be beneficialto our stockholders. Provisions in our second amended and restated certificate of incorporation and second amended and restated bylaws, and in the Delaware GeneralCorporation Law, may make it difficult and expensive for a third-party to pursue a takeover attempt we oppose even if a change in control of ourcompany would be beneficial to the interests of our stockholders. Any provision of our second amended and restated certificate of incorporation orsecond amended and restated bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for ourstockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for ourcommon stock. Our board of directors has the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the powers,preferences and rights of each series without stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisitionproposals or make it more difficult for a third party to gain control of our company, or otherwise could adversely affect the market price of our commonstock. Further, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. This section generally prohibits usfrom engaging in mergers and other business combinations with stockholders that beneficially own 15% or more of our voting stock, or with theiraffiliates, unless our directors or stockholders approve the business combination in the prescribed manner. However, because funds affiliated with ABSCapital Partners and Norwest acquired their shares prior to our initial public offering, Section 203 is currently inapplicable to any business combinationor transaction with them or their affiliates. In addition, our second amended and restated certificate of incorporation includes a classified board ofdirectors and requires that any action to be taken by stockholders must be taken at a duly called meeting of stockholders and may not be taken by37Table of Contentswritten consent. Our second amended and restated bylaws require that any stockholder proposals or nominations for election to our board of directorsmust meet specific advance notice requirements and procedures, which make it more difficult for our stockholders to make proposals or directornominations.Item 2. Properties Our corporate headquarters are located in Arlington, Virginia, where we sublease approximately 31,281 square feet of space. The term of thissublease runs through December 31, 2013 and we have the right to extend that lease for an additional three years. We believe that our headquartersspace will be adequate for the foreseeable future. We continue to lease approximately 14,541 square feet of space in Arlington, Virginia, which was the site of our corporate headquarters until late2008. This space consists of multiple leased spaces with lease obligations with terms ending between December 31, 2009 and August 31, 2013. Weintend to continue to attempt to sublease a portion of this space, but we cannot assure you that we will be able to sublease any of this space or that, if wedo, it will be on terms that will cover our rent expense related to the space. We currently own a facility with approximately 62,000 square feet of usable space in Harrisonburg, Virginia, that serves as our operations office,where we perform most of our product development. In addition, we lease a facility with approximately 40,000 square feet in Harrisonburg, Virginiafor use as a packing and distribution center for all of our U.S. and some of our international fulfillment. We are seeking additional space inHarrisonburg to support our future growth. We also lease space for our three full service retail outlets in Missouri, New Jersey, and New York and for small offices in Boulder, Colorado,Tokyo, Japan, Seoul, South Korea, Munich, Germany and London, United Kingdom. Our Boulder office serves as a research and development locationwhile our Tokyo, Seoul and London offices serve as our regional sales offices. As of December 31, 2009, we also had site licenses for 242 kiosks. Most of our kiosk site licenses have terms of three to six months and providefor a minimum rent plus a percentage rent based upon sales after certain minimum thresholds have been achieved. These site licenses generally requirethat we pay insurance, utilities, real estate taxes and repair and maintenance expenses. Some of the site licenses also contain early termination options,which can be exercised by us or the licensor under certain conditions.Item 3. Legal Proceedings In July 2009, we filed a lawsuit in the United States District Court for the Eastern District of Virginia against Google Inc., seeking, among otherthings, to prevent Google from infringing upon our trademarks. In this lawsuit, we assert, among other things, that Google allows third parties,including individuals involved in software piracy operations, to purchase the right to use our trademarks or other terms confusingly similar in Google'sAdwords advertising program. This lawsuit seeks, among other things, injunctive relief to prevent Google from selling our trademarks or other termsconfusingly similar for use in Google's Adwords advertising program. To date, Google has not made any counterclaims for damages against us,however, we expect to incur material legal fees and other costs and expenses in pursuit of our claims against Google. From time to time, we have been subject to various claims and legal actions in the ordinary course of our business. We are not currently involvedin any legal proceeding the ultimate outcome of which, in our judgment based on information currently available, would have a material adverse impacton our business, financial condition or results of operations.38Table of ContentsPART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market for Common Stock Our common stock is listed on the New York Stock Exchange under the symbol "RST." The following table sets forth, for each of the periodsindicated, the high and low reported sales price of our common stock on the NYSE. On March 2, 2010, the last reported sales price of our common stock on the NYSE was $23.64 per share. As of that date, there wereapproximately 667 holders of record of our common stock.Dividends We have not paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain allavailable funds and any future earnings to support the operation of and to finance the growth and development of our business. We do not anticipatepaying any cash dividends in the foreseeable future.Securities Authorized For Issuance Under Equity Compensation Plans For information regarding securities authorized for issuance under equity compensation plans, see Part III "Item 12—Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters."Stockholder Return Performance Presentation The following graph compares the change in the cumulative total stockholder return on our common stock during the period from April 16, 2009(the first day our stock began trading on the NYSE) through December 31, 2009, with the cumulative total return on the NYSE Composite Index andthe SIC Code Index that includes all U.S. public companies in the Standard Industrial Classification (SIC) Code 7372-Prepackaged Software. Thecomparison assumes that $100 was invested on April 16, 2009 in our common stock and in each of the foregoing indices and assumes reinvestment ofdividends, if any.39 High Low Year ended December 31, 2009 Fourth Quarter $23.72 $16.55 Third Quarter 30.69 20.35 Second Quarter (Beginning April 16) 31.67 22.10 First Quarter — — Year ended December 31, 2008 Fourth Quarter — — Third Quarter — — Second Quarter — — First Quarter — — Table of ContentsCOMPARISON OF 8 MONTH CUMULATIVE TOTAL RETURN*Among Rosetta Stone Inc., The NYSE Composite IndexAnd SIC code 7372 index*$100 invested on 4/16/09 in stock or index, including reinvestment of dividends.Fiscal year ending December 31.Use of Proceeds from Public Offering of Common Stock On April 15, 2009, our registration statement (File No. 333-153632) was declared effective for our initial public offering, pursuant to which weregistered the offering and sale of 3,125,000 shares of common stock by Rosetta Stone Inc. and the associated sale of 3,125,000 shares of commonstock by funds associated with ABS Capital Partners and Norwest Equity Partners VIII, LP (collectively, the "Private Equity Funds") and the additionalsale pursuant to the underwriters' over-allotment option for an additional 937,500 shares of common stock by the Private Equity Funds, at a publicoffering price of $18.00 per share. The offering closed on April 21, 2009. The managing underwriters were Morgan Stanley & Co. Incorporated andWilliam Blair & Company, LLC. As a result of the offering, we received net proceeds of approximately $49.0 million, after deducting underwriting discounts and commissions of$3.9 million and additional offering-related expenses of approximately $3.3 million. In April 2009, we used $7.9 million to satisfy the federal, state andlocal withholding tax obligations associated with the "net issuance" of stock grants we made to 10 of our key employees, including executive officers,on April 15, 2009. In April 2009, we used $9.9 million of the net proceeds to repay the outstanding balances under our revolving line of credit withWells Fargo. We anticipate that we will use the remaining net proceeds from our initial public offering for working capital and other general corporatepurposes, which may include the acquisition of other businesses, products or technologies. We do not, however, have agreements or commitments forany specific acquisitions at this time. Pending such uses, we plan to invest the net proceeds in short-term, interest-bearing, investment grade securities.40Table of ContentsItem 6. Selected Consolidated Financial Data The following table sets forth our selected consolidated statement of operations, balance sheet and other data for the periods indicated. The selectedconsolidated statement of operations data for the years ended December 31, 2009, 2008 and 2007, and the period from January 4, 2006 throughDecember 31, 2006, and the consolidated balance sheet data as of December 31, 2009, 2008, 2007 and 2006 have been derived from Rosetta Stone Inc.,or the Successor, audited consolidated financial statements. The selected consolidated statement of operations data for the period from January 1, 2006through January 4, 2006 and the year ended December 31, 2005, represents the operations of Fairfield & Sons, Ltd., or the Predecessor, which wasacquired by Rosetta Stone Inc. on January 4, 2006 and have been derived from Predecessor audited consolidated financial statements. The selectedconsolidated financial data as of December 31, 2005 has been derived from Predecessor audited financial statements. This information should be read inconjunction "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statementscontained elsewhere in this Annual Report on Form 10-K. Our historical results for any prior period are not necessarily indicative of results to beexpected in any future period. The Predecessor incurred transaction-related expenses during the period from January 1, 2006 through January 4, 2006 relating to the acquisitionby Rosetta Stone Inc. on January 4, 2006. Included in the expenses were $5.9 million related to restricted common stock, $3.1 million in cash bonusesand $1.2 million in acquisition-related bank fees. Successor Predecessor Year EndedDecember 31, Period fromJanuary 4,throughDecember 31, Period fromJanuary 1,throughJanuary 4, Year EndedDecember 31, 2009 2008 2007 2006 2006 2005 (in thousands, except per share data) Statements ofOperationsData: Revenue $252,271 $209,380 $137,321 $91,298 $272 $48,402 Cost of revenue 33,427 28,676 20,687 12,541 203 8,242 Gross profit 218,844 180,704 116,634 78,757 69 40,160 Operatingexpenses: Sales andmarketing 114,899 93,384 65,437 45,854 695 22,432 Research anddevelopment 26,239 18,387 12,893 8,117 41 2,819 Acquired in-processresearch anddevelopment — — — 12,597 — — General andadministrative 57,174 39,577 29,786 16,590 142 8,157 Leaseabandonment — 1,831 — — — — Transaction-relatedexpenses — — — — 10,315 — Totaloperatingexpenses 198,312 153,179 108,116 83,158 11,193 33,408 Income (loss)fromoperations 20,532 27,525 8,518 (4,401) (11,124) 6,752 Other income andexpense: Interest income 159 454 673 613 — 38 Interest expense (356) (891) (1,331) (1,560) — — Other (expense)income 112 239 154 60 3 134 Interest and otherincome(expense), net (85) (198) (504) (887) 3 172 Income (loss)before incometaxes 20,447 27,327 8,014 (5,288) (11,121) 6,924 Income taxexpense(benefit) 7,084 13,435 5,435 (1,240) — 143 Net income (loss) 13,363 13,892 2,579 (4,048) (11,121) 6,781 Preferred stock41accretion — — (80) (159) — — Income (loss)attributable tocommonstockholders $13,363 $13,892 $2,499 $(4,207)$(11,121)$6,781 Income (loss) pershareattributable tocommonstockholders: Basic $0.89 $7.29 $1.47 $(2.63)$(37,194)$24,658 Diluted $0.67 $0.82 $0.15 $(2.63)$(37,194)$24,658 Common sharesandequivalentsoutstanding: Basic weightedaverage shares 14,990 1,905 1,702 1,598 0.299 0.275 Diluted weightedaverage shares 19,930 16,924 16,533 1,598 0.299 0.275 Table of Contents 42 Successor Predecessor Year EndedDecember 31, Period fromJanuary 4,throughDecember 31, Period fromJanuary 1,throughJanuary 4, Year EndedDecember 31, 2009 2008 2007 2006 2006 2005 (in thousands, except per share data) Other Data: Stock-basedcompensationincluded in: Cost of sales $34 $2 $2 $1 $— $— Sales andmarketing 999 153 189 59 — — Research anddevelopment 5,959 482 360 128 — — General andadministrative 15,158 953 776 373 — — Transaction-relatedexpenses — — — — 5,930 — Total stock-basedcompensationexpense $22,150 $1,590 $1,327 $561 $5,930 $— Intangibleamortizationincluded in: Cost of sales $— $13 $1,227 $1,213 $— $— Sales andmarketing 42 3,003 3,596 4,113 — — Total intangibleamortizationexpense $42 $3,016 $4,823 $5,326 $— $— Sucessor Predecessor Year EndedDecember 31, Year EndedDecember 31, 2009 2008 2007 2006 2005 (in thousands) Consolidated Balance Sheet Data: Cash and cash equivalents $95,188 $30,626 $21,691 $16,917 $11,738 Total assets 225,442 138,818 110,376 96,754 25,620 Deferred revenue 26,106 15,744 12,939 8,105 6,231 Notes payable and capital lease obligation — 9,910 13,324 15,917 63 Redeemable convertible preferred stock — — 5,000 4,920 — Total stockholders' equity $156,435 $79,071 $58,125 $53,548 $8,985 Table of ContentsItem 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction withour consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. Our actual results may differmaterially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including thosediscussed under "Risk Factors" and elsewhere in this Annual Report on Form 10-K.Overview We are a leading provider of technology-based language learning solutions. We develop, market and sell language learning solutions consisting ofsoftware, online services and audio practice tools primarily under our Rosetta Stone brand. Our teaching method, which we call Dynamic Immersion, isdesigned to leverage the innate, natural language learning ability that children use to learn their native language. Our courses are based on ourproprietary interactive technologies and pedagogical content and utilize a sophisticated sequencing of images, text and sounds to teach a new languagewithout translation or grammar explanation. We believe our award-winning solutions provide an effective, convenient and fun way to learn languages.We currently offer our self-study language learning solutions in 31 languages. Our customers include individuals, educational institutions, armed forces,government agencies and corporations. The strength and breadth of our solutions have allowed us to develop a business model that we believe distinguishes us from other languagelearning companies. Our scalable technology platform and our proprietary content can be deployed across many languages, which have enabled us tocost-effectively develop a broad product portfolio. We have a multi-channel marketing and distribution strategy that directly targets customers, utilizingprint, online, television and radio advertising, public relations initiatives and our branded kiosks. Approximately 82% of our revenue for the year endedDecember 31, 2009 was generated through our direct sales channels, which include our call centers, websites, institutional sales force and kiosks. Wealso distribute our solutions through select retailers such as Amazon.com, Apple, Barnes & Noble, Borders and Office Depot. We generate revenue primarily from sales of packaged software and audio practice products and online software subscriptions. Our continuedgrowth depends, in part, on our ability to maintain strong brand recognition in order to generate sales from new customers. We continuously balanceour need to achieve short-term financial goals with the equally critical need to invest in our products, our brand and our infrastructure to ensure ourfuture success. In making decisions about spending levels in our various functional organizations, we consider many factors, including:•our ability to expand our presence and penetration of existing markets; •the extent to which we can sell new products and services to existing customers; •our success in expanding our brand; •the evolution of our product and service offerings; and •our ability to expand our presence and reach geographically. We believe the primary factors that affect our financial performance include the following:•customer acceptance of our product and service offerings; •continued product and service innovation; •average revenue per customer;43Table of Contents•direct marketing variables, including: •print, television and radio media discounts and rates; •the relevance of our advertising; •online pay-per-click and other online advertising rates; •internal and external call center conversion rates; and •website traffic and conversion rates; •customer brand loyalty; •the number and quality of our kiosk locations; •our presence in international markets; and •cross-channel management of consumer and institutional markets. We believe that our multi-channel marketing and distribution models are fundamental to our success. Specifically, we focus on educatingcustomers about the many benefits of our products and services by leveraging our advertising and kiosk network in order to drive website and callcenter traffic.Components of Our Statement of OperationsRevenue We derive revenue from sales of language learning solutions consisting of packaged software and audio practice products and online softwaresubscriptions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements. Our audio practiceproducts are normally combined with our packaged software products and sold as a solution. Product revenue consists of revenue from sales of our packaged software and audio products. Subscription and service revenue consists primarilyof revenue from our online software subscriptions. The content of our packaged software and subscription offerings are the same. We simply offer ourcustomers the ability to choose which format they prefer without differentiating the learning experience. We intend to begin bundling time-basedsubscription licenses of our web-based TOTALe services with perpetual licenses of our Rosetta Stone Version 3 language learning solutions in theU.S. consumer market during the third quarter of 2010 as part of our Rosetta Stone Version 4 TOTALe launch. As a result, we anticipate that we willbe deferring approximately 20%-25% of each of these bundled sales. The deferred revenue will be recognized over the subscription term in accordancewith Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition. We sell our solutions directly to individuals, educational institutions, armed forces, government agencies and corporations. We distribute ourconsumer products predominantly through our direct sales channels, primarily our websites and call centers, which we refer to as our direct-to-consumer channel. We also distribute our consumer products through our kiosks, which we own, as well as through select retailers. The majority of ourconsumer customers purchase our packaged software and audio practice products. We sell to institutions primarily through our direct institutional salesforce. Many institutions elect to license our products on a subscription basis. For purposes of explaining variances in our revenue, we separatelydiscuss changes in our consumer and institutional sales channels because the customers and revenue drivers of these channels are different. Weanticipate that revenue growth in future periods will be less significant than we have experienced historically. Our consumer revenue is affected by seasonal trends associated with the holiday shopping season. As a result, our fourth quarter endedDecember 31, 2009 accounted for 31% of our annual revenue in44Table of Contents2009. Our institutional revenue is seasonally stronger in the second and third quarters of the calendar year due to education, home school andgovernment purchasing cycles. We expect these trends to continue.Cost of Revenue Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute our products. Such costs includepackaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty fees andinventory storage, obsolescence and shrinkage. Cost of subscription and service revenue primarily represents costs associated with supporting ouronline language learning service, which includes hosting costs and depreciation. We also include the cost of credit card processing and customertechnical support in both cost of product revenue and cost of subscription and service revenue. We expect our cost of revenue to increase in absolutedollars in future periods as our unit sales continue to grow. We also expect cost of revenue will increase as a percentage of revenue in future periodswith the planned launch of Rosetta Stone Version 4 TOTALe which includes services that have higher direct costs to deliver to customers than ourexisting software solutions.Operating Expenses We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative. Our operating expenses primarily consist of personnel costs, direct advertising and marketing expenses and professional fees associated withcontract product development, legal, accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses,stock-based compensation and employee benefit costs. Sales and Marketing. Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print, radio, onlineand other direct marketing activities, personnel costs for our sales and marketing staff, rental payments for our kiosks and commissions paid to our salespersonnel. Sales and marketing expenses also include amortization expense of intangible assets related to customer relationships associated with the2006 acquisition of Fairfield & Sons, Ltd. These intangible assets were fully amortized by January 2009. In 2007, we began to make significantinvestments to expand our sales and marketing operations in Europe and Japan. In 2009, we began to make significant investments to expand our salesand marketing operations in South Korea. In each case we established local sales offices and call centers, added employees and launched marketing andpublic relations campaigns within the region. We intend to continue to expand our sales activities within these regions as well as to expand our presenceinto new countries, including Germany, in addition to expanding our media and advertising campaigns in the United States. As a result, we expect salesand marketing expenses to increase in future periods. Research and Development. Research and development expenses consist primarily of personnel costs and contract development fees associatedwith the development of our solutions. Our development efforts are primarily based in the United States and are devoted to expanding our productportfolio through the addition of new content and new complimentary products and services to our language learning solutions. We expect ourinvestment in research and development expenses to increase in future years but provide us with significant benefits in the future. General and Administrative. General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, humanresources and other administrative personnel, as well as accounting and legal professional services fees and other corporate expenses. We expect generaland administrative expenses to increase in future periods as we expect to continue to invest in corporate45Table of Contentsinfrastructure and incur additional expenses associated with being a public company, including increased legal and accounting costs, investor relationscosts, independent director compensation, exchange listing fees and stockholder related fees, higher insurance premiums and compliance costs inconnection with Section 404 of the Sarbanes-Oxley Act of 2002. We also intend to increase administrative expenses as a result of our plannedinternational expansion. Stock Compensation Charge. Included in the respective operating expense lines is an aggregate $18.8 million expense, consisting of$18.5 million in stock-based compensation expense and $0.3 million in payroll tax expense, related to common stock grants awarded to key employeesequal to a total of 591,491 shares in April 2009. This grant was net of the number of shares required to be withheld to satisfy the federal, state and localtax withholding obligations. The aggregate grant date fair value of the awards was $18.5 million, which we recognized as stock-based compensationexpense on the grant date, as the awards were immediately vested. We allocated this $18.8 million aggregate expense among the operating expense lineitems in accordance with the functions performed by the respective employees who received the grants.Other Income (Expense) Other income (expense) primarily consists of interest income and interest expense. Interest expense is related to our long-term debt, the outstandingbalance of which was zero as of December 31, 2009. Interest income represents interest received on our cash and cash equivalents.Income Tax Expense Income tax expense consists of federal and state income taxes in the United States. For the year ended December 31, 2009, our worldwideeffective tax rate was approximately 35%-38%. We expect our worldwide rate to be approximately 35% in 2010 and beyond assuming no generalincrease in U.S. federal or state income tax rates applicable to companies such as ours. However, we expect our income tax expense to increase inabsolute dollars as our income continues to grow.Critical Accounting Policies and Estimates In presenting our financial statements in conformity with accounting principles generally accepted in the United States, or GAAP, we are requiredto make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. Webase these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under thecircumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Our future estimates may change if the underlyingassumptions change. Actual results may differ significantly from these estimates. We believe that the critical accounting policies listed below involve our more significant judgments, assumptions and estimates and, therefore,could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessaryto understand and evaluate the consolidated financial statements contained in this annual report on Form 10-K.Revenue Recognition Revenue is primarily derived from the sale of packaged software and audio practice products, online software subscriptions and professionalservices. Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta StoneTOTALe,46Table of Contentswhich was released in July 2009. Revenue is recognized for software products and related services in accordance with Accounting StandardsCodification subtopic 985-605, Software: Revenue Recognition ("ASC 985-605"). Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered orservices have been rendered; the fee is fixed and determinable; and collectability is probable. Revenues from packaged software and audio practiceproducts and online software subscriptions are recorded net of discounts. Revenue is recognized from the sale of packaged software and audio practice products when the product has been delivered, assuming theremaining revenue recognition criteria have been met. Software products include sales to end user customers and resellers. In most cases, revenue fromsales to resellers is not contingent upon resale of the software to the end user and is recorded in the same manner as all other product sales. Revenuefrom sales of packaged software products are recognized as the products are shipped and title passes. A limited amount of packaged software productsare sold to resellers on a consignment basis. Revenue is recognized for these consignment transactions once the end-user sale has occurred, assumingthe remaining revenue recognition criteria have been met. In accordance with Accounting Standards Codification subtopic 985-605-50, Software:Revenue Recognition: Customer Payments and Incentives ("ASC 985-605-50"), price protection for changes in the manufacturer suggested retail valuegranted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue. We offercustomers the ability to make payments for packaged software purchases in installments over a period of time, which typically ranges between three andfive months. Given that these installment payment plans are for periods less than twelve months and a successful collection history has been established,revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met. For the years ended December 31, 2009,2008 and 2007, installment sales represented 8%, 4% and 3% respectively. Packaged software is provided to customers who purchase directly from uswith a six-month right of return. We also allow our retailers to return unsold products, subject to some limitations. In accordance with AccountingStandards Codification subtopic 985-605-15, Software: Revenue Recognition: Products ("ASC 985-605-15"), product revenue is reduced for estimatedreturns, which are based on historical return rates. Revenue for software license agreements sold via online software subscriptions as hosting agreements are recognized in accordance withAccounting Standards Codification subtopic 985-605-05, Software: Revenue Recognition: Background ("ASC 985-605-05"). Revenue for onlinesoftware subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria have been met, whichtypically ranges between three and twelve months. Some online licensing arrangements include a specified number of licenses that can be activated overa period of time, which typically ranges between twelve and twenty-four months. Revenue for these arrangements is recognized on a per license basisratably over the term of the individual license subscription period, assuming all revenue recognition criteria have been met, which typically rangesbetween three and twelve months. Revenue for set-up fees related to online licensing arrangements is recognized ratably over the term of the onlinelicensing arrangement, assuming all revenue recognition criteria have been met. Accounts receivable and deferred revenue are recorded at the time acustomer enters into a binding subscription agreement and the subscription services are made available to the customer. In connection with packagedsoftware product sales and online software subscriptions, technical support is provided to customers, including customers of resellers, at no additionalcharge. As the fee for technical support is included in the initial licensing fee, the technical support and services are generally provided within one year,the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenuesare recognized together with the software product and license revenue. Costs associated with the technical support are accrued at the time of sale.47Table of Contents Revenue from the sale of packaged software products with specific upgrade rights is recognized in accordance with ASC 985-605. Revenuerecognition for these sales is deferred until the earlier of the point at which sufficient vendor-specific objective evidence ("VSOE") exist for the specificupgrade right or all elements of the arrangement have been delivered. In accordance with ASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identifiedbenefit is identified and the fair value is reasonably determinable. We have been engaged to develop language learning software for certain endangered languages under fixed fee arrangements. These arrangementsalso include contractual periods of post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue for multi-elementcontracts will be recognized ratably once the PCS and online hosting periods begin, over the longer of the PCS or online hosting period. When thecurrent estimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for the entire loss on the contract isrecorded.Stock-Based Compensation We account for stock-based compensation in accordance with Accounting Standards Codification topic 718, Compensation—Stock Compensation("ASC 718"), which was adopted by us effective January 1, 2006. Under ASC 718, all stock-based awards, including employee stock option grants,are recorded at fair value as of the grant date and recognized as expense in the statement of operations on a straight-line basis over the requisite serviceperiod, which is the vesting period. As of December 31, 2009 and 2008, there were approximately $5.3 million and $4.4 million of unrecognized stock-based compensation expenserelated to non-vested stock option awards that is expected to be recognized over a weighted average period of 2.49 and 2.21 years, respectively. The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statementline items (in thousands): In accordance with ASC topic 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expenseis then recognized on a straight-line basis over the requisite service period of the award. We use the Black-Scholes pricing model to value our stockoptions, which requires the use of estimates, including future stock price volatility, expected term and forfeitures. Stock-based compensation expenserecognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation.48 Years Ended December 31, 2009 2008 2007 Included in cost of revenue: Cost of product revenue $34 $2 $2 Cost of subscription and service revenue — — — Total included in cost of revenue 34 2 2 Included in operating expenses: Sales and marketing 999 153 189 Research and development 5,959 482 360 General and administrative 15,158 953 776 Total included in operating expenses 22,116 1,588 1,325 Total $22,150 $1,590 $1,327 Table of ContentsThe fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model as follows: Prior to the completion of our initial public offering in April 2009, our stock was not publicly quoted and we had a limited history of stock optionactivity, so we reviewed a group of comparable industry-related companies to estimate our expected volatility over the most recent period commensuratewith the estimated expected term of the awards. In addition to analyzing data from the peer group, we also considered the contractual option term andvesting period when determining the expected option life and forfeiture rate. Subsequent to the initial public offering, we continue to review a group ofcomparable industry-related companies to estimate volatility, but also review the volatility of our own stock since the initial public offering. We considerthe volatility of the comparable companies to be the best estimate of future volatility. For the risk-free interest rate, we use a U.S. Treasury Bond rateconsistent with the estimated expected term of the option award. The following table sets forth all stock option grants since the date of plan inception, through the date of this Annual Report on Form 10-K:49 Year Ended December 31, 2009 2008 2007Expected stock price volatility 61% 57%-62% 62%-70%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 1.71%-2.46% 2.08%-3.36% 3.50%-4.96%Grant Date Number ofOptions Granted Exercise Price Common StockFair ValuePer Shareat GrantDate May 22, 2006 1,366,456 $3.85 $4.57 August 16, 2006 29,861 3.85 5.10 August 21, 2006 149,500 3.85 5.14 September 5, 2006 130,000 3.85 5.25 December 8, 2006 29,133 3.85 5.92 February 2, 2007(1) 20,423 3.85 6.35 March 21, 2007 221,559 6.08 6.73 April 20, 2007(1) 31,330 6.08 6.98 June 5, 2007 59,800 7.31 7.31 August 3, 2007(1) 18,824 7.31 9.60 August 22, 2007 27,911 10.60 10.60 November 28, 2007 34,229 11.19 11.19 December 17, 2007(1) 22,178 10.60 11.30 February 8, 2008(1) 57,447 11.19 11.64 April 29, 2008(1) 99,346 11.64 10.36 May 28, 2008 110,916 10.36 10.36 August 19, 2008 36,075 14.22 14.22 November 19, 2008 99,021 17.49 17.49 April 15, 2009 441,911 18.00 18.00 May 28, 2009 15,000 22.30 22.30 August 19, 2009 1,974 20.35 20.35 November 18, 2009 12,445 16.74 16.74 December 7, 2009 1,259 18.05 18.05 (1)The exercise price for these stock options was established at the fair value of our common stock on the date ofgrant approval by the board of directors. However, in accordance with ASC 718, because all of the key terms ofthe stock option grants were not communicated to employees on a timelyTable of ContentsStock-based Compensation Expense in Connection with Executive Stock Grants and IPO Option and Restricted Stock Grants We made stock grants, restricted stock grants and stock option grants to our employees on April 15, 2009. In connection with these grants, werecorded an aggregate expense of approximately $18.5 million in the second quarter of 2009, and an additional $6.3 million that will be recorded overthe four-year vesting period of the stock options and restricted stock grants.Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable consist of amounts due to us from our normal business activities. We provide an allowance for doubtful accounts to reflect theexpected non-collection of accounts receivable based on past collection history and specific risks identified.Intangible Assets Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark andother intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives inaccordance with Accounting Standards Codification topic 350, Goodwill and Other Intangible Assets ("ASC 350"). On an annual basis, we review ourindefinite lived intangible assets for impairment based on the fair value of indefinite lived intangible assets as compared to the carrying value inaccordance with ASC 350. In the event the carrying value exceeds the fair value of the assets, the assets are written down to their fair value. There hasbeen no impairment of intangible assets during any of the periods presented.Goodwill In accordance with ASC 350, goodwill is not amortized and is tested for impairment annually on June 30th and whenever events andcircumstances occur indicating goodwill might be impaired. The first step is a screen for potential impairment by comparing the fair value of our onereporting unit with its carrying amount. The second step measures the amount of impairment loss, if any. As of June 30, 2009 and 2008, we reviewedthe goodwill for impairment and determined that no impairment of goodwill was identified during any of the periods presented, nor is the reporting unitat risk of failing step one of the goodwill impairment test.Valuation of Long-Lived Assets In accordance with Accounting Standards Codification topic 360, Accounting for the Impairment or Disposal of Long-lived Assets ("ASC 360"),we evaluate the recoverability of our long-lived assets. ASC 360 requires recognition of impairment of long-lived assets in the event that the net bookvalue of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the period ofidentification to the extent the carrying amount of an asset exceeds the fair value of such asset. Based on our analysis, we believe that no impairment ofour long-lived assets was indicated as of December 31, 2009 and 2008.50basis, we established the option grant date, the interpolated common stock fair value and stock option fair value asof the date on which all key option terms were communicated to the employees, which is the date reflected above.Table of ContentsIncome Taxes For the years ended December 31, 2009, 2008 and 2007, we accounted for income taxes in accordance with Accounting Standards Codificationtopic 740, Income Taxes ("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred tax assets andliabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the taxbases of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and taxcredit carryforwards. Deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowancewhen, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The impact of taxrate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted. In June 2006, the Financial Accounting Standards Board ("FASB") issued certain provisions in the Accounting Standards Codification topic 740-10-25, Income Taxes: Overall: Recognition, ("ASC 740-10-25"), which clarify the accounting for uncertainty in income taxes recognized in anenterprise's financial statements in accordance with ASC 740 and prescribe a recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken in a tax return. These provisions also provide guidance on de-recognition,classification, interest and penalties, accounting in interim periods, disclosures, and transition. We adopted these recognition provisions of ASC 740-10-25 effective January 1, 2007. The adoption of ASC 740-10-25 did not have a material impact on our financial condition, results of operations or cashflows.51Table of ContentsResults of Operations The following table sets forth our consolidated statement of operations for the periods indicated.52 Year Ended December 31, 2009 2008 2007 (in thousands, except per share data) Statements of Operations Data: Revenue $252,271 $209,380 $137,321 Cost of revenue 33,427 28,676 20,687 Gross profit 218,844 180,704 116,634 Operating expenses: Sales and marketing 114,899 93,384 65,437 Research and development 26,239 18,387 12,893 General and administrative 57,174 39,577 29,786 Lease abandonment — 1,831 — Total operating expenses 198,312 153,179 108,116 Income from operations 20,532 27,525 8,518 Other income and expense: Interest income 159 454 673 Interest expense (356) (891) (1,331) Other (expense) income 112 239 154 Interest and other income (expense), net (85) (198) (504) Income before income taxes 20,447 27,327 8,014 Income tax expense (benefit) 7,084 13,435 5,435 Net income 13,363 13,892 2,579 Preferred stock accretion — — (80) Income attributable to common stockholders $13,363 $13,892 $2,499 Income per share attributable to common stockholders: Basic $0.89 $7.29 $1.47 Diluted $0.67 $0.82 $0.15 Common shares and equivalents outstanding: Basic weighted average shares 14,990 1,905 1,702 Diluted weighted average shares 19,930 16,924 16,533 Stock-based compensation included in: Cost of sales $34 $2 $2 Sales and marketing 999 153 189 Research and development 5,959 482 360 General and administrative 15,158 953 776 Transaction-related expenses — — — $22,150 $1,590 $1,327 Intangible amortization included in: Cost of sales $— $13 $1,227 Sales and marketing 42 3,003 3,596 $42 $3,016 $4,823 Table of ContentsComparison of the Year Ended December 31, 2009 and the Year Ended December 31, 2008Revenue Total revenue for the year ended December 31, 2009 was $252.3 million, an increase of $42.9 million, or 21%, from the year ended December 31,2008.Consumer Consumer revenue was $199.3 million for the year ended December 31, 2009 an increase of $31.6 million, or 19%, from the year endedDecember 31, 2008. The increase in consumer revenue was attributable to a 14% increase in unit sales, which resulted in a $23.8 million increase inrevenue, combined with a 4% increase in the average selling price of each unit, which accounted for a $7.8 million increase in revenue. Unit growth wasdriven by the planned expansion of our direct marketing programs, as well as growth in our retail distribution network. Direct advertising expensesincreased 25% to $42.4 million during the year ended December 31, 2009, while the number of kiosks increased from 150 to 242 from December 31,2008 to December 31, 2009. Our 2008 revenue includes a $2.6 million initial stocking order we received from Barnes & Noble in June 2008 to supporttheir expansion of our product line to over 650 of their stores nationally. We did not have any such large initial stocking orders in 2009. Product revenue represented 96% of total consumer revenue for the year ended December 31, 2009, with the balance attributable to subscriptionand service revenue. We intend to begin bundling time-based subscription licenses of our web-based TOTALe services with perpetual licenses of ourRosetta Stone Version 3 language learning solutions in the U.S. consumer market during the third quarter of 2010 with the planned launch of RosettaStone Version 4 TOTALe. As a result, we will be deferring approximately 20% - 25% of each of these bundled sales. We will recognize the deferredrevenue over the term of the subscription license in accordance with Accounting Standards Codification subtopic 985-605, Software: RevenueRecognition.Institutional Institutional revenue was $53.0 million for the year ended December 31, 2009, an increase of $11.3 million, or 27%, compared to the year endedDecember 31, 2008. The increase in institutional revenue was primarily due to the expansion of our direct sales force. As a result, we had a $4.8 millionincrease in education revenue, a $3.9 million increase in government revenue and a $2.0 million increase in corporate revenue.53 Year Ended December 31, 2009 2008 Change % Change (dollars in thousands) Product revenue $218,549 86.6%$184,182 88.0%$34,367 18.7%Subscription and service revenue 33,722 13.4% 25,198 12.0%$8,524 33.8% Total revenue $252,271 100.0%$209,380 100.0%$42,891 20.5% Revenue by sales channel: Direct-to-consumer $114,002 45.2%$96,702 46.2%$17,300 17.9%Kiosk 40,418 16.0% 36,314 17.3%$4,104 11.3%Retail 44,850 17.8% 34,638 16.5%$10,212 29.5% Total consumer 199,270 79.0% 167,654 80.1% 31,616 18.9%Institutional 53,001 21.0% 41,726 19.9%$11,275 27.0% Total revenue $252,271 100.0%$209,380 100.0%$42,891 20.5% Table of Contents Product revenue represented 52% of total institutional revenue for the year ended December 31, 2009, and subscription and service revenuerepresented 48% for the same period.Cost of Revenue and Gross Profit Cost of revenue for the year ended December 31, 2009 was $33.4 million, an increase of $4.8 million, or 17%, from the year ended December 31,2008. As a percentage of total revenue, cost of revenue decreased to 13% for the year ended December 31, 2009 compared to 14% for the year endedDecember 31, 2008. The dollar increase in cost of revenue was primarily attributable to expansion of our product offering combined with a change inour sales mix, offset in part by a reduction in affiliate commissions and the absence in the 2009 period of intangible amortization related to coretechnology associated with the acquisition of Fairfield & Sons, Ltd., which was fully amortized in 2008. Cost of subscription and service revenueincreased by $1.0 million or 48% as we released Rosetta Stone TOTALe, our new web-based service offering that includes a component of dedicatedlanguage conversation coaching. We expect our cost of revenue will increase as a percent of revenue as we begin bundling time-based subscriptionlicenses of our web-based TOTALe services with perpetual licenses of our Rosetta Stone Version 3 language learning solutions in the U.S. consumermarket with the planned launch of Rosetta Stone Version 4 during the third quarter of 2010.Operating ExpensesSales and Marketing Expenses Sales and marketing expenses for the year ended December 31, 2009 were $114.9 million, an increase of $21.5 million, or 23%, from the yearended December 31, 2008. As a percentage of total54 Year EndedDecember 31, 2009 2008 Change % Change (dollars in thousands) Revenue: Product $218,549 $184,182 $34,367 18.7%Subscription and service 33,722 25,198 $8,524 33.8% Total revenue $252,271 $209,380 $42,891 20.5% Cost of revenue: Cost of product revenue $30,264 $26,539 $3,725 14.0%Cost of subscription and servicerevenue 3,163 2,137 $1,026 48.0% Total cost of revenue 33,427 28,676 4,751 16.6% Gross profit $218,844 $180,704 $38,140 Gross margin percentages 86.7% 86.3% 0.4% Year EndedDecember 31, 2009 2008 Change % Change (dollars in thousands) Sales and marketing $114,899 $93,384 $21,515 23.0%Research and development 26,239 18,387 7,852 42.7%General and administrative 57,174 39,577 17,597 44.5%Lease abandonment — 1,831 (1,831) (100.0)% Total operating expenses $198,312 $153,179 $45,133 29.5% Table of Contentsrevenue, sales and marketing expenses were 46% for the year ended December 31, 2009, compared to 45% for the year ended December 31, 2008. Thedollar and percentage increase in sales and marketing expenses were primarily attributable to the continued expansion of our direct marketing activities.Advertising expenses grew by $8.6 million and were primarily related to television and radio media and internet marketing. We also expanded thenumber of our kiosks from 150 as of December 31, 2008 to 242 as of December 31, 2009, which resulted in $6.2 million of additional kiosk operatingexpenses, including rent and sales compensation related expenses. Personnel costs related to growth in our institutional sales channel and marketing andsales support activities also increased by $6.4 million. The stock compensation charge related to a common stock grant to key employees in connectionwith our initial public offering resulted in a $0.4 million increase in sales and marketing expense in 2009 compared to the prior year period. Completionin January 2009 of the amortization of the intangible assets associated with the 2006 acquisition of Fairfield & Sons, Ltd. resulted in a $3.0 millionreduction in amortization expense in 2009 when compared to the prior year period. Sales and marketing expenses without consideration of the stock compensation charge associated with the common stock grant to key employeesin connection with our initial public offering would have been $114.5 million, an increase of $21.1 million or 23% from the prior year. As a percentageof revenue, sales and marketing expenses would have remained the same at 45% for the year ended December 31, 2009 compared to the prior yearperiod.Research and Development Expenses Research and development expenses were $26.2 million for the year ended December 31 2009, an increase of $7.9 million, or 43%, from the yearended December 31, 2008. As a percentage of total revenue, research and development expenses increased to 10% for the year ended December 31,2009 compared to 9% for the year ended December 31, 2008. The dollar and percentage increase were primarily attributable to a stock compensationcharge related to common stock awarded to key employees which resulted in a $5.0 million increase in research and development expense in 2009 whencompared to the prior year period. In addition, research and development expenses increased $3.0 million due to the addition of new productdevelopment personnel associated with the development of new products and services that are complementary to our existing solutions. Research and development expenses without consideration of the stock compensation charge associated with the common stock grant to keyemployees in connection with our initial public offering would have been $21.2 million, an increase of $2.9 million or 16% from the prior year. As apercentage of revenue, research and development expenses would have decreased to 8% for the year ended December 31, 2009 from 9% for the prioryear period.General and Administrative Expenses General and administrative expenses for the year ended December 31, 2009 were $57.2 million, an increase of $17.6 million, or 45%, from theyear ended December 31, 2008. As a percentage of revenue, general and administrative expenses increased to 23% for the year ended December 31,2009 compared to 19% for the year ended December 31, 2008. The dollar and percentage increase was primarily attributable to a stock compensationcharge related to common stock awarded to key employees in connection with our initial public offering resulting in a $13.4 million increase in generaland administrative expense. In addition, general and administrative expenses increased due to greater personnel related costs as we expanded ourfinance, legal, information technology and other administrative functions to support the overall growth in our business. Personnel-related costsincreased $4.2 million with a corresponding increase in communications, training, recruitment, travel and other support costs of $0.6 million and newoffice space and equipment depreciation costs of $0.9 million. Legal fees also increased $0.4 million related to intellectual property protection matters,and liability insurances for directors and officers increased $0.3 million. This increase was partially offset by55Table of Contentsdecreased professional service expenses of $1.5 million as we replaced contract staff with employees and a decrease in bad debt expense $0.7 millionduring the year ended December 31, 2009 as a result of improved collection efforts. General and administrative expenses without consideration of the stock compensation charge associated with the common stock grant to keyemployees in connection with our initial public offering would have been $43.8 million, an increase of $4.2 million or 11% from the prior year. As apercentage of revenue, general and administrative expenses would have decreased to 17% for the year ended December 31, 2009 from 19% for the prioryear period.Stock-Based Compensation Charge Included in each of the respective operating expense lines for the year ended December 31, 2009 is a portion of the $18.8 million charge related tothe total of 591,491 shares of common stock awarded to 10 of our key employees in April 2009. The following table presents the stock-basedcompensation charge by operating expense line item:Lease Abandonment Expenses We incurred no lease abandonment expense for the year ended December 31, 2009; however, with respect to the year ended December 31, 2008,we incurred lease abandonment expense associated with the relocation of our headquarters of $1.8 million consisting of accrued exit costs and liabilitiesunder operating lease agreements.Interest and Other Income (Expense) Interest income represents interest earned on our cash and cash equivalents. Interest income for the year ended December 31, 2009 was$0.2 million, a decrease of $0.3 million, or 65%, from the year ended December 31, 2008. Interest expense is primarily related to our long-term debt, theoutstanding balance of which was zero as of December 31, 2009. Interest expense for the year ended December 31, 2009 was $0.4 million, a decreaseof $0.5 million, or 60% from the year ended December 31, 2008. The decrease was primarily due to the retirement of our previous Madison Capitalterm loan. Other Income for the year ended December 31, 2009 was $0.1 million, a decrease of $0.1 million, or 53% and is primarily due to foreigncurrency fluctuations.56 Year EndedDecember 31, 2009 2008 Change % Change (dollars in thousands) Sales and marketing $377 $— $377 100%Research and development 5,033 — $5,033 100%General and administrative 13,393 — 13,393 100% Total $18,803 $— $18,803 100% Year EndedDecember 31, 2009 2008 Change % Change (dollars in thousands) Interest income $159 $454 $(295) (65.0)%Interest expense (356) (891)$535 (60.0)%Other income 112 239 $(127) (53.1)% Total $(85)$(198)$113 (57.1)% Table of ContentsIncome Tax Expense Income tax expense for the year ended December 31, 2009 was $7.1 million, a decrease of $6.4 million, or 47%, compared to the year endedDecember 31, 2008. The decrease was the result of a decrease of $6.9 million in pre-tax income for the year ended December 31, 2009 and a lowereffective tax rate, compared to the year ended December 31, 2008. Our effective tax rate decreased to 35% for the year ended December 31, 2009compared to 49% for the year ended December 31, 2008. The reduction in our effective tax rate was a result of changes in the geographic distribution ofour income and a change in our transfer pricing agreements. We determine the pricing among our associated entities on the basis of detailed functional and economic analysis involving benchmarking againsttransactions among entities that are not under common control. Based on our analysis, we made changes to the transfer pricing agreements effectiveJanuary 1, 2009. The resulting change in geographic distributions of income contributed to a lower effective tax rate as compared to the year endedDecember 31, 2008. We do not currently record income tax on the results of our U.K., Japan or German subsidiaries. Despite enacting certain tax planning strategiesduring the year ended December 31, 2009, no subsidiary has produced sustainable pretax profits as of December 31, 2009 and each remains in a three-year cumulative loss position. Accordingly we continue to carry a full valuation allowance on net operating loss carryforwards and other deferred taxassets for these jurisdictions. As we continue operations in accordance with the revised transfer pricing agreements, we will monitor actual results andupdated projections on a quarterly basis. When and if the subsidiaries realize or realistically anticipate sustainable profitability, we will assess theappropriateness of releasing the valuation allowance in whole or in part.Comparison of the Year Ended December 31, 2008 and the Year Ended December 31, 2007Revenue Total revenue for the year ended December 31, 2008 was $209.4 million, an increase of $72.1 million, or 53%, from the year ended December 31,2007.57 Year EndedDecember 31, 2009 2008 Change % Change (dollars in thousands) Income tax expense $7,084 $13,435 $(6,351) (47.3)% Year Ended December 31, 2008 2007 Change % Change (dollars in thousands) Product revenue $184,182 88.0%$119,897 87.3%$64,285 53.6%Subscription and service revenue 25,198 12.0% 17,424 12.7%$7,774 44.6% Total revenue $209,380 100.0%$137,321 100.0%$72,059 52.5% Revenue by sales channel: Direct-to-consumer $96,702 46.2%$61,950 45.1%$34,752 56.1%Kiosk 36,314 17.3% 23,947 17.4%$12,367 51.6%Retail 34,638 16.5% 21,206 15.4%$13,432 63.3% Total consumer 167,654 80.1% 107,103 78.0% 60,551 56.5%Institutional 41,726 19.9% 30,218 22.0%$11,508 38.1% Total revenue $209,380 100.0%$137,321 100.0%$72,059 52.5% Table of ContentsConsumer Consumer revenue was $167.7 million for the year ended December 31, 2008, an increase of $60.6 million, or 57%, from the year endedDecember 31, 2007. The increase in consumer revenue was attributable to a 22% increase in unit sales, which resulted in a $23.7 million increase inrevenue, combined with a 28% increase in the average selling price of each unit, which accounted for a $36.9 million increase in revenue. Unit growthwas driven by the expansion of our direct advertising campaign as well as growth in our retail distribution network. Direct advertising expensesincreased 38% to $33.9 million during the year ended December 31, 2008, while the number of kiosks increased from 86 to 150 from December 31,2007 to December 31, 2008. We also received a $2.6 million initial stocking order from Barnes & Noble in June 2008 to support their expansion of ourproduct line to over 650 of their stores nationally. In August 2007, we released our Version 3 solution for ten of our best selling languages. All Version 3 solutions include three course levels,while our Version 2 solutions only include one or two course levels. Upon the release of a language in Version 3, we discontinue selling that languagein Version 2 and, as a result, sales of Version 3 products replace sales of Version 2 products for that language. Our solutions are often purchased insets including all available course levels for a language. The additional levels included in Version 3 enabled us to offer additional languages with threecourse levels, resulting in a greater number of available products at our highest price point for a complete set. In March 2008, we released Version 3 infour additional languages and, in June 2008, we released seven additional Version 3 languages. Also in June 2008, we released our Audio Companionpractice tool product for all 14 then-available Version 3 languages. In September 2008, we released Version 3 and our Audio Companion in sevenadditional languages. This expansion of our product portfolio with higher price point options has resulted in the 28% increase in average selling priceper unit for the year ended December 31, 2008. Product revenue represented 94% of total consumer revenue for the year ended December 31, 2008, with the balance attributable to subscriptionand service revenue.Institutional Institutional revenue was $41.7 million for the year ended December 31, 2008, an increase of $11.5 million, or 38%, compared to the year endedDecember 31, 2007. The increase in institutional revenue was primarily due to the expansion of our direct sales force. As a result, we had a $9.4 millionincrease in education and home school revenue and a $1.6 million increase in corporate revenue. Product revenue represented 65% of total institutional revenue for the year ended December 31, 2008, and subscription and service revenuerepresented 35% for the same period.58Table of ContentsCost of Revenue and Gross Profit Cost of revenue for the year ended December 31, 2008 was $28.7 million, an increase of $8.0 million, or 39%, from the year ended December 31,2007. As a percentage of total revenue, cost of revenue was 14% for the year ended December 31, 2008 compared to 15% for the year endedDecember 31, 2007. The dollar increase in cost of revenue was attributable to growth in unit sales. The increase in gross margin percentage was due to a$0.9 million write down of inventory in the 2007 period associated with the transition from Version 2 to Version 3 product and packaging.Operating ExpensesSales and Marketing Expenses Sales and marketing expenses for the year ended December 31, 2008 were $93.4 million, an increase of $27.9 million, or 43%, from the yearended December 31, 2007. As a percentage of total revenue, sales and marketing expenses were 45% for the year ended December 31, 2008, comparedto 48% for the year ended December 31, 2007. The dollar increase in sales and marketing expenses was primarily attributable to the continuedexpansion of our direct marketing activities. Advertising expenses grew by $9.3 million and were primarily related to the purchase of additionaltelevision media. We also expanded the number of our kiosks from 86 as of December 31, 2007 to 150 as of December 31, 2008, which resulted in$7.9 million of additional kiosk operating expenses, including sales compensation related expenses. Personnel costs related to growth in our institutionalsales channel and marketing and sales support activities also increased by $7.7 million.59 Year Ended December 31, 2008 2007 Change % Change (dollars in thousands) Revenue: Product $184,182 $119,897 $64,285 53.6%Subscription and service 25,198 17,424 $7,774 44.6% Total revenue $209,380 $137,321 $72,059 52.5% Cost of revenue: Cost of product revenue $26,539 $19,055 $7,484 39.3%Cost of subscription and servicerevenue 2,137 1,632 $505 30.9% Total cost of revenue 28,676 20,687 7,989 38.6% Gross profit $180,704 $116,634 $64,070 Gross margin percentages 86.3% 84.9% 1.4% Year Ended December 31, 2008 2007 Change % Change (dollars in thousands) Sales and marketing $93,384 $65,437 $27,947 42.7%Research and development 18,387 12,893 $5,494 42.6%General and administrative 39,577 29,786 $9,791 32.9%Lease abandonment 1,831 — $1,831 100.0% Total operating expenses $153,179 $108,116 $45,063 41.7% Table of ContentsResearch and Development Expenses Research and development expenses were $18.4 million for the year ended December 31, 2008, an increase of $5.5 million, or 43%, from the yearended December 31, 2007. As a percentage of total revenue, research and development expenses were 9% for the years ended December 31, 2008 and2007. The dollar increase was primarily attributable to additional personnel and contract development costs associated with the transition of Version 2languages to Version 3, as well as the development of new products and services that are complementary to our existing solutions.General and Administrative Expenses General and administrative expenses for the year ended December 31, 2008 were $39.6 million, an increase of $9.8 million, or 33%, from the yearended December 31, 2007. As a percentage of revenue, general and administrative expenses decreased to 19% for the year ended December 31, 2008compared to 22% for the year ended December 31, 2007. The dollar increase was primarily attributable to a $4.3 million increase in personnel-relatedcosts as we expanded our finance, information technology and other administrative functions to support the overall growth in our business, and acorresponding increase in communications, travel and other support costs of $4.4 million. Depreciation expense also increased $0.9 million and baddebt expense increased $0.8 million during the year ended December 31, 2008 as a result of greater capital expenditures and credit sales. We alsoincurred an additional $1.0 million in legal fees related to intellectual property protection matters. This increase was partially offset by decreasedprofessional service expenses of $0.2 million as we replaced contract staff with employees.Lease Abandonment Expenses Lease abandonment expense associated with the relocation of our headquarters was $1.8 million for the year ended December 31, 2008, consistingof accrued exit costs and liabilities under operating lease agreements.Interest and Other Income (Expense) Interest expense for the year ended December 31, 2008 was $0.9 million, a decrease of $0.4 million, or 33%, from the year ended December 31,2007. The decrease was due to a reduction in the outstanding balance of our long-term debt as a result of $3.4 million in principal payments during theperiodIncome Tax Expense60 Year EndedDecember 31, 2008 2007 Change % Change (dollars in thousands) Interest income $454 $673 $(219) (32.5)%Interest expense (891) (1,331)$440 (33.1)%Other income 239 154 $85 55.2% Total $(198)$(504)$306 (60.7)% Year EndedDecember 31, 2008 2007 Change % Change (dollars in thousands) Income tax expense $13,435 $5,435 $8,000 147.2%Table of Contents Income tax expense for the year ended December 31, 2008 was $13.4 million, an increase of $8.0 million, or 147%, compared to the year endedDecember 31, 2007. The increase was the result of an increase of $19.3 million in pre-tax income for the year ended December 31, 2008, compared tothe year ended December 31, 2007. Our effective tax rate decreased to 49.2% for the year ended December 31, 2008 compared to 67.8% for the yearended December 31, 2007 as a result of a decline in the percentage of foreign losses relative to total consolidated income before tax. We do not currentlyrecognize income tax benefits on losses in our foreign subsidiaries.Liquidity and Capital Resources Our primary operating cash requirements include the payment of salaries, incentive compensation, employee benefits and other personnel-relatedcosts, as well as direct advertising expenses, costs of office facilities and costs of information technology systems. Since our inception, we have financed our operations solely through cash flow from operations with the exception of the acquisition of Fairfield &Sons, Ltd., which was funded in part through the sale of preferred and common stock and a $17.0 million term loan from Madison CapitalFunding LLC. At December 31, 2009, our principal sources of liquidity were cash and cash equivalents totaling $95.2 million and available borrowingsunder our credit facility. On January 16, 2009, we entered into a new secured credit agreement with Wells Fargo Bank, N.A., or Wells Fargo, that provides us with a$12.5 million revolving line of credit. This revolving credit facility has a two-year term and the applicable interest rate is 2.5% above one month LIBOR,or approximately 2.73% as of December 31, 2009. On January 16, 2009, we borrowed approximately $9.9 million under this revolving credit facilityand used these funds to repay the entire outstanding principal and interest of the term loan we had with Madison Capital. As a result, we have noborrowings owed to Madison Capital under either their term loan or revolving credit facility, and we have terminated these credit agreements. In April2009, we completed our initial public offering and received net proceeds of $49.0 million after deducting the underwriters discount and initial publicoffering expenses. We used $9.9 million to repay Wells Fargo the outstanding principal and interest of the revolving credit facility. The full$12.5 million under the Wells Fargo revolving credit facility remains available to us for borrowing, subject to specified conditions. We expect that our future growth will continue to require additional working capital. Our future capital requirements will depend on many factors,including development of new products, market acceptance of our products, the levels of advertising and promotion required to launch additionalproducts and improve our competitive position in the marketplace, the expansion of our sales, support and marketing organizations, the establishment ofadditional offices in the United States and worldwide and building the infrastructure necessary to support our growth, the response of competitors toour products and our relationships with suppliers and clients. We have experienced increases in our expenditures consistent with the growth in ouroperations and personnel, and we anticipate that our expenditures will continue to increase in the future. We believe that anticipated cash flows fromoperations and available sources of funds, including available borrowings under our revolving credit facility, will provide sufficient liquidity to fund ourbusiness and meet our obligations in the foreseeable future. In April 2009, we completed an initial public offering. After deducting the payment of underwriters' discounts and commissions and offeringexpenses, our net proceeds from the sale of shares in the offering were $49.0 million. The net proceeds from the offering were used to repay a$9.9 million balance on our revolving credit facility with Wells Fargo and $7.9 million to satisfy the federal, state and local withholding tax obligationsassociated with the net issuance of common stock to certain of our key employees.61Table of ContentsCash Flow AnalysisNet Cash Provided By Operating Activities Net cash provided by operating activities was $41.2 million for the year ended December 31, 2009. Net cash provided by operating activities wasprimarily generated from net income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $13.4 millionfor the year ended December 31, 2009. Depreciation, amortization and stock compensation expense for the period totaled $27.6 million. A decrease inamortization resulting from the full amortization of intangible assets in January 2009 was partially offset by increases in depreciation on tangible assetsassociated with the expansion of the business. The increase in stock-based compensation expense was primarily the result of $18.5 million in expenseassociated with the issuance of common stock to key employees in April 2009. Additionally, a $10.3 million increase in deferred revenue resulting fromgreater sales of subscription licenses contributed to net cash provided by operations. Net cash provided by operating activities was $18.3 million for the year ended December 31, 2008. Net cash provided by operating activities wasprimarily generated from net income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $13.9 millionfor the year ended December 31, 2008. Depreciation, amortization and stock compensation expense for the period totaled $8.7 million. Increases indeferred revenue resulting from greater sales of subscription licenses also contributed to net cash provided by operations; the increase represented$3.1 million for the year ended December 31, 2008. As a result of the growth in our retail channel and institutional sales, accounts receivable increasedby $16.5 million. This increase in accounts receivable was offset in part by increases in net liabilities associated with the expansion of our business. Net cash provided by operating activities was $15.8 million for the year ended December 31, 2007. Net cash provided by operating activities wasprimarily generated from net income as adjusted for depreciation and amortization and stock compensation expense. Net income totaled $2.6 million forthe year ended December 31, 2007. Depreciation and amortization and stock compensation expense for the period aggregated to $9.1 million. Increasesin deferred revenue resulting from greater sales of subscription licenses also contributed to net cash provided by operations; the increase represented$4.8 million for the year ended December 31, 2007. As a result of the growth in our business, we had increases in accounts receivable and inventory,offset in part by increases in net liabilities.Net Cash Used In Investing Activities Net cash used in investing activities was $8.6 million, $7.0 million, and $9.2 million for the years ended December 31, 2009, 2008 and 2007,respectively. Our investing activities during these periods primarily related to the purchase of property and equipment associated with the expansion ofour information technology systems and our facilities as a result of our growth.Net Cash Used In Financing Activities Net cash provided by financing activities was $32.0 million for the year ended December 31, 2009 primarily related to $49.0 million in netproceeds from our initial public offering, offset by the $9.9 million payment of the balance outstanding under our revolving credit facility with WellsFargo and the $7.9 million payment of taxes associated with the common stock grant to some of our key employees. Net cash used in financing activities was $4.6 million and $1.8 million for the years ended December 31, 2008 and 2007, respectively. Net cashused in financing activities during these periods was primarily related to principal payments on our long-term debt. Additionally, for the year endedDecember 31, 2008, net cash used in financing activities also included payments associated with our planned initial public offering.62Table of Contents We believe that our current cash and cash equivalents and funds generated from our operations will be sufficient to meet our working capital andcapital expenditure requirements through 2010. Thereafter, we may need to raise additional funds through public or private financings or increasedborrowings to develop or enhance products, to fund expansion, to respond to competitive pressures or to acquire complementary products, businessesor technologies. If required, additional financing may not be available on terms that are favorable to us, if at all. If we raise additional funds through theissuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and these securities might have rights,preferences and privileges senior to those of our current stockholders. No assurance can be given that additional financing will be available or that, ifavailable, such financing can be obtained on terms favorable to our stockholders and us. During the last three years, inflation and changing prices have not had a material effect on our business and we do not expect that inflation orchanging prices will materially affect our business in the foreseeable future.Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financing arrangements. We do not have any interest in entities referred to as variable interest entities,which include special purpose entities and other structured finance entities.Contractual Obligations The following table summarizes our contractual obligations at December 31, 2009 and the effect such obligations are expected to have on ourliquidity and cash flow in future periods. On January 4, 2006, we entered into a credit agreement for a $17.0 million term loan, or term loan, and a $4.0 million revolving credit facility, orrevolver. The credit agreement was amended on August 2, 2007 and April 23, 2008 to amend some covenants, terms, and definitions. The term loanand revolver accrue interest at the base rate plus the applicable margin or the LIBOR rate plus the applicable margin, as specified by us. As ofDecember 31, 2008, the interest rate on the term loan was 4.65%. On January 16, 2009, we entered into a new credit agreement with Wells Fargo Bank, N.A., or Wells Fargo, that provides us with a $12.5 millionrevolving line of credit. This revolving credit facility has a two-year term and the applicable interest rate is 2.5% above one month LIBOR, orapproximately 2.73% as of December 31, 2009. On January 16, 2009, we borrowed approximately $9.9 million under this revolving credit facility andused these funds to repay the entire outstanding principal and interest of the term loan we had with Madison Capital. As a result, we have noborrowings owed to Madison Capital under either their term loan or revolving credit facility, and we have terminated these credit agreements. With aportion of the net proceeds from our April 2009 initial public offering, we repaid the $9.9 million of borrowing under the Wells Fargo revolving creditfacility, which had been used to prepay the borrowings made under the Madison Capital credit facility. As a consequence, the remaining balance ofapproximately $12.5 million under the Wells Fargo credit facility is available to us for borrowing, subject to specified conditions.63 Total Less than 1Year 1 - 3 Years 3 - 5 Years More than 5Years (in thousands) Long-term debt $— $— $— $— $— Operating lease obligations 12,720 5,593 5,128 1,911 88 Total $12,720 $5,593 $5,128 $1,911 $88 Table of Contents The operating lease obligations reflected in the table above include our corporate office leases and site licenses for our kiosks.Recent Accounting Pronouncements In February 2008, the FASB issued Accounting Standards Codification topic 820, Fair Value Measurements and Disclosures ("ASC 820"). Theprovisions of ASC 820, which provide guidance for, among other things, the definition of fair value and the methods used to measure fair value, wereadopted January 1, 2008 for financial instruments. The provisions adopted in 2008 did not have an impact on the Company's financial statements. Theeffective date of ASC 820 for all nonrecurring fair value measurements of nonfinancial assets and liabilities (except for those that are recognized ordisclosed at fair value in the financial statements on a recurring basis) was fiscal years beginning after November 15, 2008. On January 1, 2009 weadopted the provisions in ASC 820 for nonrecurring fair value measurements of nonfinancial assets and liabilities. We applied the provisions adopted inthe first quarter of 2009 to the accounting for the acquisition of SGLC International Co. Ltd. See note 4. In December 2007, the FASB issued Accounting Standards Codification topic 805, Business Combinations ("ASC 805"), which establishesprinciples and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest; recognizes and measures the goodwill acquired in the business combination or a gainfrom a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financialeffects of the business combination. ASC 805 is to be applied prospectively to business combinations for which the acquisition date is on or after anentity's fiscal year that begins after December 15, 2008. We applied the provisions adopted in the first quarter of 2009 to the fair value measurementsrecorded as part of the acquisition of SGLC International Co. Ltd. See note 4. In December 2007, the FASB issued Accounting Standards Codification topic 810, Consolidation ("ASC 810"), which establishes newaccounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statementrequires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent'sequity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the incomestatement. ASC 810 clarifies that changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation are equity transactions ifthe parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when asubsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidationdate. ASC 810 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. ASC 810 is effectivefor fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The adoption ofASC 810 did not have a material impact on our financial position, results of operations or cash flows. In March 2008, the FASB issued Accounting Standards Codification topic 815, Derivatives and Hedging ("ASC 815"), which requires enhanceddisclosures about an entity's derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivativeinstruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged itemsaffect an entity's financial position, financial performance and cash flows. The adoption of ASC 815 did not have a significant impact on our financialposition, results of operations or cash flows.64Table of Contents In May 2008, the FASB issued Accounting Standards Codification topic ASC 105, Generally Accepted Accounting Principles, ("ASC 105"),which identifies the sources of accounting principles and provides the framework for selecting the principles used in the preparation of financialstatements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. ASC 105 iseffective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of ASC 105 did not havesignificant impact on our financial position, results of operation, or cash flows. On October 10, 2008, the FASB issued Accounting Standards Codification topic 820, Fair Value Measurements and Disclosures ("ASC 820"),which was effective upon issuance, including periods for which financial statements have not been issued. ASC 820 provided an illustrative example todemonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. The adoption of ASC 820 did nothave a material impact on our consolidated financial position and the results of operations. In April 2009, the FASB issued Accounting Standards Codification topic 820-10-65-4, Fair Value Measurements and Disclosures ("ASC 820"),which provides guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability hassignificantly decreased. ASC 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly. In addition, ASC 820requires disclosure in interim and annual periods of the inputs and valuation methods used in determining fair value and a discussion of any changes inthose valuation methods. ASC 820 is effective for annual and interim periods ending on or after June 15, 2009. The adoption of ASC 820 did not havea material impact on our consolidated financial position and the results of operations. On May 28, 2009, the FASB issued Accounting Standards Codification topic 855, Subsequent Events ("ASC 855"). Although ASC 855 does notsignificantly change current practice surrounding the disclosure of subsequent events, it provides guidance on management's assessment of subsequentevents and the requirement to disclose the date through which subsequent events have been evaluated. ASC 855 became effective for the quarter endedJune 30, 2009. The adoption of ASC 855 did not have any impact on our consolidated financial position or results of operations. On June 12, 2009, the FASB issued Statement No. 167, Amendments to FASB Interpretation No. 46(R) ("SFAS No. 167"). SFAS No. 167modifies the existing quantitative guidance used in determining the primary beneficiary of a variable interest entity ("VIE") by requiring entities toqualitatively assess whether an enterprise is a primary beneficiary, based on whether the entity has (i) power over the significant activities of the VIE,and (ii) an obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE. SFAS No. 167 becomes effectivefor all new and existing VIEs on January 1, 2010. The adoption of SFAS No. 167 will not have any impact on our consolidated financial position orresults of operations. On June 29, 2009, the FASB issued Accounting Standards Codification topic ASC 105, Generally Accepted Accounting Principles ("ASC 105"),which establishes the FASB Accounting Standards Codification (the "Codification") as the primary source of authoritative GAAP recognized by theFASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC are also sources of authoritative GAAP for SECregistrants. ASC 105 and the Codification become effective on September 30, 2009. When effective, the Codification will supersede all existing non-SEC accounting and reporting standards and the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or EmergingIssues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification;(b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The adoption ofASC 105 and the Codification on September 30, 2009 did not have a material effect on our consolidated financial statements.65Table of Contents In October 2009, the FASB issued Accounting Standards Update ("ASU") 2009-13, which amended the accounting requirements under theRevenue Recognition Topic, ASC 605-25 Multiple-Element Arrangements. The objective of this update is to address the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. The amendmentsestablish a hierarchy for determining the selling price of a deliverable and will allow for the separation of products and services in more instances thanpreviously permitted. The guidance provided within ASU 2009-13 is effective for fiscal years beginning on or after June 15, 2010 and allows for eitherprospective or retrospective application, with early adoption permitted. We are currently evaluating the impact that adoption of this guidance will have onour consolidated financial statements. In October 2009, the FASB issued ASU 2009-14 which amended the accounting requirements under the Software Topic, ASC 985-605 RevenueRecognition. The objective of this update is to address the accounting for revenue arrangements that contain tangible products and software. Specifically,products that contain software that is "more than incidental" to the product as a whole will be removed from the scope of ASC subtopic 985-605(previously AICPA Statement of Position 97-2). The amendments align the accounting for these revenue transaction types with the amendments underASU 2009-13 mentioned above. The guidance provided within ASU 2009-14 is effective for fiscal years beginning on or after June 15, 2010 andallows for either prospective or retrospective application, with early adoption permitted. We are currently evaluating the impact that adoption of thisguidance will have on our consolidated financial statements.Item 7A. Quantitative and Qualitative Disclosures About Market Risk Foreign Currency Exchange Risk The functional currency of our foreign subsidiaries is their local currency. Accordingly, our results of operations and cash flows are subject tofluctuations due to changes in foreign currency exchange rates. The volatility of the prices and applicable rates are dependent on many factors that wecannot forecast with reliable accuracy. In the event our foreign sales and expenses increase, our operating results may be more greatly affected byfluctuations in the exchange rates of the currencies with which we do business. At this time we do not, but we may in the future, invest in derivatives orother financial instruments in an attempt to hedge our foreign currency exchange risk.Interest Rate Sensitivity Interest income and expense are sensitive to changes in the general level of U.S. interest rates. However, based on the nature and current level ofour marketable securities, which are primarily short-term investment grade and government securities and our notes payable, we believe that there is nomaterial risk of exposure.Item 8. Financial Statements and Supplementary Data Our consolidated financial statements, together with the related notes and the report of independent registered public accounting firm, are set forthon the pages indicated in Item 15.Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None.66Table of ContentsItem 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of ourdisclosure controls and procedures as of December 31, 2009. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosedby a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periodsspecified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to thecompany's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding requireddisclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assuranceof achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls andprocedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2009, our Chief Executive Officer and ChiefFinancial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.Changes in Internal Control over Financial Reporting There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and15d-15(d) of the Exchange Act that occurred during the period covered by this report that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.Management's Annual Report on Internal Control over Financial Reporting and Attestation Report of the Registered Accounting Firm This annual report does not include a report of management's assessment regarding internal control over financial reporting or an attestation reportof the company's registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newlypublic companies.Item 9B. Other Information None.PART III Certain information required by Part III is omitted from this Annual Report as we intend to file our definitive Proxy Statement for the 2010 AnnualMeeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 days after the end of thefiscal year covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein by reference.Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is incorporated herein by reference to the information provided under the headings "Election of Directors,""Section 16(A) Beneficial Ownership Reporting Compliance," "Corporate Governance—Board of Directors," "Corporate Governance—Committees,"67Table of Contents"Corporate Governance—Audit Committee," "Corporate Governance—Nominating & Corporate Governance Committee" and "Stockholder Proposalsfor 2011 Annual Meeting and Director Nominations" in our definitive proxy statement for the 2010 Annual Meeting of Stockholders to be filed withthe Securities and Exchange Commission no later than 120 days after the fiscal year ended December 31, 2009 (the "2010 Proxy Statement").Code of Ethics and Business Conduct We have adopted a code of ethics and business conduct ("code of conduct") that applies to all of our employees, officers and directors, includingwithout limitation our principal executive officer, principal financial officer and controller or principal accounting officer. Copies of both the code ofconduct, as well as any waiver of a provision of the code of conduct granted to any senior officer or director or material amendment to the code ofconduct, if any, are available, without charge, under the "Corporate Governance—Highlights" tab on our website at www.rosettastone.com.Item 11. Executive Compensation The information required by this Item is incorporated herein by reference to the information provided under the headings "Compensation &Management Development Committee Report", "Executive Compensation," "Non-Employee Director Compensation" and "Compensation CommitteeInterlocks and Insider Participation" in the 2010 Proxy Statement.Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is incorporated herein by reference to the information provided under the headings "Security Ownership ofCertain Beneficial Owners and Management" and "Equity Compensation Plan Information" in the 2010 Proxy Statement.Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is incorporated herein by reference to the information provided under the headings "Corporate Governance—Board of Directors," "Corporate Governance—Committees" and "Interests of Management and Others in Certain Transactions" in the 2010 ProxyStatement.Item 14. Principal Accounting Fees and Services The information required by this Item is incorporated herein by reference to the information provided under the heading "Principal AccountantFees and Services" in the 2010 Proxy Statement.PART IV Item 15. Exhibits and Financial Statement Schedules (a) Consolidated Financial Statements1.Consolidated Financial Statements. The consolidated financial statements as listed in the accompanying "Index to Consolidated FinancialInformation" are filed as part of this Annual Report. 2.Consolidated Financial Statement Schedules. Schedules have been omitted because they are not applicable or are not required or theinformation required to be set forth in those schedules is included in the consolidated financial statements or related notes.68Table of ContentsAll other schedules not listed in the accompanying index have been omitted as they are either not required or not applicable, orthe required information is included in the consolidated financial statements or the notes thereto. (b) Exhibits The exhibits listed in the Index to Exhibits are filed as part of this Annual Report on Form 10-K.69Table of ContentsSIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.Date: March 9, 2010 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theregistrant and in the capacities on the 9th day of March, 2010.70 ROSETTA STONE INC. By: /s/ TOM P.H. ADAMSTom P.H. AdamsChief Executive OfficerSignature Title /s/ TOM P.H. ADAMSTom P.H. Adams Chief Executive Officer and Director(Principal Executive Officer)/s/ BRIAN D. HELMANBrian D. Helman Chief Financial Officer(Principal Financial Officer)/s/ LAURA L. WITTLaura L. Witt Chairman of the Board, Director/s/ PHILLIP A. CLOUGHPhillip A. Clough Director/s/ JOHN T. COLEMANJohn T. Coleman Director/s/ LAURENCE FRANKLINLaurence Franklin Director/s/ PATRICK W. GROSSPatrick W. Gross Director/s/ THEODORE J. LEONSISTheodore J. Leonsis Director/s/ JOHN E. LINDAHLJohn E. Lindahl DirectorTable of ContentsINDEX TO CONSOLIDATED FINANCIAL STATEMENTS F-1 PageReport of Independent Registered Public Accounting Firm F-2Consolidated Balance Sheets F-3Consolidated Statements of Operations F-4Consolidated Statements of Changes in Stockholders' Equity F-5Consolidated Statements of Cash Flows F-6Notes to Consolidated Financial Statements F-7Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders ofRosetta Stone Inc.Arlington, VA We have audited the accompanying consolidated balance sheets of Rosetta Stone Inc. and subsidiaries (the "Company") as of December 31, 2009and 2008, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the periodended December 31, 2009. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinionon the financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. TheCompany is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits includedconsideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not forthe purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no suchopinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as ofDecember 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, inconformity with accounting principles generally accepted in the United States of America. As discussed in Notes 2 and 15 to the consolidated financial statements, effective January 1, 2007, the Company adopted the uncertain tax positionrelated accounting provisions of Accounting Standards Codification 740, Income Taxes (formerly FIN No. 48)./s/ DELOITTE & TOUCHE LLPMcLean, VirginiaMarch 9, 2010F-2Table of ContentsROSETTA STONE INC. CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) As of December 31, 2009 2008 Assets Current assets: Cash and cash equivalents $95,188 $30,626 Restricted cash 50 34 Accounts receivable (net of allowance for doubtful accounts of $1,349 and $1,103, respectively) 37,400 26,497 Inventory, net 8,984 4,912 Prepaid expenses and other current assets 7,447 6,598 Deferred income taxes 6,020 2,282 Total current assets 155,089 70,949 Property and equipment, net 18,374 15,727 Goodwill 34,838 34,199 Intangible assets, net 10,704 10,645 Deferred income taxes 5,565 6,828 Other assets 872 470 Total assets $225,442 $138,818 Liabilities and stockholders' equity Current liabilities: Accounts payable $1,605 $3,207 Accrued compensation 10,463 8,570 Other current liabilities 25,638 20,021 Deferred revenue 24,291 14,382 Income tax payable 4,184 1,332 Current maturities of long-term debt—related party (Note 9) — 4,250 Total current liabilities 66,181 51,762 Long-term debt—related party (Note 9) — 5,660 Deferred revenue 1,815 1,362 Other long-term liabilities 1,011 963 Total liabilities 69,007 59,747 Commitments and contingencies (Note 14) Stockholders' equity: Class A, Series A-1 Convertible Preferred Stock, $0.001 par value; zero and 269 shares authorized; zero and 269shares issued and outstanding, liquidation preference of zero and $26,876 at December 31, 2009 and December 31,2008, respectively — 26,876 Class A, Series A-2 Convertible Preferred Stock, $0.001 par value; zero and 178 shares authorized; zero and 178shares issued and outstanding, liquidation preference of zero and $17,820 at December 31, 2009 and December 31,2008, respectively — 17,820 Class B Convertible Preferred Stock, $0.001 par value; zero and 115 shares authorized; zero and 111 issued andoutstanding, liquidation preference of zero and $11,341 at December 31, 2009 and 2008, respectively — 11,341 Preferred Stock, $0.001 par value; 10,000 and zero shares authorized; zero and zero shares issued and outstanding atDecember 31, 2009 and December 31, 2008, respectively — — Class A Convertible Common Stock, $0.00005 par value; zero and 900 shares authorized; zero and zero shares issuedand outstanding at December 31, 2009 and 2008, respectively — — Class B Convertible Common Stock,$0.00005 par value; zero and 20,000 shares authorized; zero and zero sharesissued and outstanding at December 31, 2009 and 2008, respectively — — Non-designated common stock, $0.00005 par value, 190,000 and 39,100 shares authorized, 20,440 and 1,936 sharesissued and outstanding at December 31, 2009 and December 31, 2008, respectively 2 1 Additional paid-in capital 130,872 10,814 Accumulated income 25,785 12,422 Accumulated other comprehensive loss (224) (203) Total stockholders' equity 156,435 79,071 See accompanying notes to consolidated financial statements.F-3Total liabilities and stockholders' equity $225,442 $138,818 Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands except per share amounts) See accompanying notes to consolidated financial statements.F-4 Year Ended December 31, 2009 2008 2007 Revenue: Product $218,549 $184,182 $119,897 Subscription and service 33,722 25,198 17,424 Total revenue 252,271 209,380 137,321 Cost of revenue: Cost of product revenue 30,264 26,539 19,055 Cost of subscription and service revenue 3,163 2,137 1,632 Total cost of revenue 33,427 28,676 20,687 Gross profit 218,844 180,704 116,634 Operating expenses Sales and marketing 114,899 93,384 65,437 Research and development 26,239 18,387 12,893 General and administrative 57,174 39,577 29,786 Lease abandonment — 1,831 — Total operating expenses 198,312 153,179 108,116 Income from operations 20,532 27,525 8,518 Other income and expense: Interest income 159 454 673 Interest expense (356) (891) (1,331) Other income 112 239 154 Total other income (expense) (85) (198) (504)Income before income taxes 20,447 27,327 8,014 Income tax provision 7,084 13,435 5,435 Net income 13,363 13,892 2,579 Preferred stock accretion — — (80) Net income attributable to common shareholders $13,363 $13,892 $2,499 Net income per share attributable to common stockholders: Basic $0.89 $7.29 $1.47 Diluted $0.67 $0.82 $0.15 Common shares and equivalents outstanding: Basic weighted average shares 14,990 1,905 1,702 Diluted weighted average shares 19,930 16,924 16,533 Table of ContentsROSETTA STONE INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY(in thousands) Class A,Series A-1ConvertiblePreferred Stock Class A,Series A-2ConvertiblePreferred Stock Class BConvertiblePreferred Stock Class AConvertibleCommon Stock Class BConvertibleCommon Stock Non-DesignatedCommon Stock AccumulatedOtherComprehensiveIncome(loss) AdditionalPaid-inCapital AccumulatedIncome(loss) TotalStockholders'Equity Shares Amount Shares Amount Shares Amount Shares Amount Shares Amount Shares AmountBalance—January 1,2007 269 $26,876 178 $17,820 63 $6,341 — $— — $— 1,612 $1 $6,601 $(4,049)$(42)$53,548 Stock issuedupon theexercise ofstock options — — — — — — — — — — 225 — 765 — — Stock-basedcompensationexpense — — — — — — — — — — — — 1,327 — — Accretion ofRedeemableConvertibleClass BPreferred Stockto redemptionvalue — — — — — — — — — — — — (80) — — Comprehensiveincome (loss): Net income — — — — — — — — — — — — — 2,579 — Foreign currencytranslationloss, net of taxof $6 — — — — — — — — — — — — — — (14) Totalcomprehensiveincome — — — — — — — — — — — — — — — Balance—December 31,2007 269 26,876 178 17,820 63 6,341 — — — — 1,837 1 8,613 (1,470) (56) 58,125 Stock issed uponthe exercise ofstock options — — — — — — — — — — 99 — 365 — — Stock-basedcompensationexpense — — — — — — — — — — — — 1,590 — — Tax benefit onstock optionsexercised — — — — — — — — — — — — 246 — — Expiration ofredemptionrights of Class BRedeemableConvertiblePreferred Stock — — — — 48 5,000 — — — — — — — — — Comprehensiveincome: Net income — — — — — — — — — — — — — 13,892 — 13,892 Foreign currencytranslationloss, net of taxof $52 — — — — — — — — — — — — — — (147) Totalcomprehensiveincome — — — — — — — — — — — — — — — 13,745 Balance—December 31,2008 269 $26,876 178 $17,820 111 $11,341 — $— — $— 1,936 $1 $10,814 $12,422 $(203)$79,071 Stock issed uponthe exercise ofstock options — — — — — — — — — — 89 — 386 — — Stock issued toemployees — — — — — — — — — — 591 — 10,647 — — 10,647Stock-basedSee accompanying notes to consolidated financial statements.F-5 compensationexpense — — — — — — — — — — — — 3,616 — — Tax benefit onstock optionsexercised — — — — — — — — — — — — 336 — — Conversion ofpreferred stock (269) (26,876) (178) (17,820) (111) (11,341) — — — — 14,508 1 56,036 — — Sale of commonstock — — — — — — — — — — 3,125 — 49,037 — — 49,037 Comprehensiveincome: Net income — — — — — — — — — — — — — 13,363 — 13,363 Foreign currencytranslationloss, net of taxof $(8) — — — — — — — — — — — — — — (21) Totalcomprehensiveincome — — — — — — — — — — — — — — — 13,342 Balance—December 31,2009 — $— — $— — $— — $— — $— 20,249 $2 $130,872 $25,785 $(224)$156,435 Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, 2009 2008 2007 Cash Flows From Operating Activities: Net income $13,363 $13,892 $2,579 Adjustments to reconcile net income to cash provided by operating activities, net of businessacquisitions Stock-based compensation expense 22,150 1,590 1,327 Compensation expense related to put-options — — (7) Bad debt expense 911 1,611 828 Depreciation and amortization 5,428 7,075 7,769 Amortization of deferred financing costs 209 104 104 Gain on embedded derivative — (4) (29) Deferred income tax benefit (2,475) (2,177) (1,299) Loss on disposal of equipment 42 17 193 Net change in: Restricted cash (16) 359 (383) Accounts receivable (11,779) (16,494) (4,010) Inventory (3,916) (1,092) (2,563) Prepaid expenses and other current assets (1,006) (1,041) (139) Other assets (429) (91) (169) Accounts payable (1,604) (1,430) 2,630 Accrued compensation 1,905 3,933 1,348 Other current liabilities 5,678 7,393 2,108 Income tax payable 3,188 925 652 Excess tax benefit from stock options exercised (336) (246) — Other long-term liabilities (463) 963 — Deferred revenue 10,300 3,051 4,830 Net cash provided by operating activities 41,150 18,338 15,769 Cash Flows From Investing Activities: Purchases of property and equipment (8,455) (7,019) (9,167) Acquisition, net of cash acquired (100) — — Proceeds from employee and stockholder loans — — 2 Net cash used in investing activities (8,555) (7,019) (9,165) Cash Flows From Financing Activities: Proceeds from common stock issuance, net of issuance costs 49,037 — — Proceeds from the exercise of stock options 473 365 765 Tax benefit of stock options exercised 336 246 — Costs incurred for intended initial public offering — (1,801) — Payment of payroll taxes on net common stock issuance (7,887) — — Payment of payroll taxes on stock options exercised (89) — — Proceeds from long-term debt 9,929 — — Principal payments under long-term debt (19,839) (3,402) (2,550) Payments under capital lease obligations (3) (12) (16) Net cash provided by (used in) financing activities 31,957 (4,604) (1,801) Increase in cash and cash equivalents 64,552 6,715 4,803 Effect of exchange rate changes in cash and cash equivalents 10 2,220 (29) Net increase in cash and cash equivalents 64,562 8,935 4,774 See accompanying notes to consolidated financial statements.F-6Cash and cash equivalents—beginning of year 30,626 21,691 16,917 Cash and cash equivalents—end of year $95,188 $30,626 $21,691 Supplemental Cash Flow Disclosure: Cash paid during the periods for: Interest $104 $936 $1,259 Income taxes, net $6,364 $14,642 $4,821 Noncash financing and investing activities: Accrued liability for purchase of property and equipment $546 $1,076 $455 Equipment acquired under capital lease $14 $— $— Contingent liability for acquisition $850 $— $— Table of ContentsROSETTA STONE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS Rosetta Stone Inc. and subsidiaries ("Rosetta Stone," the "Company" or the "Successor") develops, markets and supports a suite of languagelearning software products under the Rosetta Stone brand name. The Company's software products are sold on a direct basis and through select retailers.The Company provides its software applications to customers through the sale of CD-ROM's and on line subscriptions. Rosetta Stone Inc. wasincorporated on December 23, 2005 in the state of Delaware and acquired Rosetta Stone Holdings Inc., a Delaware corporation, on January 4, 2006.Rosetta Stone Holdings Inc. acquired Rosetta Stone Ltd. (formerly Fairfield & Sons, Ltd.) and Rosetta Stone (UK), Limited (formerly Fairfield & SonsUK Limited), on January 4, 2006. Rosetta Stone Inc. has six wholly owned operating subsidiaries—Rosetta Stone Holdings Inc., a Delawarecorporation, Rosetta Stone Ltd., a Virginia corporation, Rosetta Stone International Inc., a Delaware corporation, Rosetta Stone (UK), a corporationincorporated under the laws of England and Wales, Rosetta Stone Japan Inc., a company incorporated under the laws of Japan, and RosettaStone GmbH, a company incorporated under the laws of Germany. On November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd., headquartered in Seoul, South Korea, see Note 4—Acquisitions.2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESInitial Public Offering In April 2009, the Company completed an initial public offering consisting of 7,187,500 shares of common stock at $18.00 per share. The totalshares sold in the offering included 4,062,500 sold by selling stockholders and 3,125,000 shares sold by the Company. After deducting the payment of underwriters' discounts and commissions and offering expenses, the net proceeds to the Company from the sale ofshares in the offering were $49.0 million. The net proceeds from the offering were used to repay a $9.9 million balance on the revolving credit facilityand $7.9 million to satisfy the federal, state and local withholding tax obligations associated with the net issuance of stock grants made to keyemployees.Principles of Consolidation The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America andinclude the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated inconsolidation.Use of Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires thatmanagement make certain estimates and assumptions. Significant estimates and assumptions have been made regarding the allowance for doubtfulaccounts, estimated sales returns, stock-based compensation, fair value of assets and liabilities acquired, lease abandonment accrual, fair value ofintangibles and goodwill, fair value of stock issued, inventory reserve, disclosure of contingent assets and liabilities and disclosure of contingentlitigation. Actual results may differ from these estimates.F-7Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)Revenue Recognition Revenue is primarily derived from the sale of packaged software and audio practice products, online software subscriptions and professionalservices. Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta StoneTOTALe, which was released in July 2009. Rosetta Stone TOTALe is currently sold only as an online software subscription. Revenue is recognizedfor software products and related services in accordance with Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition("ASC 985-605"). Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered orservices have been rendered; the fee is fixed and determinable; and collectability is probable. Revenues from packaged software and audio practiceproducts and online software subscriptions are recorded net of discounts. Revenue is recognized from the sale of packaged software and audio practice products when the product has been delivered, assuming theremaining revenue recognition criteria have been met. Software products include sales to end user customers and resellers. In most cases, revenue fromsales to resellers is not contingent upon resale of the software to the end user and is recorded in the same manner as all other product sales. Revenuefrom sales of packaged software products are recognized as the products are shipped and title passes. A limited amount of packaged software productsare sold to resellers on a consignment basis. Revenue is recognized for these consignment transactions once the end-user sale has occurred, assumingthe remaining revenue recognition criteria have been met. In accordance with Accounting Standards Codification subtopic 985-605-50, Software:Revenue Recognition: Customer Payments and Incentives ("ASC 985-605-50"), price protection for changes in the manufacturer suggested retail valuegranted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue. TheCompany offers customers the ability to make payments for packaged software purchases in installments over a period of time, which typically rangesbetween three and five months. Given that these installment payment plans are for periods less than twelve months and a successful collection historyhas been established, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met. For the years endedDecember 31, 2009, 2008 and 2007, installment sales represented 8%, 4% and 3% of revenue, respectively. Packaged software is provided tocustomers who purchase directly from us with a six-month right of return. The Company also allows its retailers to return unsold products, subject tosome limitations. In accordance with Accounting Standards Codification subtopic 985-605-15, Software: Revenue Recognition: Products ("ASC 985-605-15"), product revenue is reduced for estimated returns, which are based on historical return rates. Revenue for software license agreements sold via online software subscriptions as hosting agreements are recognized in accordance withAccounting Standards Codification subtopic 985-605-05, Software: Revenue Recognition: Background ("ASC 985-605-05"). Revenue for onlinesoftware subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria have been met, whichtypically ranges between three and twelve months. Some online licensing arrangements include a specified number of licenses that can be activated overa period of time, which typically ranges between twelve and twenty-four months. Revenue for these arrangements is recognized on a per license basisratably over the term of the individual license subscription period, assuming all revenue recognition criteria have been met, which typically rangesbetween three and twelve months. Revenue for set-up fees related to online licensing arrangements isF-8Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)recognized ratably over the term of the online licensing arrangement, assuming all revenue recognition criteria have been met. Accounts receivable anddeferred revenue are recorded at the time a customer enters into a binding subscription agreement and the subscription services are made available to thecustomer. In connection with packaged software product sales and online software subscriptions, technical support is provided to customers, includingcustomers of resellers, at no additional charge. As the fee for technical support is included in the initial licensing fee, the technical support and servicesare generally provided within one year, the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancementsare offered, technical support revenues are recognized together with the software product and license revenue. Costs associated with the technicalsupport are accrued at the time of sale. Revenue from the sale of packaged software products with specific upgrade rights is recognized in accordance with ASC 985-605. Revenuerecognition for these sales is deferred until the earlier of the point at which sufficient vendor-specific objective evidence ("VSOE") exist for the specificupgrade right or all elements of the arrangement have been delivered. In accordance with ASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identifiedbenefit is identified and the fair value is reasonably determinable. The Company has been engaged to develop language learning software for certain endangered languages under fixed fee arrangements. Thesearrangements also include contractual periods of post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue formulti-element contracts will be recognized ratably once the PCS and online hosting periods begin, over the longer of the PCS or online hosting period.When the current estimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for the entire loss on thecontract is recorded.Cash and Cash Equivalents Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and demand deposits with financialinstitutions.Restricted Cash Restricted cash is restricted for the reimbursement of funds to employees under the Company's flexible benefit plan and security for a credit cardprocessing vendor.Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable consist of amounts due to the Company from its normal business activities. The Company provides an allowance for doubtfulaccounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified.Inventories Inventories are stated at the lower of cost, determined on a first-in first-out basis, or market. The Company reviews inventory for excess quantitiesand obsolescence based on its best estimates of futureF-9Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)demand, product lifecycle status and product development plans. The Company uses historical information along with these future estimates to reservefor obsolete and potential obsolete inventory.Concentrations of Credit Risk Accounts receivable and cash and cash equivalents subject the Company to its highest potential concentrations of credit risk. The Companyreserves for credit losses and does not require collateral on its trade accounts receivable. In addition, the Company maintains cash and investmentbalances in accounts at various banks and brokerage firms. The Company is insured by the Federal Deposit Insurance Corporation for up to $250,000at each bank. The Company's cash and cash equivalents may exceed the insured limits at times. The Company has not experienced any losses on cashand cash equivalent accounts to date and the Company believes it is not exposed to any significant credit risk related to cash. The Company sellsproducts to retailers, resellers, government agencies, and individual consumers and extends credit based on an evaluation of the customer's financialcondition, without requiring collateral. Exposure to losses on receivables is principally dependent on each customer's financial condition. The Companymonitors its exposure for credit losses and maintains allowances for anticipated losses. No customer accounted for more than 10% of the Company'srevenue during the years ended December 31, 2009, 2008 or 2007. The Company had 3 customers that accounted for 47% of accounts receivable atDecember 31, 2009, and two customers that accounted for 38% of accounts receivable at December 31, 2008.Fair Value of Financial Instruments The carrying value of the Company's financial instruments, which include cash and cash equivalents, restricted cash, accounts receivable, accountspayable, and other accrued expenses, approximate their fair values due to their short maturities. Based on borrowing rates currently available to theCompany for loans with similar terms, the carrying value of debt approximates fair value at December 31, 2009 and 2008.Property, Equipment and Software Property, equipment, and software are stated at cost, less accumulated depreciation and amortization. Depreciation on property, leaseholdimprovements, equipment, and software is computed on a straight-line basis over the estimated useful lives of the assets, as follows: Expenses for repairs and maintenance that do not extend the life of equipment are charged to expense as incurred. Expenses for major renewals andbetterments, which significantly extend the useful lives of existing property and equipment, are capitalized and depreciated. Upon retirement orF-10Software 3 yearsComputer equipment 3 - 5 yearsAutomobiles 5 yearsFurniture and equipment 5 - 7 yearsBuilding 39 yearsBuilding improvements 15 yearsLeasehold improvements 4 - 7 yearsAssets under capital leases lesser of lease term or economic lifeTable of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)disposition of property and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss isrecognized.Intangible Assets Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark andother intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives inaccordance with Accounting Standards Codification topic 350, Goodwill and Other Intangible Assets ("ASC 350"). On an annual basis, the Companyreviews its indefinite lived intangible assets for impairment based on the fair value of indefinite lived intangible assets as compared to the carrying valuein accordance with ASC 350. In the event the carrying value exceeds the fair value of the assets, the assets are written down to their fair value. Therehas been no impairment of intangible assets during any of the periods presented.Goodwill In accordance with ASC 350, goodwill is not amortized and is tested for impairment annually on June 30th and whenever events andcircumstances occur indicating goodwill might be impaired. As of June 30, 2009 and 2008, the Company reviewed the goodwill for impairment anddetermined that no impairment of goodwill was identified during any of the periods presented.Valuation of Long-Lived Assets In accordance with Accounting Standards Codification topic 360, Accounting for the Impairment or Disposal of Long-lived Assets ("ASC 360"),the Company evaluates the recoverability of its long-lived assets. ASC 360 requires recognition of impairment of long-lived assets in the event that thenet book value of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the periodof identification to the extent the carrying amount of an asset exceeds the fair value of such asset. Based on its analysis, the Company believes that noimpairment of its long-lived assets was indicated as of December 31, 2009 and 2008.Financial Instruments with Characteristics of Both Liabilities and Equity The Company issues financial instruments that have characteristics of both liabilities and equity. The Company accounts for these arrangements inaccordance with Accounting Standards Codification topic 480, Accounting for Certain Financial Instruments with Characteristics of Both Liabilitiesand Equity ("ASC 480"), as well as related interpretations of this standard.Derivative Instruments The Company enters into financing arrangements that consist of freestanding derivative instruments or are hybrid instruments that containembedded derivative features. The Company accounts for these arrangements in accordance with Accounting Standards Codification topic 815,Accounting for Derivative Instruments and Hedging Activities ("ASC 815") as well as related interpretation of this standard. In accordance with thisstandard, derivative instruments are recognized as either assets or liabilities in the balance sheet and are measured at fair values with gains or lossesrecognized in earnings. Embedded derivatives that are not clearly and closely related to the hostF-11Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)contract are bifurcated and are recognized at fair value with changes in fair value recognized as either a gain or loss in earnings. The Companydetermines the fair value of derivative instruments and hybrid instruments based on available market data using appropriate valuation models, givingconsideration to all of the rights and obligations of each instrument.Stock Split On March 23, 2009, in connection with the Company's initial public offering of common stock, the Board of Directors approved a 1.3-to-1 split ofcommon stock to stockholders of record as of such date. All references to the number of common shares and per share amounts have been restated asappropriate to reflect the effect of the split for all periods presented.Guarantees Indemnifications are provided of varying scope and size to certain institutional customers against claims of intellectual property infringement madeby third parties arising from the use of its products. The Company has not incurred any costs or accrued any liabilities as a result of such obligations.Cost of Revenue Cost of revenue consists of the direct and indirect costs to produce and distribute Rosetta Stone software. Inventory related costs include materialspurchasing, inbound freight, inventory receiving, production assembly of boxed products, product royalty fees, storage of inventory, inventoryobsolescence and inventory shrinkage. Distribution related costs include out-bound freight, fulfillment partner fees, internal shipping labor andpackaging materials. Other costs included in cost of revenue include credit card processing fees, amortization of certain intangible assets, depreciation offixed assets used, and the cost of technical support for customers.Research and Development Research and development expenses include employee compensation costs, professional services fees and overhead costs associated with productdevelopment. Software products are developed for sale to external customers. The Company considers technological feasibility to be established whenall planning, designing, coding, and testing has been completed according to design specifications. The Company has determined that technologicalfeasibility for its software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility isestablished have not been material, and accordingly, the Company has expensed all research and development costs when incurred.Software Developed for Internal Use Product development also includes certain software products for internal use. Development costs for internal use software are expensed as incurreduntil the project reaches the application development stage, in accordance with Accounting Standards Codification topic 350, Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use ("ASC 350"). Internal-use software is defined to have the following characteristics: (a) thesoftware is internally developed, or modified solely to meet the entity's internal needs, and (b) during the software's development or modification, nosubstantiveF-12Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)plan exists or is being developed to market the software externally. Internally developed software is amortized over a three-year useful life. For the years ended December 31, 2009, 2008 and 2007, the Company capitalized zero, $0.2 million and $1.1 million in internal-use software,respectively. For the years ended December 31, 2009, 2008 and 2007, the Company recorded amortization expense relating to internal-use software of$0.5 million, $0.5 million and $0.4 million, respectively.Income Taxes For the years ended December 31, 2009, 2008 and 2007, the Company accounted for income taxes in accordance with Accounting StandardsCodification topic 740, Income Taxes ("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred taxassets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilitiesversus the tax bases of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operatingloss and tax credit carryforwards. Deferred liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuationallowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Theimpact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted. In June 2006, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Codification topic 740-10-25, Accounting forUncertainty in Income Taxes ("ASC 740-10-25"), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financialstatements in accordance with ASC 740 and prescribes a recognition threshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosures, and transition. The Company adopted ASC 740-10-25 effective January 1, 2007. Theadoption of ASC 740-10-25 did not have a material impact on the Company's financial condition, results of operations or cash flows.Stock-Based Compensation The Company accounts for its stock-based compensation in accordance Accounting Standards Codification topic 718, Compensation—StockCompensation ("ASC 718"), which was adopted by the Company effective January 1, 2006. Under ASC 718, all stock-based awards, includingemployee stock option grants, are recorded at fair value as of the grant date and recognized as expense in the statement of operations on a straight-linebasis over the requisite service period, which is the vesting period.Net Income Per Share Net income per share is computed under the provisions of Accounting Standards Codification topic 260, Earnings Per Share. Basic income pershare is computed using net income and the weighted average number of common shares outstanding. Diluted earnings per share reflect the weightedaverage number of common shares outstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive shares consist ofshares issuable upon the exercise of stock options (usingF-13Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)the treasury stock method), restricted stock awards, restricted stock units and conversion of preferred shares (using the as-converted method). Commonequivalent shares are excluded from the diluted computation if their effect is anti-dilutive. The following table sets forth the computation of basic and diluted net income per common share (in thousands, except per share amounts): The following table sets forth common stock equivalent shares included in the calculation of the Company's diluted net income per share (inthousands): Share-based awards to purchase approximately 15,000, 135,000 and 103,000 shares of common stock that had an exercise price in excess of theaverage market price of the common stock during the years ended December 31, 2009, 2008 and 2007, respectively, were not included in the calculationof diluted earnings per share because they were anti-dilutive.Comprehensive Income (Loss) Comprehensive income consists of net income and other comprehensive income. Other comprehensive income refers to revenues, expenses, gains,and losses that are not included in net income, but rather are recorded directly in stockholders' equity. For the years ended December 31, 2009, 2008 and2007, the Company's comprehensive income consisted of net income and foreign currency translation gains (losses).F-14 Years Ended December 31, 2009 2008 2007 Numerator: Net income $13,363 $13,892 $2,579 Accretion of redeemable convertible preferredstock — — (80) Net income attributable to common stockholders $13,363 $13,892 $2,499 Denominator: Weighted average number of common shares: Basic 14,990 1,905 1,702 Diluted 19,930 16,924 16,533 Income per common share: Basic $0.89 $7.29 $1.47 Diluted $0.67 $0.82 $0.15 Years Ended December 31, 2009 2008 2007 Equity instruments: Convertible preferred stock 4,134 14,508 14,508 Restricted common stock units 7 — — Restricted common stock 93 — — Stock options 706 511 322 Total common stock equivalent shares 4,940 15,019 14,830 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)Foreign Currency Translation and Transactions The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiariesare translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for theperiod. Translation adjustments are recorded as a component of other comprehensive income in stockholders' equity. Cash flows of consolidated foreign subsidiaries, whose functional currency is the local currency, are translated to U.S. dollars using averageexchange rates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item inthe reconciliation of the changes in cash and cash equivalents during the period. Gains and losses resulting from foreign currency transactions are included in other income and expense. Foreign currency transaction gains(losses) were $(44,000), $0.2 million and $0.1 million for the years ended December 31, 2009, 2008 and 2007, respectively.Recently Issued Accounting Standards In February 2008, the FASB issued Accounting Standards Codification topic 820, Fair Value Measurements and Disclosures ("ASC 820"). Theprovisions of ASC 820, which provide guidance for, among other things, the definition of fair value and the methods used to measure fair value, wereadopted January 1, 2008 for financial instruments. The provisions adopted in 2008 did not have an impact on the Company's financial statements. Theeffective date of ASC 820 for all nonrecurring fair value measurements of nonfinancial assets and liabilities (except for those that are recognized ordisclosed at fair value in the financial statements on a recurring basis) was fiscal years beginning after November 15, 2008. On January 1, 2009 theCompany adopted the provisions in ASC 820 for nonrecurring fair value measurements of nonfinancial assets and liabilities. The Company applied theprovisions adopted in the first quarter of 2009 to the fair value measurements recorded as part of the acquisition of SGLC International Co. Ltd. Seenote 4. In December 2007, the FASB issued Accounting Standards Codification topic 805, Business Combinations ("ASC 805"), which establishesprinciples and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest; recognizes and measures the goodwill acquired in the business combination or a gainfrom a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financialeffects of the business combination. ASC 805 is to be applied prospectively to business combinations for which the acquisition date is on or after anentity's fiscal year that begins after December 15, 2008. The Company applied the provisions adopted in the first quarter of 2009 to the accounting forthe acquisition of SGLC International Co. Ltd. See note 4. In December 2007, the FASB issued Accounting Standards Codification topic 810, Consolidation ("ASC 810"), which establishes newaccounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statementrequires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent'sequity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the incomeF-15Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)statement. ASC 810 clarifies that changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation are equity transactions ifthe parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when asubsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidationdate. ASC 810 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. ASC 810 is effectivefor fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The adoption ofASC 810 did not have a material impact on the Company's financial position, results of operations or cash flows. In March 2008, the FASB issued Accounting Standards Codification topic 815, Derivatives and Hedging ("ASC 815"), which requires enhanceddisclosures about an entity's derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivativeinstruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged itemsaffect an entity's financial position, financial performance and cash flows. The adoption of ASC 815 did not have a significant impact on the Company'sfinancial position, results of operations or cash flows. In May 2008, the FASB issued Accounting Standards Codification topic ASC 105, Generally Accepted Accounting Principles, ("ASC 105"),which identifies the sources of accounting principles and provides the framework for selecting the principles used in the preparation of financialstatements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. ASC 105 iseffective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of ASC 105 did not havesignificant impact on the Company's financial position, results of operation, or cash flows. On October 10, 2008, the FASB issued Accounting Standards Codification topic 820, Fair Value Measurements and Disclosures ("ASC 820"),which was effective upon issuance, including periods for which financial statements have not been issued. ASC 820 provided an illustrative example todemonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. The adoption of ASC 820 did nothave a material impact on the Company's consolidated financial position and the results of operations. In April 2009, the FASB issued Accounting Standards Codification topic 820-10-65-4, Fair Value Measurements and Disclosures ("ASC 820"),which provides guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability hassignificantly decreased. ASC 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly. In addition, ASC 820requires disclosure in interim and annual periods of the inputs and valuation methods used in determining fair value and a discussion of any changes inthose valuation methods. ASC 820 is effective for annual and interim periods ending on or after June 15, 2009. The adoption of ASC 820 did not havea material impact on the Company's consolidated financial position and the results of operations. On May 28, 2009, the FASB issued Accounting Standards Codification topic 855, Subsequent Events ("ASC 855"). Although ASC 855 does notsignificantly change current practice surrounding the disclosure of subsequent events, it provides guidance on management's assessment of subsequentevents and the requirement to disclose the date through which subsequent events have been evaluated.F-16Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)ASC 855 became effective for the quarter ended June 30, 2009. The adoption of ASC 855 did not have any impact on the Company's consolidatedfinancial position or results of operations. On June 12, 2009, the FASB issued Statement No. 167, Amendments to FASB Interpretation No. 46(R) ("SFAS No. 167"). SFAS No. 167modifies the existing quantitative guidance used in determining the primary beneficiary of a variable interest entity ("VIE") by requiring entities toqualitatively assess whether an enterprise is a primary beneficiary, based on whether the entity has (i) power over the significant activities of the VIE,and (ii) an obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE. SFAS No. 167 becomes effectivefor all new and existing VIEs on January 1, 2010. The adoption of SFAS No. 167 will not have any impact on the Company's consolidated financialposition or results of operations. On June 29, 2009, the FASB issued Accounting Standards Codification topic ASC 105, Generally Accepted Accounting Principles ("ASC 105"),which establishes the FASB Accounting Standards Codification (the "Codification") as the primary source of authoritative GAAP recognized by theFASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC are also sources of authoritative GAAP for SECregistrants. ASC 105 and the Codification become effective on September 30, 2009. When effective, the Codification will supersede all existing non-SEC accounting and reporting standards and the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or EmergingIssues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification;(b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The adoption ofASC 105 and the Codification on September 30, 2009 did not have a material effect on the Company's consolidated financial statements. In October 2009, the FASB issued Accounting Standards Update ("ASU") 2009-13, which amended the accounting requirements under theRevenue Recognition Topic, ASC 605-25 Multiple-Element Arrangements. The objective of this update is to address the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. The amendmentsestablish a hierarchy for determining the selling price of a deliverable and will allow for the separation of products and services in more instances thanpreviously permitted. The guidance provided within ASU 2009-13 is effective for fiscal years beginning on or after June 15, 2010 and allows for eitherprospective or retrospective application, with early adoption permitted. The Company is currently evaluating the impact that adoption of this guidancewill have on its consolidated financial statements. In October 2009, the FASB issued ASU 2009-14 which amended the accounting requirements under the Software Topic, ASC 985-605 RevenueRecognition. The objective of this update is to address the accounting for revenue arrangements that contain tangible products and software. Specifically,products that contain software that is "more than incidental" to the product as a whole will be removed from the scope of ASC subtopic 985-605(previously AICPA Statement of Position 97-2). The amendments align the accounting for these revenue transaction types with the amendments underASU 2009-13 mentioned above. The guidance provided within ASU 2009-14 is effective for fiscal years beginning on or after June 15, 2010 andallows for either prospective or retrospective application, with early adoption permitted. The Company is currently evaluating the impact that adoption ofthis guidance will have on its consolidated financial statements.F-17Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)3. INVENTORY Inventory consisted of the following (in thousands):4. ACQUISITIONS On November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd., a software reseller headquartered in Seoul, SouthKorea. As the assets acquired constituted a business, this transaction was accounted for under Accounting Standards Codification topic 805, BusinessCombination ("ASC 805"). The purchase price consisted of an initial cash payment of $100,000, followed by three annual cash installment payments,based on revenue performance in South Korea. The terms of the acquisition agreement provide for additional consideration to be paid by the Companyin each of the following three years, if the acquired company's revenues exceed certain targeted levels each of these years. The amount is calculated asthe lesser of a percentage of the revenue generated or a fixed amount for each year, based on the terms of the agreement. Based on these terms, the minimum additional cash payment is zero if none of the minimum revenue targets are met, and the maximum additionalpayment is $1.1 million. Management determined that the total contingent consideration for inclusion in the purchase price was the maximum of$1.1 million, the fair value of which is $850,000. Including the cash paid upon the acquisition date of $100,000, the total purchase price was $950,000. Under the purchase method of accounting, the total purchase price was allocated to the tangible and intangible assets acquired on the basis of theirrespective estimated fair values at the date of acquisition. The valuation of the identifiable intangible assets and their useful lives acquired reflectsmanagement's estimates. The summary of fair value of assets acquired in the asset acquisition is as follows (in thousands): A total of $100,000 was allocated to amortizable intangible assets consisting of customer relationships, and a total of $620,257 was allocated togoodwill. Goodwill represents the excess of theF-18 As of December 31, 2009 2008 Raw materials $4,053 $3,023 Finished goods 5,696 2,359 9,749 5,382 Reserve for obsolete inventory (765) (470) Inventory, net $8,984 $4,912 Tangible assets: Inventory $135 Property and equipment 95 Intangible assets: Customer relationships 100 Goodwill 620 Total assets acquired $950 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)4. ACQUISITIONS (Continued)purchase price over the fair value of tangible and amortizable intangible assets acquired. No liabilities were assumed in this acquisition, and proformarequirements were immaterial to the presentation.5. PROPERTY AND EQUIPMENT Property and equipment consisted of the following (in thousands): The Company leases certain computer equipment, software and machinery under capital lease agreements, with bargain purchase options at the endof the lease term. As of December 31, 2009 and 2008, leased computer equipment and software included in property and equipment above was $56,000and $44,000, respectively. The Company recorded depreciation expense for the years ended December 31, 2009, 2008 and 2007 in the amount of $5.4 million, $4.0 millionand $2.9 million, respectively.6. GOODWILL The value of goodwill is primarily derived from the acquisition of Rosetta Stone, Ltd. in January 2006 and the acquisition of certain assets ofSGLC International Co. Ltd. in November 2009, as detailed in Note 4. The Company tests goodwill for impairment annually on June 30 of each year atthe reporting unit level using a fair value approach, in accordance with the provisions of Accounting Standards Codification topic 350, Intangibles—Goodwill and Other ("ASC 350"). If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unitbelow its carrying value, goodwill will be evaluated for impairment between annual tests. The Company's annual testing resulted in no impairments ofgoodwill since the dates of acquisition. For income tax purposes, the goodwill balance is amortized over a period of 15 years.F-19 As of December 31, 2009 2008 Land $390 $390 Buildings and improvements 7,952 5,437 Leasehold improvements 1,453 1,166 Computer equipment 7,617 6,134 Software 11,327 8,251 Furniture and equipment 2,589 2,060 31,328 23,438 Less: accumulated depreciation (12,954) (7,711) Property and equipment, net $18,374 $15,727 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)6. GOODWILL (Continued) The following table represents the balance and changes in goodwill for the years ended December 31, 2009, 2008, 2007 and 2006 (in thousands):7. INTANGIBLE ASSETS Intangible assets consisted of the following items as of the dates indicated (in thousands): The Company recorded intangible assets of $23.8 million, associated with the acquisition of Rosetta Stone Ltd. in January 2006, and $100,000with the acquisition of certain assets of SGLC International Co. Ltd. in November 2009. The Company did not record any additions to intangible assetsduring 2008. The estimated lives of the acquired core technology and customer relationships are between 18 to 36 months. The intangible assetassociated with the trade name and trademark has an indefinite useful life. The estimated life of the website rights is 60 months. The Company computesF-20Balance as of January 1, 2006 $— Rosetta Stone Ltd. acquisition 34,199 Balance as of December 31, 2006 $34,199 No acquisition activity — Balance as of December 31, 2007 $34,199 No acquisition activity — Balance as of December 31, 2008 $34,199 SGLC International Co. LTD. acquisition 620 Balance as of December 31, 2009 $34,819 Effect of change in foreign currency rate 19 Balance as of December 31, 2009 $34,838 December 31, 2009 December 31, 2008 GrossCarryingAmount AccumulatedAmortization NetCarryingAmount GrossCarryingAmount AccumulatedAmortization NetCarryingAmount Trade name /trademark $10,607 $— $10,607 $10,607 $— $10,607 Coretechnology 2,453 (2,453) — 2,453 (2,453) — Customerrelationships 10,842 (10,747) 95 10,739 (10,706) 33 Website 12 (10) 2 12 (7) 5 Total $23,914 $(13,210)$10,704 $23,811 $(13,166)$10,645 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)7. INTANGIBLE ASSETS (Continued)amortization of intangible assets on a straight-line basis over the estimated useful life. Below are the estimated useful lives of the intangible assetsacquired: Amortization expense consisted of the following (in thousands): The following table summarizes the estimated future amortization expense related to intangible assets as of December 31, 2009 (in thousands):8. OTHER CURRENT LIABILITIES The following table summarizes other current liabilities (in thousands):F-21 WeightedAverageLifeTrade name / trademark IndefiniteCore technology 24 monthsCustomer relationships 33 monthsWebsite 60 months Years Ended December 31, 2009 2008 2007 Included in cost of revenue: Cost of product revenue $— $13 $1,227 Cost of subscription and service revenue — — — Total included in cost of revenue — 13 1,227 Included in operating expenses: $42 $3,003 $3,596 Total $42 $3,016 $4,823 As ofDecember 31,2009 2010 $54 2011 43 Thereafter — Total $97 December 31, 2009 2008 Marketing expenses $8,746 $4,803 Professional and consulting fees 2,720 2,249 Sales return reserve 4,708 3,229 Taxes payable 2,043 1,527 Other 7,421 8,213 $25,638 $20,021 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)9. BORROWING AGREEMENT On January 4, 2006, the Company entered into a Credit Agreement with Madison Capital, which provided the Company a $4.0 million revolvingcredit facility ("Revolver") and a $17.0 million term loan ("Term Loan"). The Credit Agreement was amended on August 2, 2007 and April 23, 2008 toamend certain covenants, terms, and definitions. Under the Credit Agreement, all amounts outstanding under the Revolver and the Term Loan accruedinterest at the Base Rate plus the Applicable Margin or the LIBOR Rate plus the Applicable Margin, as specified by the Company. As of December 31,2008, the interest rate on the term loan was 4.65%. On January 16, 2009, the Company entered into a new credit agreement with Wells Fargo Bank, N.A. ("Wells Fargo"), which provides theCompany with a $12.5 million revolving line of credit. This revolving credit facility has a two-year term and the applicable interest rate is 2.5% aboveone month LIBOR, or approximately 2.73% as of December 31, 2009. On January 16, 2009, the Company borrowed approximately $9.9 million underthis revolving credit facility and used these funds to repay the entire outstanding principal and interest of the Term Loan the Company had with MadisonCapital. As a result, the Company has no borrowings owed to Madison Capital under either their Term Loan or Revolver, and the Company hasterminated these credit agreements. As a result of the early repayment of the Madison Capital Loan, the Company wrote-off the remaining unamortizedcapitalized financing costs associated with this loan. The amount of the write-off was approximately $0.2 million. Upon completion of the Company'sinitial public offering, the Company repaid the $9.9 million balance of its revolving credit facility with Wells Fargo during the three months endedJune 30, 2009, and a total of $12.5 million under revolving credit facility is available to the Company for borrowing thereunder. Long-term borrowings consist of the following (in thousands): Certain of the Company's assets are pledged as collateral to secure any borrowings by the Company under the credit agreement with Wells Fargo.The line of credit contains financial covenants tested on a quarterly basis and is applicable for the term of the loan. The primary covenants under the lineof credit are limitations on liens and encumbrances, restrictions on investments, limitations on the sale of certain assets, and a minimum liquiditythreshold. In addition, the Company is required to provide a quarterly report to the lender within 45 days following the end of a quarter, and an auditedannual report 120 days following the close of the fiscal year. Non-compliance with debt covenants are considered events of default and could result inthe line of credit becoming immediately due and/or being terminated. Interest expense for the twelve months ended December 31, 2009 and 2008 was $0.4 million and $0.9 million, respectively.F-22 December 31, 2009 2008 Term loan, Madison Capital $— $9,910 Revolver, Wells Fargo Bank N.A. — — — 9,910 Less current portion — (4,250) Total $— $5,660 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION2006 Stock Incentive Plan On January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under which the Company'sBoard of Directors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The planinitially authorized the grant of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized thegrant of additional stock options for up to 195,000 shares of common stock under the plan, resulting in total stock options available for grant under the2006 Plan of 2,137,200 as of December 31, 2008. The stock options granted under the Stock Plan generally expire at the earlier of a specified periodafter termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from suchgrant date. Stock issued as a result of exercises of stock options will be issued from the Company's authorized available stock.2009 Omnibus Incentive Plan On February 27, 2009, the Company's Board of Directors approved a new Stock Incentive and Award Plan (the "2009 Plan") that provides for theability of the Company to grant up to 2,437,744 new stock incentive awards or options including Incentive and Nonqualified Stock Options, StockAppreciation Rights, Restricted Stock, Restricted Stock Units, Performance Units, Performance Shares, Performance based Restricted Stock, ShareAwards, Phantom Stock and Cash Incentive Awards. The stock incentive awards and options granted under the 2009 Plan generally expire at the earlierof a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than tenyears from such grant date. Concurrent with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants. At December 31, 2009 there were1,960,958 shares available for future grant under the 2009 Plan. In accordance with Accounting Standards Codification topic 718, Compensation—Stock Compensation ("ASC 718"), the fair value of stock-basedawards to employees is calculated as of the date of grant. Compensation expense is then recognized on a straight-line basis over the requisite serviceperiod of the award. The Company uses the Black-Scholes pricing model to value its stock options, which requires the use of estimates, including futurestock price volatility, expected term and forfeitures. Stock-based compensation expense recognized is based on the estimated portion of the awards thatare expected to vest. Estimated forfeiture rates were applied in the expense calculation.The fair value of each option grant is estimated on the date ofgrant using the Black Scholes option pricing model as follows:F-23 Year Ended December 31, 2009 2008 2007Expected stock price volatility 61% 57% - 62% 62% - 70%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 1.71% - 2.46% 2.08% - 3.36% 3.50% - 4.96%Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) Prior to the completion of the Company's initial public offering in April 2009, the Company's stock was not publicly quoted and the Company hada limited history of stock option activity, so the Company reviewed a group of comparable industry-related companies to estimate its expected volatilityover the most recent period commensurate with the estimated expected term of the awards. In addition to analyzing data from the peer group, theCompany also considered the contractual option term and vesting period when determining the expected option life and forfeiture rate. Subsequent to theinitial public offering, the Company continues to review a group of comparable industry-related companies to estimate volatility, but also reviews thevolatility of its own stock since the initial public offering. The Company considers the volatility of the comparable companies to be the best estimate offuture volatility. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the optionaward. Stock Options—The following table summarizes the Company's stock option activity for the years ended December 31, 2009, 2008 and 2007:F-24 OptionsOutstanding WeightedAverageExercisePrice WeightedAverageContractualLife (years) AggregateIntrinsicValue Balance at January 1, 2007 1,531,231 $3.85 9.46 $3,415,823 Options granted 415,574 7.28 Options exercised (238,735) 3.85 Options cancelled (214,367) 4.53 Balance at December 31, 2007 1,493,703 4.70 8.70 9,695,391 Options granted 402,805 12.89 Options exercised (103,506) 3.96 Options cancelled (135,203) 7.97 Balance at December 31, 2008 1,657,799 6.48 8.05 18,268,386 Options granted 472,589 18.11 Options exercised (93,505) 5.10 Options cancelled (60,654) 12.48 Balance at December 31, 2009 1,976,229 9.14 7.58 17,511,103 Vested and expected to vest at December 31, 2008 1,572,720 6.23 7.99 17,722,546 Vested and expected to vest at December 31, 2009 1,878,917 8.73 7.5 17,396,124 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) The following tables summarize the status of options outstanding under the Company's stock option plan as of December 31, 2009: As of December 31, 2009 and 2008, there were approximately $5.3 million and $4.4 million of unrecognized stock-based compensation expenserelated to non-vested stock option awards that is expected to be recognized over a weighted average period of 2.49 and 2.21 years, respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options outstanding at December 31, 2009 was 7.58 yearsand $17.5 million, respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options exercisable atDecember 31, 2009 was 6.84 years and $13.4 million, respectively. As of December 31, 2009, options were vested and exercisable as to a total of1,072,837 shares of common stock with a weighted average exercise price per share of $5.47. The weighted average grant-date fair value per share of stock options granted was $10.32, $7.19 and $5.04 for the years ended December 31,2009, 2008 and 2007, respectively. The aggregate intrinsic value disclosed above represents the total intrinsic value (the difference between the fair market value of the Company'scommon stock as of December 31, 2009, and the exercise price, multiplied by the number of in-the-money options) that would have been received bythe option holders had all option holders exercised their options on December 31, 2009. This amount is subject to change based on changes to the fairmarket value of the Company's common stock.F-25 Outstanding Exercisable Range of Exercise Prices NumberOutstandingas of 12/31/09 WeightedAverageRemainingContractual Life(in years) WeightedAverageExercisePrice NumberExercisableas of12/31/09 WeightedAverageExercisePrice $3.85 - $3.85 909,725 6.50 $3.85 762,478 $3.85 $6.08 - $10.36 323,040 7.47 7.33 192,345 6.99 $11.19 - $17.49 298,591 8.46 13.76 102,329 12.83 $18.00 - $18.00 426,640 9.24 18.00 15,187 18.00 $18.05 - $20.35 3,233 9.75 19.45 498 20.35 $22.30 - $22.30 15,000 9.41 22.30 — — $3.85 - $22.30 1,976,229 7.58 9.14 1,072,837 5.47 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) Restricted Stock—The following table summarizes the Company's restricted stock activity for the year ended December 31, 2009: During 2009, 191,468 shares of restricted stock were granted. The aggregate grant date fair value of the awards was $3.6 million, which will berecognized as expense on a straight-line basis over the requisite service period of the awards, which is also the vesting period. The Company's restrictedstock grants are accounted for as equity awards. The grant date fair value is based on the market price of the Company's common stock at the date ofgrant. The Company did not grant any restricted stock prior to April 2009. Restricted stock awards are considered outstanding at the time of grant as the stock holders are entitled to voting rights and to receive anydividends declared subject to the loss of the right to receive accumulated dividends if the award is forfeited prior to vesting. Unvested restricted stockawards are not considered outstanding in the computation of basic earnings per share. Restricted Stock Units—During 2009, 9,858 restricted stock units were granted. The aggregate grant date fair value of the awards was $180,000,which was recognized as expense on the grant date, as the awards were immediately vested. The Company's restricted stock units are accounted for asequity awards. The grant date fair value is based on the market price of the Company's common stock at the date of grant. The Company did not grantany restricted stock units prior to April 2009. Common Stock Grant—In May 2006, the Company adopted the Rosetta Stone Inc. Liquidity Performance Award Plan. The Company amendedthis plan by resolution dated December 31, 2008. This plan provides a bonus to its key employees in the event of an acquisition of the Company, anacquisition of substantially all of the assets of the Company, a liquidation of the Company or any other transaction resulting in liquidating distributionsto any holders of its preferred stock. This plan terminates upon completion of an initial public offering. In April 2009, the Company's Board ofDirectors awarded 10 of the Company's key employees a total of 591,491 shares of common stock. This grant is net of the number of shares required tobe withheld to satisfy the federal, state and local tax withholding obligations, which were paid by the Company to the respective taxing authorities incash. Thus, the grant is referred to as a "net issuance." The aggregate grant date fair value of the awards was $18.5 million, which was recognized asexpense on the grant date, as the grants were immediately vested.F-26 NonvestedOutstanding WeightedAverageGrant DateFair Value AggregateFairValue Nonvested Awards, January 1, 2009 — — $— Awards granted 191,468 18.72 Awards vested — Awards cancelled (11,666) 19.55 Nonvested Awards, December 31, 2009 179,802 18.67 3,356,903 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statementline items (in thousands):11. COMMON STOCK At December 31, 2008, the Company had the authority to issue 60,000,000 shares of common stock, of which 900,000 shares were designated asClass A Convertible Common Stock, 20,000,000 shares are designated Class B Convertible Common Stock and 39,100,000 are non-designated,collectively referred to as "Common Stock." On February 28, 2008, the Company changed the par value of its Class A Convertible Common Stock,Class B Convertible Common Stock and Non-Designated Common Stock from $0.001 to $0.00005 per share. At December 31, 2008, 1,935,654shares of Non-Designated Common Stock were issued and outstanding, respectively. On March 23, 2009, in connection with the Company's initial public offering of common stock, the Board of Directors approved a 1.3-to-1 split ofcommon stock to stockholders of record as of such date. All references to the number of common shares and per share amounts have been restated asappropriate to reflect the effect of the split for all periods presented. On April 15, 2009, the Company completed an initial public offering consisting of 7,187,500 shares of common stock at $18.00 per share. Thetotal shares sold in the offering included 4,062,500 sold by selling stockholders and 3,125,000 shares sold by the Company. On April 21, 2009, in conjunction with the Company's qualified underwritten initial public offering of common stock, its total outstandingpreferred shares in the amount of 557,989 automatically converted at a ratio of 26:1 into 14,507,714 shares of Common Stock. At December 31, 2009, the Company's Board of Directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 weredesignated as Common Stock, with a par value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001per share. At December 31, 2009, 20,440,181 shares of Common Stock were issued and outstanding.F-27 Years Ended December 31, 2009 2008 2007 Included in cost of revenue: Cost of product revenue $34 $2 $2 Cost of subscription and service revenue — — — Total included in cost of revenue 34 2 2 Included in operating expenses: Sales and marketing 999 153 189 Research and development 5,959 482 360 General and administrative 15,158 953 776 Total included in operating expenses 22,116 1,588 1,325 Total $22,150 $1,590 $1,327 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)11. COMMON STOCK (Continued)Dividends Holders of each class of Common Stock are entitled to dividends, in cash or stock in the same form and per share amount as declared by the Boardof Directors.Liquidation In the event of any dissolution, liquidation, or winding up of the Company, whether voluntary or involuntary, the holders of the Common Stockare entitled to participate in the distribution of assets of the Company remaining after the provision for payment of all debts and liabilities of theCompany and after the Company has paid or set aside for payment on behalf of any class of stock having preference over the common stock in theevent of dissolution, liquidation or winding up.Voting Rights Each holder of Common Stock is entitled to cast one vote for each outstanding share of common stock on any matter properly considered and actedupon by the stockholders, except in a vote for the election or removal of one or more directors of the Company for which the Common Stock may bevoted, at which each holder of one share of Common Stock is entitled to cast 0.653775 votes, and one vote for each outstanding share of Class BConvertible Common Stock.12. CONVERTIBLE PREFERRED STOCK At December 31, 2008, the Company had outstanding 268,758 shares of Class A, Series A-1 Convertible Preferred Stock, 178,200 shares ofClass A Series A-2 Convertible Preferred Stock and 111,031 shares of Class B Convertible Preferred Stock, $0.001 par value per share. On April 21, 2009, in conjunction with the Company's qualified underwritten initial public offering of common stock, its total outstandingpreferred shares in the amount of 557,989 automatically converted at a ratio of 26:1 into 14,507,714 shares of Common Stock and the then-existingclasses of preferred stock ceased to exist. At December 31, 2009, the Company had no preferred shares outstanding and the authorized preferred stockwas undesignated blank check preferred.13. EMPLOYEE BENEFIT PLAN The Company maintains a defined contribution 401(k) Plan (the "Plan"). The Company matches employee contributions to the Plan up to 4% oftheir compensation that vest immediately. The Company recorded expenses for the Plan totaling $1.1 million and $0.9 million for the years endedDecember 31, 2009 and 2008, respectively.14. COMMITMENTS AND CONTINGENCIESOperating Leases The Company leases many kiosks, copiers, parking spaces, buildings, a warehouse and office space under operating lease and site licensearrangements, some of which contain renewal options. The rental payments under some kiosk site licenses are based on a minimum rental plus apercentage of the kiosk's sales in excess of stipulated amounts. Kiosk site licenses range from a period of one month toF-28Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. COMMITMENTS AND CONTINGENCIES (Continued)five years. Building, warehouse and office space leases range from three months to 85 months. Certain leases also include lease renewal options. The following table summarizes future minimum operating lease payments as of December 31, 2009 and the years thereafter (in thousands): Total expenses under operating leases were $11.6 million and $9.8 million during the years ended December 31, 2009 and 2008, respectively. The Company accounts for its leases under the provisions of Accounting Standards Codification topic 840, Accounting for Leases ("ASC 840"),and subsequent amendments, which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes.Certain operating leases contain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the differencebetween the rent paid and the straight-line rent recorded as either a deferred rent asset or liability depending on the calculation. Lease incentives receivedfrom landlords are recorded as deferred rent liabilities and are amortized on a straight-line basis over the lease term as a reduction to rent expense. Thedeferred rent liability was $0.5 million and $0.3 million at December 31, 2009 and 2008, respectively. The deferred rent asset was $0.5 million and$0.3 million at December 31, 2009 and 2008, respectively. The deferred rent asset is classified in prepaid and other assets as all associated leases haveless than one year remaining on their term. On October 6, 2008, the Company entered into an operating sublease agreement (the "Lease") for additional office space in Arlington, Virginia.The Lease is for a five year period terminating on December 31, 2013 with total rental payments of $7.5 million. Rents range from $117,000 per monthfor the first year of the Lease term to $132,000 per month in the final year of the Lease term. The Company provided the landlord a security deposit of$352,000 in the form of a letter of credit. The Company has the option to renew this Lease for an additional three-year period. The Company exited its facility at 1101 Wilson Boulevard, Arlington, Virginia in December 2008 as a result of a relocation of its headquarters to1919 North Lynn, Arlington, Virginia. The Company estimated its liability under operating lease agreements and accrued exit costs in accordance withAccounting Standards Codification topic 420, Exit or Disposal Cost Obligations ("ASC 420"), as the leases associated with this facility do notterminate until December 31, 2009 and August 31, 2013, respectively. Accrued exit costs associated with the headquarters relocation were charged toleaseF-29 As ofDecember 31,2009 Periods Ending December 31, 2010 $5,593 2011 3,185 2012 1,943 2013 1,752 2014 159 2015 and thereafter 88 $12,720 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. COMMITMENTS AND CONTINGENCIES (Continued)abandonment expense in December 2008. The following table summarizes the accrued exit costs for the 1101 Wilson Boulevard facility (in thousands):Royalty Agreement On December 28, 2006 the Company entered into an agreement to license software from a vendor for incorporation in software products that theCompany is developing. The agreement required a one-time, non-refundable payment of $0.3 million, which was expensed in full as research anddevelopment costs during 2006 because the products in which the licensed software were to be incorporated into had not yet reached technologicalfeasibility. In addition, the agreement specifies that, in the event the software is incorporated into specified Company software products, royalties will bedue at a rate of 20% of sales for those products up to an additional amount totaling $0.4 million. There were no additional royalty payments made underthis agreement in 2009 or 2008.Employment Agreements The Company has agreements with certain of its executives and key employees which provide guaranteed severance payments upon termination oftheir employment without cause. The severance payments range from six to fifteen months of base salary.Litigation In July 2009, the Company filed a lawsuit in the United States District Court for the Eastern District of Virginia against Google Inc., seeking,among other things, to prevent Google from infringing upon its trademarks. In this lawsuit, the Company asserts, among other things, that Googleallows third parties, including individuals involved in software piracy operations, to purchase the right to use its trademarks or other terms confusinglysimilar in Google's Adwords advertising program. This lawsuit seeks, among other things, injunctive relief to prevent Google from selling theCompany's trademarks or other terms confusingly similar for use in Google's Adwords advertising program. To date, Google has not made anycounterclaims for damages against us, however, the Company expects to incur material legal fees and other costs and expenses in pursuit of its claimsagainst Google. The Company is involved in various litigation matters arising out of the normal course of business. In the opinion of management, the amount ofliability, if any, resulting from the final resolution of these matters will not have a material adverse impact on the Company's results of operations,financial position and cash flows.F-30 As ofDecember 31,2009 As ofDecember 31,2008 Accrued exit costs, beginning of period $1,676 $— Costs incurred and charged to expense (8) 1,676 Principal reductions (649) — Accrued exit costs, end of period $1,019 $1,676 Accrued exit cost liability Short-term $504 $713 Long-term 515 963 Total $1,019 $1,676 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES The following table summarizes the significant components of the Company's deferred tax assets and liabilities as of December 31, 2009 and 2008(in thousands): At December 31, 2009, the Company had $7.8 million of net operating loss ("NOL") carryforwards for United Kingdom income tax purposes thatdo not expire, with a tax value of $2.2 million. The Company also had $5.2 million of NOL carryforwards for Japanese income tax purposes whichexpire in 2014 and 2015, with a tax value of $2.2 million. Accounting Standards Codification topic 740, Income Taxes ("ASC 740") requires that avaluation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. As a result of the lossesincurred for the years ended December 31, 2008 and 2007, both the United Kingdom and Japanese operations remain in cumulative loss positionsproviding sufficient negative evidence under the provisions of ASC 740 for the Company to determine that a valuation allowance of $5.0 million againstthe deferred tax assets associated with its foreign operations is appropriate. The decrease of $0.3 million in the valuation allowance is attributable toutilization of net deferred tax assets, primarily operating losses, in the United Kingdom and Japan in the year ended December 31, 2009 and changesyear over year in the value of deferred tax assets when translated from local currency to U.S. dollars. The valuation allowance will offset assetsassociated with future foreign tax deductions as well as carryforward items.F-31 As ofDecember 31, 2009 2008 Deferred tax assets: Inventory $290 $183 Amortization and depreciation 3,521 5,068 Net operating loss carryforwards 4,359 5,112 Deferred revenue 663 528 Accrued liabilities 6,456 3,118 Stock-based compensation 2,266 965 Bad debt reserve 425 338 17,980 15,312 Valuation allowance (5,012) (5,263) 12,968 10,049 Deferred tax liabilities: Prepaid expenses 1,328 876 Foreign currency translation loss 50 58 Other 5 5 1,383 939 Net deferred tax assets $11,585 $9,110 Net deferred tax assets as of December 31 are classified asfollows: Current $6,020 $2,282 Non-current 5,565 6,828 Total $11,585 $9,110 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES (Continued)Despite enacting certain tax planning strategies during the year ended December 31, 2009, neither subsidiary has produced sustainable pretax profits asof December 31, 2009. Company management will monitor actual results and updated projections on a quarterly basis. When and if the subsidiariesrealize or realistically anticipate sustainable profitability, the Company will assess the appropriateness of releasing the valuation allowance in whole or inpart. Although management believes that these assets could ultimately be fully utilized, future performance cannot be assured. The components of income (loss) before income taxes are as follows (in thousands): The provision for taxes on income consists of the following (in thousands):F-32 Year Ended December 31, 2009 2008 2007 United States $19,030 $36,109 $14,825 Foreign 1,417 (8,782) (6,811) Income before income taxes $20,447 $27,327 $8,014 Year Ended December 31, 2009 2008 2007 Current: Federal $7,555 $12,842 $5,311 State 1,864 2,788 1,429 Foreign 140 34 — Total current $9,559 $15,664 $6,740 Deferred: Federal $(1,917)$(1,946)$(944) State (430) (283) (361) Foreign (128) — — Total deferred (2,475) (2,229) (1,305) Provision for income taxes $7,084 $13,435 $5,435 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES (Continued) Reconciliation of income tax expense computed at the U.S. federal statutory rate to income tax expense is as follows (in thousands): The Company adopted Accounting Standards Codification topic 740-10-25, Income Taxes: Overall: Recognition, ("ASC 740-10-25") onJanuary 1, 2007, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance withAccounting Standards Codification topic 740, Income Taxes. ASC 740-10-25 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidanceon de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. At the adoption date and as of December 31, 2009, the Company had no material unrecognized tax benefits and no adjustments to liabilities oroperations were required under ASC 740-10-25. The Company's practice is to recognize interest and penalty expense related to uncertain tax positionsin income tax expense, which were zero at the adoption date and for the year ended December 31, 2009. The Company is subject to taxation in the United States and various states and foreign jurisdictions. The Company's tax years 2008, 2007 and2006 are subject to examination by the tax authorities. There were no income tax examinations in process as of December 31, 2009. While the ultimateresults cannot be predicted with certainty, the Company's management believes that examinations, if any, will not have a material adverse effect on itsconsolidated financial condition or results of operations, and that the accrued tax liabilities are adequate for all years. The Company made income tax payments of $6.4 million, $14.6 million and $4.8 million in 2009, 2008 and 2007, respectively.16. SEGMENT INFORMATION The Company operates as one operating segment as the principal business activity relates to developing and selling language learning software.The chief operating decision maker, the Chief Executive Officer, evaluates the performance of the Company based upon software revenues. Products and services are sold primarily in the United States, but are also sold through direct and indirect sales channels in other countries,primarily in Japan, South Korea and Europe. Less than 5%F-33 Year Ended December 31, 2009 2008 2007 Income tax expense at statutory federal rate $7,157 $9,565 $2,805 State income tax expense, net of federal income taxeffect 809 1,529 568 Domestic production activities deduction (481) (811) (348)Nondeductible intercompany interest 205 174 122 Other nondeductible expenses 143 101 92 Tax rate differential on foreign operations (192) 90 (53)Increase (decrease) in valuation allowance (566) 2,791 2,293 Other 9 (4) (44) Income tax expense $7,084 $13,435 $5,435 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)16. SEGMENT INFORMATION (Continued)of the Company's revenues were generated from sales outside of the United States for the years ended December 31, 2008 and 2007, and approximately8% of the Company's revenue was generated from sales outside the United States for the year ended December 31, 2009. As of December 31, 2009 and2008, the Company had $1.0 million and $0.4 million, respectively, of long-lived assets held outside of the United States. No single customer accounted for more than 10% of the Company's revenue for the years ended December 31, 2009, 2008 and 2007, respectively.17. RELATED PARTIES As of December 31, 2009 and 2008, the Company had outstanding receivables from stockholders of $74,000 and $0.2 million, respectively, andoutstanding receivables from employees in the amount of $8,000 and zero, respectively.18. VALUATION AND QUALIFYING ACCOUNTS The following table includes the Company's valuation and qualifying accounts for the respective periods (in thousands):F-34 Year Ended December 31, 2009 2008 2007 Allowance for doubtful accounts: Beginning balance $1,103 $627 $267 Charged to costs and expenses 911 1,611 828 Deductions—accounts written off (665) (1,135) (468) Ending balance 1,349 1,103 627 Sales return reserve: Beginning balance 3,229 1,688 858 Charged to costs and expenses 18,340 14,337 10,413 Deductions—reserves utilized (16,861) (12,796) (9,583) Ending balance 4,708 3,229 1,688 Reserve for excess and obsolete inventory: Beginning balance 470 478 190 Charged to costs and expenses 1,090 2,093 1,677 Deductions—reserves utilized (795) (2,101) (1,389) Ending balance $765 $470 $478 Deferred income tax asset valuation allowance: Beginning balance 5,263 2,980 687 Charged to costs and expenses — 2,283 2,293 Deductions (251) — — Ending balance $5,012 $5,263 $2,980 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)19. SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (Unaudited) Summarized quarterly supplemental consolidated financial information for 2009 and 2008 are as follows (in thousands, except per share amounts):F-35 Quarter Ended March 31, June 30, September 30, December 31, 2009 Revenue $50,284 $56,460 $67,216 $78,311 Gross profit $43,857 $48,758 $58,208 $68,021 Net income (loss)(a) $3,195 $(7,292)$5,303 $12,157 Basic income per share(a) $1.65 $(0.42)$0.26 $0.60 Shares used in basic per share computation 1,939 17,370 20,177 20,216 Diluted income per share(a) $0.19 $(0.42)$0.25 $0.58 Shares used in diluted per share computation 17,095 17,370 20,988 20,968 2008 Revenue $35,585 $47,742 $59,803 $66,250 Gross profit $31,049 $41,197 $51,227 $57,231 Net income (loss) $(432)$3,361 $6,021 $4,942 Basic income per share $(0.23)$1.77 $3.13 $2.55 Shares used in basic per share computation 1,864 1,899 1,921 1,936 Diluted income per share $(0.23)$0.20 $0.36 $0.29 Shares used in diluted per share computation 1,864 16,827 16,931 17,043 (a)The second quarter of 2009 contained an IPO-related $18.8 million expense, consisting of $18.5 million in stock-basedcompensation expense and $0.3 million in payoll tax expense, related to common stock grants awarded to key employees equal toa total of 591,491 shares.Table of ContentsEXHIBIT INDEX Index to exhibits 2.1(1) Stock Purchase Agreement dated as of January 4, 2006, by and among Fairfield & Sons, Ltd., RosettaStone Inc., Rosetta Stone Holdings Inc., the Shareholders of Fairfield & Sons, Ltd., Tom Adams, andEugene Stoltzfus 3.1(1) Second Amended and Restated Certificate of Incorporation 3.2(1) Second Amended and Restated Bylaws 4.1(1) Specimen certificate evidencing shares of common stock 4.2(1) Subscription Agreement dated as of January 4, 2006, by and among Rosetta Stone Inc., ABS CapitalPartners IV, L.P., ABS Capital Partners IV A, L.P., ABS Capital Partners Offshore, L.P., ABS CapitalPartners Special Offshore, L.P., Norwest Equity Partners VIII, L.P., Madison Capital Funding LLC, andTom Adams 4.3(1) Registration Rights Agreement dated as of January 4, 2006 among Rosetta Stone Inc. and the InvestorShareholders and other Shareholders listed on Exhibit A Thereto 10.1+(1) 2006 Incentive Option Plan 10.2+(1) 2009 Omnibus Incentive Plan 10.3+(1) Director Form of Option Award Agreement under the 2006 Plan 10.4+(1) Executive Form of Option Award Agreement under the 2006 Plan 10.5+(1) Standard Form of Option Award Agreement under the 2006 Plan 10.6+(1) Form of Option Award Agreement under the 2009 Plan 10.7(1) Form of Indemnification Agreement entered into with each director and executive officer 10.8+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Tom Adams dated February 20, 2009 10.9(1) Lease Agreement dated as of February 26, 2006, by and between Premier Flex Condos, LLC and FairfieldLanguage Technologies, Inc., as amended 10.10(1) Sublease Agreement dated as of October 6, 2008, by and between The Corporate Executive BoardCompany and Rosetta Stone Ltd. 10.11(1) Software License Agreement by and between The Regents of the University of Colorado and Fairfield &Sons, Ltd. dated as of December 22, 2006*** 10.12+(1) Form of Restricted Stock Award under the 2009 Plan 10.13(1) Credit Agreement dated as of January 16, 2009 between Rosetta Stone Ltd. and Wells Fargo Bank N.A. 10.14+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Brian Helman dated February 20, 2009 10.15+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Eric Eichmann dated February 20, 2009 10.16+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Gregory Long dated February 20, 2009 10.17+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu dated February 20, 2009 21.1 Subsidiaries of the Registrant 23.1 Consent of Deloitte & Touche LLP, independent registered public accounting firm 24.1 The Power of Attorney with Board of Directors' Signatures 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002***Portions of this exhibit have been omitted pursuant to a request for confidential treatment. +Identifies management contracts and compensatory plans or arrangements. (1)Incorporated by reference to exhibit filed with Registrant's registration statement on Form S-1 (File No. 333-153632), asamended.QuickLinks -- Click here to rapidly navigate through this documentExhibit 21.1 ROSETTA STONE INC. SUBSIDIARIESEntity Jurisdiction of IncorporationRosetta Stone Holdings Inc. DelawareRosetta Stone Ltd. (Formerly Fairfield & Sons Ltd., d/b/a FairfieldLanguage Technologies) VirginiaRosetta Stone (UK) Limited (Formerly Fairfield & Sons Limited) England and WalesRosetta Stone Japan Inc. (Formerly Rosetta World K.K.) JapanRosetta Stone International Inc. DelawareRosetta Stone GmbH GermanyQuickLinksExhibit 21.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the Registration Statement No. 333-158828 on Form S-8 of our report dated March 9, 2010,relating to the consolidated financial statements of Rosetta Stone Inc. and subsidiaries (which report expresses an unqualified opinion and includes anexplanatory paragraph regarding the Company's adoption of a new accounting standard), appearing in this Annual Report on Form 10-K of RosettaStone Inc. and subsidiaries for the year ended December 31, 2009./s/ DELOITTE & TOUCHE LLPMcLean, VirginiaMarch 9, 2010QuickLinksExhibit 23.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 24.1 ROSETTA STONE INC.POWER OF ATTORNEY Each person whose signature appears below hereby constitutes and appoints Tom P. H. Adams and Michael C. Wu, or either of them, each withpower to act without the other, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name,place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Rosetta Stone Inc. (the "Company") and any or all subsequentamendments and supplements to the Annual Report on Form 10-K, and to file the same, or cause to be filed the same, with all exhibits thereto, and otherdocuments in connection therewith, with the Securities and Exchange Commission, granting unto each said attorney-in-fact and agent full power to doand perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he mightor could do in person, hereby qualifying and confirming all that said attorney-in-fact and agent or his substitute or substitutes may lawfully do or causeto be done by virtue hereof. Each person whose signature appears below may at any time revoke this power of attorney as to himself or herself only by an instrument inwriting specifying that this power of attorney is revoked as to him or her as of the date of execution of such instrument or at a subsequent specified date.This power of attorney shall be revoked automatically with respect to any person whose signature appears below effective on the date he or she ceasesto be a member of the Board of Directors or an officer of the Company. Any revocation hereof shall not void or otherwise affect any acts performed byany attorney-in-fact and agent named herein pursuant to this power of attorney prior to the effective date of such revocation.Dated: March 9, 2010Signature Title /s/ TOM P. H. ADAMSTom P. H.Adams Chief Executive Officer and Director(Principal Executive Officer)/s/ BRIAN D. HELMANBrian D. Helman Chief Financial Officer(Principal Financial Officer)/s/ LAURA L. WITTLaura L. Witt Chairman of the Board, Director/s/ PHILLIP A. CLOUGHPhillip A. Clough Director/s/ JOHN T. COLEMANJohn T. Coleman Director/s/ LAURENCE FRANKLINLaurence Franklin Director/s/ PATRICK W. GROSSPatrick W. Gross DirectorSignature Title /s/ THEODORE J. LEONSISTheodore J. Leonsis Director/s/ JOHN E. LINDAHLJohn E. Lindahl DirectorQuickLinksExhibit 24.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.1 CERTIFICATION OFCHIEF EXECUTIVE OFFICEROF ROSETTA STONE INC.PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTEDPURSUANT TO SECTION 302 OF THESARBANES-OXLEY ACT OF 2002I, Tom P. H. Adams, certify that:1.I have reviewed this Annual Report on Form 10-K of Rosetta Stone Inc. (the "Registrant"); 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary tomake the statements made, in light of the circumstances under which such statements were made, not misleading with respect to theperiod covered by this report; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4.The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (asdefined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15d-15(f)) for the Registrant and have: a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made knownto us by others within those entities, particularly during the period in which this report is being prepared; b.[Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986]; c.evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusionsabout the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on suchevaluation; and d.disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during theRegistrant's most recent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materiallyaffected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and 5.The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financialreporting, to the Registrant's auditors and the audit committee of the Registrant's Board of Directors (or persons performing theequivalent functions): a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting whichare reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information;and b.any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant'sinternal control over financial reporting. By: /s/ TOM P. H. ADAMSTom P. H. AdamsChief Executive OfficerDate: March 9, 2010 QuickLinksExhibit 31.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.2 CERTIFICATION OFCHIEF FINANCIAL OFFICEROF ROSETTA STONE INC.PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTEDPURSUANT TO SECTION 302 OF THESARBANES-OXLEY ACT OF 2002I, Brian D. Helman, certify that:1.I have reviewed this Annual Report on Form 10-K of Rosetta Stone Inc. (the "Registrant"); 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary tomake the statements made, in light of the circumstances under which such statements were made, not misleading with respect to theperiod covered by this report; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4.The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (asdefined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15d-15(f)) for the Registrant and have: a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made knownto us by others within those entities, particularly during the period in which this report is being prepared; b.[Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986]; c.evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusionsabout the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on suchevaluation; and d.disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during theRegistrant's most recent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materiallyaffected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and 5.The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financialreporting, to the Registrant's auditors and the audit committee of the Registrant's Board of Directors (or persons performing theequivalent functions): a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting whichare reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information;and b.any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant'sinternal control over financial reporting. By: /s/ BRIAN D. HELMANBrian D. HelmanChief Financial OfficerDate: March 9, 2010 QuickLinksExhibit 31.2QuickLinks -- Click here to rapidly navigate through this documentExhibit 32.1 CERTIFICATION OFCHIEF EXECUTIVE OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002 In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2009 filed with the Securities andExchange Commission on the date hereof (the "Report"), I, Tom P. H. Adams, Chief Executive Officer of Rosetta Stone Inc. (the "Company"), herebycertify, to my knowledge, that:1.the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of theCompany.Date: March 9, 2010 /s/ TOM P. H. ADAMSTom P. H. AdamsQuickLinksExhibit 32.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 32.2 CERTIFICATION OFCHIEF FINANCIAL OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002 In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2009 filed with the Securities andExchange Commission on the date hereof (the "Report"), I, Brian D. Helman, Chief Financial Officer of Rosetta Stone Inc. (the "Company"), herebycertify, to my knowledge, that:1.the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of theCompany.Date: March 9, 2010 /s/ BRIAN D. HELMANBrian D. HelmanQuickLinksExhibit 32.2

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