BBBB Blackboard (MM)

 

 

 

Commission file number 000-50784

 

 

 

 

Registrant’s Telephone Number, Including Area Code:

(202) 463-4860

 

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   þ      Accelerated filer  o      Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No  þ

 

 

 

 

Blackboard Inc.

Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2007

INDEX

 

 

 

Throughout this Quarterly Report on Form 10-Q, the terms “we,” “us,” “our” and “Blackboard” refer to Blackboard Inc. and its subsidiaries.

 

PART I — FINANCIAL INFORMATION

 

 

See notes to unaudited consolidated financial statements.

 

See notes to unaudited consolidated financial statements.

BLACKBOARD INC.

 

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

in the balance sheet, for which it is practicable to estimate that value. Due to their short-term nature, the carrying amounts reported in the consolidated financial statements approximate the fair value for cash and cash equivalents, accounts receivable, accounts payable and accrued expenses. As of September 30, 2007, the fair value of the Company’s long-term debt was $178.2 million based on the quoted market price.

 

Deferred Income Taxes

 

Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting bases and the tax bases of assets and liabilities. Deferred tax assets are also recognized for tax net operating loss carryforwards. These deferred tax assets and liabilities are measured using the enacted tax rates and laws that will be in effect when such amounts are expected to reverse or be utilized. The realization of total deferred tax assets is contingent upon the generation of future taxable income. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized.

 

Income tax provision includes U.S. federal, state and local income taxes and is based on pre-tax income or loss. The interim period provision or benefit for income taxes is based upon the Company’s estimate of its annual effective income tax rate. In determining the estimated annual effective income tax rate, the Company analyzes various factors, including projections of the Company’s annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes and the ability of the Company to use tax credits and net operating loss carryforwards.

 

The Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. It prescribes that a company should use a more-likely-than-not recognition threshold based on the technical merits of the tax position taken. Tax positions that meet the more-likely-than-not recognition threshold should be measured as the largest amount of the tax benefits, determined on a cumulative probability basis, which is more likely than not to be realized upon ultimate settlement in the financial statements. As a result of the implementation of FIN 48, the Company recognized an increase of $0.5 million in the unrecognized tax benefit liability, which was accounted for as an increase to the January 1, 2007 accumulated deficit balance. At September 30, 2007, the Company’s unrecognized tax benefit liability totaled $0.6 million, all of which would affect the Company’s effective tax rate if recognized. Also, upon adoption of FIN 48, the Company reclassified $1.0 million of previously accrued tax contingencies which were included in accrued expenses and recorded an offsetting valuation allowance against certain deferred tax assets that were recorded on the consolidated balance sheets at December 31, 2006. The Company did not record any interest or penalties related to its adoption of FIN 48. The Company’s continuing practice is to recognize interest and penalties related to income tax matters in income tax expense. The Company is not aware of any unrecognized tax benefits that may significantly increase or decrease within the next twelve months.

 

Cost of Product Revenues

 

Cost of product revenues excludes amortization of acquired technology intangibles resulting from acquisitions, which is included as amortization of intangibles resulting from acquisitions. Amortization expense related to acquired technology was $2.8 million and $2.9 million for the three months ended September 30, 2006 and 2007, respectively, and $6.5 million and $8.7 million for the nine months ended September 30, 2006 and 2007, respectively.

 

Basic and Diluted Net (Loss) Income per Common Share

 

Basic net (loss) income per common share excludes dilution for potential common stock issuances and is computed by dividing net (loss) income by the weighted average number of common shares outstanding for the

 

 

Stock-Based Compensation

 

The Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2005), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method on January 1, 2006. Under the modified prospective transition method, compensation cost recognized includes: (a) compensation cost for all equity-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all equity-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated.

 

Comprehensive Net (Loss) Income

 

Comprehensive net (loss) income includes net (loss) income, combined with unrealized gains and losses not included in earnings and reflected as a separate component of stockholders’ equity. There were no material differences between net (loss) income and comprehensive net (loss) income for the three and nine months ended September 30, 2006 and 2007.

 

Recent Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. It clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of SFAS 157 on its consolidated results of operations and financial condition.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), to permit all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

SFAS 157. An entity is prohibited from retrospectively applying SFAS 159, unless it chooses early adoption. The Company is currently evaluating the impact of the provisions of SFAS 159 on its consolidated financial statements.

 

 

On February 28, 2006, the Company completed its merger with WebCT, Inc. (“WebCT”) pursuant to the Agreement and Plan of Merger dated as of October 12, 2005. Pursuant to the Agreement and Plan of Merger, the Company acquired all the outstanding common stock of WebCT in a cash transaction for approximately $178.3 million. The effective cash purchase price of WebCT before transaction costs was approximately $150.4 million, net of WebCT’s February 28, 2006 cash balance of approximately $27.9 million. The Company has included the financial results of WebCT in its consolidated financial statements beginning February 28, 2006.

 

The merger was accounted for under the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations” (“SFAS 141”). Assets acquired and liabilities assumed were recorded at their fair values as of February 28, 2006. The total purchase price was $187.5 million, including the acquisition-related transaction costs of approximately $9.2 million. Acquisition-related transaction costs include investment banking, legal and accounting fees, and other external costs directly related to the merger.

 

Of the total purchase price, $18.7 million has been allocated to net tangible assets and $73.3 million has been allocated to definite-lived intangible assets acquired. Definite-lived intangible assets of $73.3 million consist of the value assigned to WebCT’s customer relationships of $39.6 million and developed and core technology of $33.7 million. Goodwill represents the excess of the purchase price of an acquired business over the fair value of the net tangible and intangible assets acquired. The Company allocated $95.5 million to goodwill which is not deductible for tax purposes.

 

During the quarter ended March 31, 2007, the Company determined that approximately $3.9 million of deferred tax assets related to WebCT net operating losses may be subject to limitations under Section 382 of the Internal Revenue Code. Accordingly, the Company recorded a valuation allowance of $3.9 million against these deferred tax assets and increased goodwill by $3.9 million. The net deferred tax liability acquired as a result of the WebCT merger was $2.5 million after this adjustment.

 

 

The Company has utilized the Black-Scholes valuation model to estimate the fair value of the stock options granted during all periods. As follows are the weighted-average assumptions used in valuing the stock options granted during the nine months ended September, 30, 2006 and 2007 and a discussion of the Company’s method.

 

 

Dividend yield  — The Company has never declared or paid dividends on its common stock and does not anticipate paying dividends in the foreseeable future.

 

Expected volatility  — Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Given the Company’s limited historical stock data following its initial public offering in June 2004, the Company has used a blended volatility to best estimate expected volatility. The blended volatility includes the average of the Company’s

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

preceding one-year weekly historical volatility and the Company’s peer group preceding four-year weekly historical volatility. The Company’s peer group historical volatility includes the historical volatility of companies that are similar in revenue size, in the same industry or are competitors.

 

Risk-free interest rate  — This is the average U.S. Treasury rate (having a term that most closely approximates the expected life of the option) for the period in which the option was granted.

 

Expected life of the options  — This is the period of time that the options granted are expected to remain outstanding. The Company uses the short-cut method to determine the expected life of the options as prescribed under the provisions of Staff Accounting Bulletin No. 107, “Share-Based Payment.” Options granted during the nine months ended September 30, 2007 have a maximum term of eight years.

 

Forfeiture rate  — This is the estimated percentage of options granted that are expected to be forfeited or cancelled on an annual basis before becoming fully vested. The Company estimates the forfeiture rate based on past turnover data and revises the rate if subsequent information, such as the passage of time, indicates that the actual number of instruments that will vest is likely to differ from previous estimates. The cumulative effect on current and prior periods of a change in the estimated number of instruments likely to vest is recognized in compensation cost in the period of the change.

 

The compensation cost that has been recognized in the consolidated statements of operations for the Company’s stock option plans was $6.0 million and $8.8 million for the nine months ended September 30, 2006 and 2007, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $0.2 million and $6.2 million for the nine months ended September 30, 2006 and 2007, respectively. For stock subject to graded vesting, the Company has utilized the “straight-line” method for allocating compensation cost by period.

 

As of September 30, 2007, approximately 2.0 million shares of common stock were available for future grants under the Company’s Amended and Restated 2004 Stock Incentive Plan (the “2004 Plan”) and no options were available for future grants under the Company’s Amended and Restated Stock Incentive Plan adopted in 1998. Stock options granted under the 2004 Plan generally vest over a three-year to four-year period and have an eight-year to ten-year expiration period. On June 7, 2007, at the Company’s Annual Meeting of Stockholders, the stockholders approved an amendment to the 2004 Plan to increase the number of shares authorized for issuance under the 2004 Plan from 4.6 million to 5.8 million. In October 2007, 26,500 options were granted under the 2004 Plan.

 

A summary of option activity under the Company’s option plans as of September 30, 2007, and changes during the nine months then ended are as follows (aggregate intrinsic value in thousands):

 

 

The weighted average remaining contractual life for all options outstanding under the Company’s stock option plans at September 30, 2007 was 6.4 years. The weighted average remaining contractual life for exercisable stock

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

options at September 30, 2007 was 5.2 years. The weighted average fair market value of the options at the date of grant for options granted during the nine months ended September 30, 2007 was $15.44.

 

As of September 30, 2007, there was approximately $31.1 million of total unrecognized compensation cost related to unvested stock options granted under the Company’s option plans. The cost is expected to be recognized through February 2013 with a weighted average recognition period of approximately 1.5 years.

 

 

 

 

Intangible assets from acquisitions are amortized over three to five years. Amortization expense related to intangible assets was approximately $12.6 million and $16.5 million for the nine months ended September 30, 2006 and 2007, respectively.

 

During the quarter ended March 31, 2007, the Company purchased technology for $1.5 million which will provide future functionality in the Company’s products. The technology is classified as acquired technology and recorded as intangible assets on the consolidated balance sheets at September 30, 2007 and is being amortized over three years.

 

As discussed in Note 3, goodwill increased $3.9 million related to the recording of a valuation allowance against deferred tax assets attributable to WebCT net operating losses that may be subject to limitations under Section 382 of the Internal Revenue Code.

 

During the nine months ended September 30, 2007, the Company capitalized $3.1 million in costs related to defending and protecting patents and amortized approximately $0.1 million.

 

 

In connection with the acquisition of WebCT, the Company paid a portion of the purchase price using borrowings under a $70.0 million senior secured credit facilities agreement with Credit Suisse (the “Credit Agreement”). The Credit Agreement provided for a $60.0 million senior secured term loan facility repayable over six years and a $10.0 million senior secured revolving credit facility due and payable in full at the end of five years. The Company repaid $10.0 million on the revolving credit facility on March 28, 2006. The Credit Agreement allowed for voluntary principal prepayments of principal with no penalty.

 

In connection with obtaining the Credit Agreement, the Company incurred $2.5 million in debt issuance costs which were recorded as a debt discount and netted against the remaining principal outstanding. These costs were being amortized as interest expense using the effective interest method over the term of the Credit Agreement and such amortization was adjusted for any prepayments on the term loan facility. During the nine months ended September 30, 2007, the Company recognized approximately $0.7 million in additional interest expense associated with the acceleration in the amortization of the debt discount due to the prepayment of debt principal.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In June 2007, the Company issued and sold $165.0 million aggregate principal amount of 3.25% Convertible Senior Notes due 2027 (the “Notes”) in a public offering. The Company used a portion of the proceeds to terminate and satisfy in full the Company’s existing indebtedness outstanding pursuant to the Credit Agreement of $19.4 million and to pay all fees and expenses incurred in connection with the termination. The Company did not pay any prepayment premium or penalties in connection with the early termination of the Credit Agreement.

 

In connection with obtaining the Notes, the Company incurred $4.5 million in debt issuance costs. These costs were recorded as a debt discount and netted against the remaining principal amount outstanding. The debt discount is being amortized as interest expense using the effective interest method over the term of the Notes. During the nine months ended September 30, 2007, the Company recorded total amortization expense, including amortization related to the Credit Agreement, of approximately $1.4 million as interest expense.

 

The Notes bear interest at a rate of 3.25% per year on the principal amount, accruing from June 20, 2007. Interest is payable semi-annually on January 1 and July 1, commencing on January 1, 2008. The Notes will mature on July 1, 2027, subject to earlier conversion, redemption or repurchase.

 

The Notes will be convertible, under certain circumstances, into cash or a combination of cash and the Company’s common stock at an initial base conversion rate of 15.4202 shares of common stock per $1,000 principal amount of Notes. The base conversion rate represents an initial base conversion price of approximately $64.85. If at the time of conversion the applicable price of the Company’s common stock exceeds the base conversion price, the conversion rate will be increased by up to an additional 9.5605 shares of the Company’s common stock per $1,000 principal amount of Notes, as determined pursuant to a specified formula. In general, upon conversion of a Note, the holder of such Note will receive cash equal to the principal amount of the Note and the Company’s common stock for the Note’s conversion value in excess of such principal amount.

 

Holders may surrender their Notes for conversion at any time prior to the close of business on the business day immediately preceding the maturity date for the Notes only under the following circumstances: (1) prior to January 1, 2027, with respect to any calendar quarter beginning after June 30, 2007, if the closing price of the Company’s common stock for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is more than 130% of the base conversion price per share of the Notes on such last trading day; (2) on or after January 1, 2027, until the close of business on the business day preceding maturity; or (3) during the five business days after any five consecutive trading day period in which the trading price per $1,000 principal amount of Notes for each day of that period was less than 95% of the product of the closing price of the Company’s common stock and the then applicable conversion rate of the Notes.

 

If a make-whole fundamental change, as defined in the Notes, occurs prior to July 1, 2011, the Company may be required in certain circumstances to increase the applicable conversion rate for any Notes converted in connection with such fundamental change by a specified number of shares of the Company’s common stock. The Notes may not be redeemed by the Company prior to July 1, 2011, after which they may be redeemed at 100% of the principal amount plus accrued interest. Holders of the Notes may require the Company to repurchase some or all of the Notes on July 1, 2011, July 1, 2017 and July 1, 2022, or in the event of certain fundamental change transactions, at 100% of the principal amount plus accrued interest.

 

The Notes are unsecured senior obligations and are effectively subordinated to all of the Company’s existing and future senior indebtedness to the extent of the assets securing such debt, and are effectively subordinated to all indebtedness and liabilities of the Company’s subsidiaries, including trade payables.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The Company, from time to time, is subject to litigation relating to matters in the ordinary course of business. The Company believes that any ultimate liability resulting from these contingencies will not have a material adverse effect on the Company’s results of operations, financial position or cash flows.

 

 

The Company’s quarterly operating results normally fluctuate as a result of seasonal variations in its business, principally due to the timing of client budget cycles and student attendance at client facilities. Historically, the Company has had lower new sales in its first and fourth quarters than in the remainder of the year. The Company’s expenses, however, do not vary significantly with these changes, and, as a result, such expenses do not fluctuate significantly on a quarterly basis. Historically, the Company has performed a disproportionate amount of its professional services, which are recognized as incurred, in its second and third quarters each year. The Company expects quarterly fluctuations in operating results to continue as a result of the uneven seasonal demand for its licenses and services offerings.

 

 

This report contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions are intended to identify forward-looking statements. The important factors discussed under the caption “Risk Factors,” presented below, could cause actual results to differ materially from those indicated by forward-looking statements made herein. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

General

 

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

 

In June 2007, the Company issued and sold $165.0 million aggregate principal amount of 3.25% Convertible Senior Notes due 2027 (the “Notes”) in a public offering.

 

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

 

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

 

We typically license our individual applications either on a stand-alone basis or bundled as part of either of two suites, the Blackboard Academic Suite ^tm and the Blackboard Commerce Suite ^tm . Our suites of products include the following products: Blackboard Learning System ^tm , Blackboard Community System ^tm , Blackboard Content System ^tm , Blackboard Outcomes System ^tm , Blackboard Portfolio System ^tm , Blackboard Transaction System ^tm and Blackboard One ^tm .

 

We generally price our software licenses on the basis of full-time equivalent students or users. Accordingly, annual license fees are generally greater for larger institutions.

 

Our operating expenses consist of cost of product revenues, cost of professional services revenues, research and development expenses, sales and marketing expenses, general and administrative expenses and amortization of intangibles resulting from acquisitions.

 

Major components of our cost of product revenues include license and other fees that we owe to third parties upon licensing software, and the cost of hardware that we bundle with our software. We initially defer these costs and recognize them into expense over the period in which the related revenue is recognized. Cost of product revenues also includes amortization of internally developed technology available for sale, employee compensation, stock-based compensation and benefits for personnel supporting our hosting, support and production functions, as well as related facility rent, communication costs, utilities, depreciation expense and cost of external professional services used in these functions. All of these costs are expensed as incurred. The costs of third-party software and

hardware that is not bundled with software are also expensed when incurred, normally upon delivery to our client. Cost of product revenues excludes $2.8 million and $2.9 million for the three months ended September 30, 2006 and 2007, respectively, and $6.5 million and $8.7 million for the nine months ended September 30, 2006 and 2007, respectively, in amortization of acquired technology included in amortization of intangibles resulting from acquisitions.

 

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

 

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

 

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

 

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

 

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

 

Critical Accounting Policies and Estimates

 

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

 

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

 

Revenue recognition.   Our revenues are derived from two sources: product sales and professional services sales. Product revenues include software license, hardware, premium support and maintenance, and hosting revenues. Professional services revenues include training and consulting services. We recognize software license and maintenance revenues in accordance with the American Institute of Certified Public Accountants’ Statement of

Position (“SOP”) 97-2, “Software Revenue Recognition,” as modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” Our software does not require significant modification and customization services. Where services are not essential to the functionality of the software, we begin to recognize software licensing revenues when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the fee is fixed and determinable; and (4) collectibility is probable.

 

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

 

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

 

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

 

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

 

We do not offer specified upgrades or incrementally significant discounts. Advance payments are recorded as deferred revenues until the product is shipped, services are delivered or obligations are met and the revenue can be recognized. Deferred revenues represent the excess of amounts invoiced over amounts recognized as revenues. We provide non-specified upgrades of our product only on a when-and-if-available basis. Any contingencies, such as rights of return, conditions of acceptance, warranties and price protection, are accounted for under SOP 97-2. The effect of accounting for these contingencies included in revenue arrangements has not been material.

 

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

 

Long-lived assets.   We record our long-lived assets, such as property and equipment, at cost. We review the carrying value of our long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We evaluate these assets by examining estimated future cash flows to determine if their current recorded value is impaired. We evaluate these cash flows by using weighted probability techniques as well as comparisons of past performance against projections. Assets may also be evaluated by identifying independent market values. If we determine that an asset’s carrying value is impaired, we will record a write-down of the carrying value of the identified asset and charge the impairment as an operating expense in the period in which the determination is made. Although we believe that the carrying values of our long-lived assets are appropriately stated, changes in strategy or market conditions or significant technological developments could significantly impact these judgments and require adjustments to recorded asset balances.

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

 

Deferred Income Taxes.   Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting bases and the tax bases of assets and liabilities. Deferred tax assets are also recognized for tax net operating loss carryforwards. These deferred tax assets and liabilities are measured using the enacted tax rates and laws that will be in effect when such amounts are expected to reverse or be utilized. The realization of total deferred tax assets is contingent upon the generation of future taxable income. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized.

 

Income tax provision includes U.S. federal, state and local income taxes and is based on pre-tax income or loss. The interim period provision or benefit for income taxes is based upon our estimate of our annual effective income tax rate. In determining the estimated annual effective income tax rate, we analyze various factors, including projections of our annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes and our ability to use tax credits and net operating loss carryforwards.

 

We adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” . It prescribes that a company should use a more-likely-than-not recognition threshold based on the technical merits of the tax position taken. Tax positions that meet the more-likely-than-not recognition threshold should be measured as the largest amount of the tax benefits, determined on a cumulative probability basis, which is more likely than not to be realized upon ultimate settlement in the financial statements. As a result of the implementation of FIN 48, we recognized an increase of $0.5 million in the unrecognized tax benefit liability, which was accounted for as an increase to the January 1, 2007 accumulated deficit balance. As of September 30, 2007, our unrecognized tax benefit liability totaled $0.6 million, all of which would affect our effective tax rate if recognized. Also, upon adoption of FIN 48, we reclassified $1.0 million of previously accrued tax contingencies which were included in accrued expenses and recorded an offsetting valuation allowance against certain deferred tax assets that were recorded on the consolidated balance sheets at December 31, 2006. We did not record any interest or penalties related to our adoption of FIN 48. Our continuing practice is to recognize interest and penalties related to income tax matters in income tax expense.

 

Stock-Based Compensation.   Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2005), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized in fiscal 2006 includes: (a) compensation cost for all equity-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS  No. 123, “Accounting for Stock-Based Compensation” and (b) compensation cost for all equity-based payments granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.

 

As of September 30, 2007, there was approximately $31.1 million of total unrecognized compensation cost related to unvested stock options granted under our option plans. The cost is expected to be recognized through February 2013 with a weighted average recognition period of approximately 1.5 years.

 

Recent Accounting Pronouncements.   In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. It clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of SFAS 157 on our consolidated results of operations and financial condition.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), to permit all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. An entity is prohibited from retrospectively applying SFAS 159, unless it chooses early adoption. We are currently evaluating the impact of the provisions of SFAS 159 on our consolidated financial statements.

 

Important Factors Considered by Management

 

We consider several factors in evaluating both our financial position and our operating performance. These factors, while primarily focused on relevant financial information, also include other measures such as general market and economic conditions, competitor information and the status of the regulatory environment.

 

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

 

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

 

 

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

 

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

 

Three Months Ended September 30, 2007 Compared to Three Months Ended September 30, 2006

 

Our total revenues for the three months ended September 30, 2007 were $61.6 million, representing an increase of $11.2 million, or 22.3%, as compared to $50.4 million for the three months ended September 30, 2006.

 

A detail of our total revenues by classification is as follows:

 

 

Product revenues.   Product revenues, including domestic and international, for the three months ended September 30, 2007 were $54.0 million, representing an increase of $10.6 million, or 24.3%, as compared to $43.4 million for the three months ended September 30, 2006. Recurring ratable product revenues increased by $10.5 million, or 30.3%, for the three months ended September 30, 2007 as compared to the three months ended September 30, 2006. This increase was primarily due to a $7.1 million increase in revenues from Blackboard Learning System enterprise licenses which was attributable to current and prior period sales to new and existing clients, including clients resulting from the WebCT merger, the continued shift of our existing clients from the Blackboard Learning System basic products to the Blackboard Learning System enterprise products and the cross-

selling of other enterprise products to existing clients. The Blackboard Learning System enterprise products have additional functionality that is not available in the Blackboard Learning System basic products and consequently some Blackboard Learning System basic product clients upgrade to the Blackboard Learning System enterprise products. Licenses of the enterprise version of the Blackboard Learning System enterprise products have higher average pricing, which normally results in at least twice the contractual value as compared to Blackboard Learning System basic product licenses. The further increase in recurring ratable product revenues was due to a $2.7 million increase in hosting revenues and the remaining increase resulted from increases in revenues from our other software products. The 2006 revenues were reduced due to the fair value adjustment to the acquired WebCT deferred revenue balances in purchase accounting subsequent to the closing of the WebCT merger.

 

The increase in non-recurring ratable product revenues was primarily due to an increase in sales of Blackboard Commerce Suite hardware products.

 

Of our total revenues, our total international revenues for the three months ended September 30, 2007 were $13.2 million, representing an increase of $3.9 million, or 41.9%, as compared to $9.3 million for the three months ended September 30, 2006. International product revenues, which consist primarily of recurring ratable product revenues, were $11.9 million for the three months ended September 30, 2007, representing an increase of $3.7 million, or 45.1%, as compared to $8.2 million for the three months ended September 30, 2006. The increase in international recurring ratable product revenues was primarily due to an increase in international revenues from Blackboard Academic Suite enterprise products, which include former WebCT products, resulting from prior period sales to new and existing clients. In addition, the increase in international revenues also reflects our investment in increasing the size of our international sales force and international marketing efforts during prior periods, which expanded our international presence and enabled us to sell more of our products to new and existing clients in our international markets.

 

Professional services revenues.   Professional services revenues for the three months ended September 30, 2007 were $7.6 million, representing an increase of $0.7 million, or 9.4%, as compared to $6.9 million for the three months ended September 30, 2006. The increase in professional services was primarily attributable to increased sales of certain enhanced support and maintenance services. As a percentage of total revenues, professional services revenues for the three months ended September 30, 2007 were 12.3% as compared to 13.7% for the three months ended September 30, 2006. This decrease was due primarily to the impact of purchase accounting adjustments to WebCT’s beginning deferred revenue balances subsequent to the closing of the WebCT merger during 2006. As a result of the fair value adjustment to the acquired deferred revenue balances during 2006, we expect the percentage of professional services revenues to continue to remain lower than in the prior year and for this trend to continue for the remainder of 2007.

 

Cost of product revenues.   Our cost of product revenues for the three months ended September 30, 2007 was $11.9 million, representing an increase of $0.6 million, or 5.3%, as compared to $11.4 million for the three months ended September 30, 2006. The increase in cost of product revenues was primarily due to a $0.7 million increase in expenses related to hosting services due to the increase in the number of clients, including former WebCT clients, contracting for new hosting services or existing clients expanding their existing hosting arrangements. The increase was partially offset by a decrease of $0.2 million in hardware costs primarily associated with third party products sold with the Blackboard Transaction System . Cost of product revenues as a percentage of product revenues decreased to 22.1% for the three months ended September 30, 2007 from 26.1% for the three months ended September 30, 2006. This increase in product revenues margin was due primarily to the fair value adjustment to the acquired WebCT deferred revenue balances during 2006. Consequently, we expect our product revenues margins to continue to remain higher than in the prior year for the remainder of 2007.

 

Cost of product revenues excludes amortization of acquired technology intangibles resulting from acquisitions, which is included as amortization of intangibles resulting from acquisitions. Amortization expense related to acquired technology was $2.8 million and $2.9 million for the three months ended September 30, 2006 and 2007, respectively. Cost of product revenues, including amortization of acquired technology, as a percentage of product revenues was 27.6% for the three months ended September 30, 2007 as compared to 32.6% for the three months ended September 30, 2006.

Cost of professional services revenues.   Our cost of professional services revenues for the three months ended September 30, 2006 and 2007 was $4.4 million. Cost of professional services revenues as a percentage of professional services revenues decreased to 58.6% for the three months ended September 30, 2007 from 63.4% for the three months ended September 30, 2006. The increase in professional services revenues margin was due to the increase in revenues from certain enhanced support and maintenance services during the three months ended September 30, 2007.

 

Research and development expenses.   Our research and development expenses for the three months ended September 30, 2007 were $6.9 million, representing a decrease of $1.1 million, or 13.4%, as compared to $8.0 million for the three months ended September 30, 2006. This decrease was primarily attributable to decreased personnel-related costs due to higher average headcount during the three months ended September 30, 2006 as compared to the three months ended September 30, 2007.

 

Sales and marketing expenses.   Our sales and marketing expenses for the three months ended September 30, 2007 were $18.2 million, representing an increase of $1.5 million, or 9.2%, as compared to $16.7 million for the three months ended September 30, 2006. This increase was primarily attributable to increased general marketing activities of $0.9 million and increased stock-based compensation expense for sales and marketing function employees of $0.3 million. Further, bad debt expense of $0.3 million was recorded during the three months ended September 30, 2007. We did not record any bad debt expense during the three months ended September 30, 2006.

 

General and administrative expenses.   Our general and administrative expenses for the three months ended September 30, 2007 were $10.4 million, representing an increase of $0.7 million, or 7.5%, as compared to $9.7 million for the three months ended September 30, 2006. This increase was primarily attributable to increased stock-based compensation expense of $0.9 million for general and administrative function employees during 2007. This increase was partially offset by decreased professional services expenses of $0.2 million associated with increased legal, accounting and integration costs resulting from the acquisition of WebCT during 2006.

 

Net interest (expense) income.   Our net interest income for the three months ended September 30, 2007 was $0.5 million, representing an increase of $2.0 million, or 132.9%, as compared to net interest expense of $1.5 million for the three months ended September 30, 2006. This increase was primarily attributable to interest income earned on higher average cash and cash equivalents balances during 2007 as compared to 2006 resulting from proceeds received in connection with the 3.25% Convertible Senior Notes due 2027 issued during 2007. Interest income was partially offset by interest expense incurred in connection with the 3.25% Convertible Senior Notes due 2027 issued during 2007. Interest expense recorded during 2006 resulted from the credit facilities agreement we entered into with Credit Suisse to fund a portion of the acquisition of WebCT.

 

Other (expense) income.   Our other income for the three months ended September 30, 2007 was $1.0 million and pertains to the remeasurement of our foreign subsidiaries ledgers, which are maintained in the respective subsidiary’s local foreign currency, into the United States dollar. Specifically, we recognized a translation gain related to our wholly-owned Canadian subsidiary as a result of the favorable change in the exchange rate of the Canadian Dollar into the US Dollar during 2007.

 

Benefit (provision) for income taxes.   Our provision for income taxes for the three months ended September 30, 2007 was $2.4 million as compared to a benefit of $2.0 million for the three months ended September 30, 2006. This increase was due to our income before provision for income taxes during the three months ended September 30, 2007 as compared to our loss before benefit for income taxes during the three months ended September 30, 2006.

 

Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30, 2006

 

Our total revenues for the nine months ended September 30, 2007 were $176.2 million, representing an increase of $44.6 million, or 33.9%, as compared to $131.6 million for the nine months ended September 30, 2006.

A detail of our total revenues by classification is as follows:

 

 

Product revenues.   Product revenues, including domestic and international, for the nine months ended September 30, 2007 were $156.3 million, representing an increase of $42.7 million, or 37.6%, as compared to $113.6 million for the nine months ended September 30, 2006. Recurring ratable product revenues increased by $39.6 million, or 43.2%, for the nine months ended September 30, 2007 as compared to the nine months ended September 30, 2006. This increase was primarily due to a $29.4 million increase in revenues from Blackboard Learning System enterprise licenses which was attributable to current and prior period sales to new and existing clients, including clients resulting from the WebCT merger, the continued shift of our existing clients moving from the Blackboard Learning System basic products to the Blackboard Learning System enterprise products and cross-selling other enterprise products to existing clients. The Blackboard Learning System enterprise products have additional functionality that is not available in the Blackboard Learning System basic products and consequently some Blackboard Learning System basic product clients upgrade to the Blackboard Learning System enterprise products. Licenses of the enterprise version of the Blackboard Learning System enterprise products have higher average pricing, which normally results in at least twice the contractual value as compared to Blackboard Learning System basic product licenses. The further increase in recurring ratable product revenues was due to a $6.4 million increase in hosting revenues and the remaining increase resulted from increases in revenues from our other software products. The results for the nine months ended September 30, 2007 included nine months of revenues related to clients acquired in the WebCT merger as compared to the nine months ended September 30, 2006 which only included seven months of revenues related to clients acquired in the WebCT merger following the completion of the merger on February 28, 2006. The 2006 revenues were further reduced due to the fair value adjustment to the acquired WebCT deferred revenue balances in purchase accounting subsequent to the closing of the WebCT merger.

 

The increase in non-recurring ratable product revenues was primarily due to an increase in sales of Blackboard Commerce Suite hardware products.

 

The increase in other product revenues was primarily due to an increase in third party hardware and software revenues, an increase in publisher revenues due to the inclusion of WebCT publisher relationships and an increase in Blackboard One revenues due to an increase in prior period sales.

 

Of our total revenues, our total international revenues for the nine months ended September 30, 2007 were $38.6 million, representing an increase of $14.4 million, or 59.5%, as compared to $24.2 million for the nine months ended September 30, 2006. International product revenues, which consist primarily of recurring ratable product revenues, were $34.8 million for the nine months ended September 30, 2007, representing an increase of $13.7 million, or 64.9%, as compared to $21.1 million for the nine months ended September 30, 2006. The increase in international recurring ratable product revenues was primarily due to an increase in international revenues from Blackboard Academic Suite enterprise products, which include former WebCT products, resulting from prior period sales to new and existing clients. In addition, the increase in international revenues also reflects our investment in increasing the size of our international sales force and international marketing efforts during prior periods, which expanded our international presence and enabled us to sell more of our products to new and existing clients in our international markets.

 

Professional services revenues.   Professional services revenues for the nine months ended September 30, 2007 were $19.9 million, representing an increase of $1.9 million, or 10.7%, as compared to $18.0 million for the

nine months ended September 30, 2006. The increase in professional services was primarily attributable to increased sales of certain enhanced support and maintenance services. As a percentage of total revenues, professional services revenues for the nine months ended September 30, 2007 were 11.3% as compared to 13.7% for the nine months ended September 30, 2006. This decrease was due primarily to the impact of purchase accounting adjustments to WebCT’s beginning deferred revenue balances subsequent to the closing of the WebCT merger during 2006. As a result of the fair value adjustment to the acquired deferred revenue balances during 2006, we expect the percentage of professional services revenues to continue to remain lower than in the prior year and for this trend to continue for the remainder of 2007.

 

Cost of product revenues.   Our cost of product revenues for the nine months ended September 30, 2007 was $35.6 million, representing an increase of $6.3 million, or 21.3%, as compared to $29.3 million for the nine months ended September 30, 2006. The increase in cost of product revenues was primarily due to a $2.7 million increase in expenses related to hosting services due to the increase in the number of clients, including former WebCT clients, contracting for new hosting services or existing clients expanding their existing hosting arrangements. Further, the increase was due to a $1.7 million increase in our technical support expenses primarily due to increased personnel costs. The results for the nine months ended September 30, 2007 included nine months of expenses related to the acquired WebCT operations as compared to the nine months ended September 30, 2006 which only included seven months of expenses related to the acquired WebCT operations following the completion of the merger on February 28, 2006. Further, the increase was due to a $1.6 million increase in hardware and software costs primarily associated with third party products sold with the Blackboard Transaction System . Cost of product revenues as a percentage of product revenues decreased to 22.8% for the nine months ended September 30, 2007 from 25.8% for the nine months ended September 30, 2006. This increase in product revenues margin was due primarily to the impact of purchase accounting adjustments to WebCT’s beginning deferred revenue balances subsequent to the closing of the WebCT merger during 2006. Consequently, we expect our product revenues margins to continue to remain higher than in the prior year for the remainder of 2007.

 

Cost of product revenues excludes amortization of acquired technology resulting from acquisitions, which is included as amortization of intangibles resulting from acquisitions. Amortization expense related to acquired technology was $6.5 million and $8.7 million for the nine months ended September 30, 2006 and 2007, respectively. Cost of product revenues, including amortization of acquired technology, as a percentage of product revenues was 28.3% for the nine months ended September 30, 2007 as compared to 31.6% for the nine months ended September 30, 2006. The results for the nine months ended September 30, 2007 included nine months of amortization expense related to amortization of acquired technology resulting from the WebCT merger as compared to the nine months ended September 30, 2006, which only included seven months of amortization expense following the completion of the merger on February 28, 2006.

 

Cost of professional services revenues.   Our cost of professional services revenues for the nine months ended September 30, 2007 was $12.3 million, representing an increase of $0.3 million, or 2.3%, as compared to $12.1 million for the nine months ended September 30, 2006. The results for the nine months ended September 30, 2007 included nine months of expenses related to the acquired WebCT operations as compared to the nine months ended September 30, 2006 which only included seven months of expenses related to the acquired WebCT operations following the completion of the merger on February 28, 2006. Cost of professional services revenues as a percentage of professional services revenues decreased to 61.8% for the nine months ended September 30, 2007 from 66.8% for the nine months ended September 30, 2006. The increase in professional services revenues margin was due to the increase in revenues from certain enhanced support and maintenance services during the nine months ended September 30, 2007.

 

Research and development expenses.   Our research and development expenses for the nine months ended September 30, 2007 were $20.8 million, representing an increase of $0.7 million, or 3.4%, as compared to $20.2 million for the nine months ended September 30, 2006. This increase was primarily attributable to a $1.0 million increase in professional services costs resulting from our continued efforts to increase the functionality of our products. This increase was partially offset by decreased personnel-related costs of $0.2 million due to higher average headcount during the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2007.

Sales and marketing expenses.   Our sales and marketing expenses for the nine months ended September 30, 2007 were $49.4 million, representing an increase of $5.5 million, or 12.5%, as compared to $43.9 million for the nine months ended September 30, 2006. This increase was primarily attributable to increased personnel-related costs of $3.8 million due to increased average headcount, increased average salaries and increased stock-based compensation expense for sale and marketing employees during 2007 as compared to 2006 and increased general marketing activities of $1.2 million. The results for the nine months ended September 30, 2007 included nine months of expenses related to the acquired WebCT operations as compared to the nine months ended September 30, 2006, which only included seven months of expenses related to the acquired WebCT operations following the completion of the merger on February 28, 2006. Further, bad debt expense of $0.5 million was recorded during the nine months ended September 30, 2007. We did not record any bad debt expense during the nine months ended September 30, 2006.

 

General and administrative expenses.   Our general and administrative expenses for the nine months ended September 30, 2007 were $28.2 million, representing an increase of $1.2 million, or 4.4%, as compared to $27.1 million for the nine months ended September 30, 2006. This increase was primarily attributable to increased stock-based compensation expense of $1.7 million for general and administrative function employees during the nine months ended September 30, 2007. This increase was partially offset by a decrease of $0.6 million in personnel-related costs due to approximately $2.1 million in retention bonuses and severance costs primarily for WebCT employees recognized during the nine months ended September 30, 2006 offset, in part, by increased personnel- related costs due to increased average headcount and increased average salaries for general and administrative employees during the nine months ended September 30, 2007.

 

Net interest expense.   Our net interest expense for the nine months ended September 30, 2007 was $0.5 million, representing a decrease of $1.3 million or 71.8%, as compared to $1.8 million for the nine months ended September 30, 2006. This decrease was primarily attributable to interest income earned on higher average cash and cash equivalents balances during 2007 as compared to 2006 resulting from proceeds received in connection with the 3.25% Convertible Senior Notes due 2027 issued during 2007. Interest income was partially offset by interest expense incurred in connection with the 3.25% Convertible Senior Notes due 2027 issued during 2007 and the credit facilities agreement we entered into with Credit Suisse to fund a portion of the acquisition of WebCT during 2006.

 

Other (expense) income.   Our other income for the nine months ended September 30, 2007 was $2.0 million and pertains to the remeasurement of our foreign subsidiaries ledgers, which are maintained in the respective subsidiary’s local foreign currency, into the United States dollar. Specifically, we recognized a translation gain related to our wholly-owned Canadian subsidiary as a result of the favorable change in the exchange rate of the Canadian Dollar into the US Dollar during 2007.

 

Benefit (provision) for income taxes.   Our provision for income taxes for the nine months ended September 30, 2007 was $6.2 million as compared to a benefit of $4.6 million for the nine months ended September 30, 2006. The increase in income taxes was due to our income before provision for income taxes during the nine months ended September 30, 2007 as compared to our loss before benefit for income taxes for the nine months ended September 30, 2006.

 

Liquidity and Capital Resources

 

Our cash and cash equivalents were $208.0 million at September 30, 2007 as compared to $30.8 million at December 31, 2006. The increase in cash and cash equivalents was primarily due to a convertible debt offering in which we issued and sold $165.0 million aggregate of the 3.25% Convertible Senior Notes due 2027.

 

We deposit our cash with financial institutions that we consider to be of high credit quality. Cash and cash equivalents consist of highly liquid investments, which are readily convertible into cash and have original maturities of three months or less.

 

Net cash provided by operating activities was $39.8 million during the nine months ended September 30, 2007 as compared to $10.6 million during the nine months ended September 30, 2006. This change for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was primarily due to net income

of $8.7 million for the nine months ended September 30, 2007, which was an increase of $19.6 million from the net loss of $10.9 million for the nine months ended September 30, 2006. Accounts receivable increased $13.5 million during the nine months ended September 30, 2007 due to an increase in invoicing associated with increased sales to new and existing clients during 2007 as compared to 2006. Amortization of intangibles increased to $16.4 million during the nine months ended September 30, 2007, as the results for 2007 included nine months of amortization expense related to amortization of acquired technology intangibles resulting from the WebCT merger as compared to the nine months ended September 30, 2006, which only included seven months of amortization expense following the completion of the merger on February 28, 2006. We recognize revenues on annually renewable agreements, which results in deferred revenues. Deferred revenues as of September 30, 2007 were $133.7 million, representing an increase of $13.5 million, or 11.2%, from $120.3 million as of December 31, 2006. This increase was due to the timing of certain client renewal invoicing and sales to new and existing clients during the current period.

 

Net cash used in investing activities was $15.7 million during the nine months ended September 30, 2007 as compared to $100.2 million during the nine months ended September 30, 2006. During the nine months ended September 30, 2006, we paid $154.6 million in net cash related to the acquisition of WebCT. During the nine months ended September 30, 2007, cash expenditures for purchase of property and equipment were $11.2 million, which represents approximately 6.3% of total revenues. During the nine months ended September 30, 2007, we purchased technology for $1.5 million which will provide future functionality in our products and made $3.0 million in payments related to patent enforcement costs.

 

Net cash provided by financing activities was $153.1 million during the nine months ended September 30, 2007 as compared to $50.8 million during the nine months ended September 30, 2006. During the nine months ended September 30, 2007, we received $11.2 million in proceeds from exercise of stock options as compared to $6.9 million during the nine months ended September 30, 2006.

 

In June 2007, we issued and sold the 3.25% Convertible Senior Notes due 2027 in a public offering and used a portion of the proceeds to terminate and satisfy in full our existing indebtedness outstanding pursuant to the senior secured credit facilities agreement, entered into in connection with the acquisition of WebCT, of $19.4 million and to pay all fees and expenses incurred in connection with the termination.

 

In connection with obtaining the Notes, we incurred $4.5 million in debt issuance costs. These costs were recorded as a debt discount and netted against the remaining principal amount outstanding. The debt discount is being amortized as interest expense using the effective interest method over the term of the Notes. During the nine months ended September 30, 2007, we recorded total amortization expense, including amortization related to the Credit Agreement, of approximately $1.4 million as interest expense.

 

The Notes bear interest at a rate of 3.25% per year on the principal amount, accruing from June 20, 2007. Interest is payable semi-annually on January 1 and July 1, commencing on January 1, 2008. The Notes will mature on July 1, 2027, subject to earlier conversion, redemption or repurchase.

 

The Notes will be convertible, under certain circumstances, into cash or a combination of cash and our common stock at an initial base conversion rate of 15.4202 shares of common stock per $1,000 principal amount of Notes. The base conversion rate represents an initial base conversion price of approximately $64.85. If at the time of conversion the applicable price of our common stock exceeds the base conversion price, the conversion rate will be increased by up to an additional 9.5605 shares of our common stock per $1,000 principal amount of Notes, as determined pursuant to a specified formula. In general, upon conversion of a Note, the holder of such Note will receive cash equal to the principal amount of the Note and our common stock for the Note’s conversion value in excess of such principal amount.

 

Holders may surrender their Notes for conversion at any time prior to the close of business on the business day immediately preceding the maturity date for the Notes only under the following circumstances: (1) prior to January 1, 2027, with respect to any calendar quarter beginning after June 30, 2007, if the closing price of the Company’s common stock for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is more than 130% of the base conversion price per share of the Notes on such last trading day; (2) on or after January 1, 2027, until the close of business on the business day

preceding maturity; or (3) during the five business days after any five consecutive trading day period in which the trading price per $1,000 principal amount of Notes for each day of that period was less than 95% of the product of the closing price of the Company’s common stock and the then applicable conversion rate of the Notes.

 

If a make-whole fundamental change, as defined in the Notes, occurs prior to July 1, 2011, we may be required in certain circumstances to increase the applicable conversion rate for any Notes converted in connection with such fundamental change by a specified number of shares of our common stock. The Notes may not be redeemed by us prior to July 1, 2011, after which they may be redeemed at 100% of the principal amount plus accrued interest. Holders of the Notes may require us to repurchase some or all of the Notes on July 1, 2011, July 1, 2017 and July 1, 2022, or in the event of certain fundamental change transactions, at 100% of the principal amount plus accrued interest.

 

The Notes are unsecured senior obligations and are effectively subordinated to all of our existing and future senior indebtedness to the extent of the assets securing such debt, and are effectively subordinated to all indebtedness and liabilities of our subsidiaries, including trade payables.

 

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

 

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

 

 

that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2007, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

 

(b)  Changes in Internal Control over Financial Reporting.

 

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

 

Our merger with WebCT presents many risks, and we may not realize the financial and strategic goals that were contemplated at the time of the transaction.

 

The WebCT merger, which was completed on February 28, 2006, is the largest acquisition that we have undertaken. We entered into this transaction with the expectation that it would result in various benefits including, among other things, enhanced revenue and profits, and enhancements to our product portfolio and customer base. Risks that we may encounter in seeking to realize these benefits include:

 

 

Our business strategy contemplates future business combinations and acquisitions which may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention.

 

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

 

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

 

Future business combinations could involve the acquisition of significant tangible and intangible assets, which could require us to record in our statements of operations ongoing amortization of intangible assets acquired in connection with acquisitions, which we currently do with respect to our historic acquisitions, including the WebCT merger. In addition, we may need to record write-downs from future impairments of identified tangible and intangible assets and goodwill. These accounting charges would reduce any future reported earnings, or increase a reported loss. In future acquisitions, we could also incur debt to pay for acquisitions, or issue additional equity securities as consideration, which could cause our stockholders to suffer significant dilution.

 

Our ability to utilize, if any, net operating loss carryforwards acquired in any acquisitions, including those acquired in the WebCT merger, may be significantly limited or unusable by us under Section 382 or other sections of the Internal Revenue Code.

Our indebtedness could adversely affect our financial condition and prevent us from fulfilling our debt obligations, including the Notes.

 

Our outstanding debt poses the following risks:

 

 

We may be more vulnerable to adverse economic conditions than less leveraged competitors and thus, less able to withstand competitive pressures. Any of these events could reduce our ability to generate cash available for investment or debt repayment or to make improvements or respond to events that would enhance profitability. We may incur significantly more debt in the future, which will increase each of the foregoing risks related to our indebtedness.

 

We may not be able to repurchase the Notes when required by the holders, including upon a fundamental change or other specified dates at the option of the holder, or pay cash upon conversion of the Notes.

 

Upon the occurrence of a fundamental change, holders of the Notes will have the right to require us to repurchase the Notes at a price in cash equal to 100% of the principal amount of the Notes plus accrued and unpaid interest. Any future credit agreement or other agreements relating to indebtedness to which we become a party may contain similar provisions. Holders will also have the right to require us to repurchase the Notes for cash on July 1, 2011, July 1, 2017 and July 1, 2022. Moreover, upon conversion of the Notes, we are required to settle a portion of the conversion obligation in cash. In the event that we are required to repurchase the Notes or upon conversion of the Notes, we may not have sufficient financial resources to satisfy all of our obligations under the Notes and our other debt instruments. Our failure to make the fundamental change offer, to pay the repurchase price when due, or to pay cash upon conversion of Notes, would result in a default under the indenture governing the Notes. Any default under our indebtedness could have a material adverse effect on our business, results of operations and financial condition.

 

Provisions of the Notes could discourage an acquisition of us by a third party.

 

Certain provisions of the Notes could make it more difficult or more expensive for a third party to acquire us. Upon the occurrence of certain transactions constituting a fundamental change, holders of the Notes will have the right, at their option, to require us to repurchase all or a portion of their Notes at a price equal to 100% of the principal amount of Notes to be repurchased, plus accrued and unpaid interest. In addition, pursuant to the terms of the Notes, we may not enter into certain mergers unless, among other things, the surviving entity assumes all of our obligations under the indenture and the Notes.

 

Conversion of the Notes may affect the market price of our common stock and may dilute the ownership of existing stockholders.

 

The conversion of some or all of the Notes and any sales in the public market of our common stock issued upon such conversion could adversely affect the market price of our common stock. The existence of the Notes may encourage short selling by market participants because the conversion of the Notes could depress our common stock price. In addition, the conversion of some or all of the Notes could dilute the ownership interests of existing stockholders to the extent that shares of our common stock are issued upon conversion.

Our reported earnings per share may be more volatile because of the contingent conversion provision of the Notes.

 

The Notes may have a dilutive effect on earnings per share in any period in which the market price of our common stock exceeds the conversion price for the Notes as a result of the inclusion of the underlying shares in the fully diluted earnings per share calculation. Volatility in our stock price could cause this condition or other conversion conditions to be met in one quarter and not in a subsequent quarter, increasing the volatility of fully diluted earnings per share.

 

The accounting method for convertible debt securities with net share settlement, like the Notes, may be subject to change.

 

For the purpose of calculating diluted earnings per share, a convertible debt security providing for net share settlement and meeting specified requirements under U.S. generally accepted accounting principles, or GAAP, may be accounted for similar to non-convertible debt, with the stated coupon constituting interest expense and any shares potentially issuable upon conversion of the security included in the denominator for the calculation of diluted earnings per share. The shares potentially issuable upon conversion are not included in the calculation of diluted earnings per share until the Notes are “in the money.” The FASB is considering alternatives to this treatment, including treatments that would result in additional interest expense as a result of amortizing the amount allocated to the equity component over the term of the instrument, which would adversely affect income available to common stockholders. We cannot determine the outcome of the FASB deliberations, whether the FASB will require that net share settled securities be accounted for under the existing method, one of the alternative methods under consideration, or some other method, or when any change would be implemented or whether it would be implemented retroactively or prospectively. We also cannot determine any other changes in GAAP that may be made affecting accounting for convertible debt securities. Any change in the accounting method for convertible debt securities could have an adverse impact on our future financial results.

 

Providing enterprise software applications to the education industry is an emerging and uncertain business; if the market for our products fails to develop, we will not be able to grow our business.

 

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

 

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

 

Most of our clients use our products to facilitate online education, which is a relatively new field; if online education does not continue to develop and gain acceptance, demand for our products could suffer.

 

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

which may impose additional burdens on clients and potential clients offering online education. This could require us to modify our products, or could cause these clients and potential clients to abandon their online education initiatives.

 

We face intense and growing competition, which could result in price reductions, reduced operating margins and loss of market share.

 

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

 

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

 

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

 

If potential clients or competitors use open source software to develop products that are competitive with our products and services, we may face decreased demand and pressure to reduce the prices for our products.

 

The growing acceptance and prevalence of open source software may make it easier for competitors or potential competitors to develop software applications that compete with our products, or for clients and potential clients to internally develop software applications that they would otherwise have licensed from us. One of the aspects of open source software is that it can be modified or used to develop new software that competes with proprietary software applications, such as ours. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies. As open source offerings become more prevalent, customers may defer or forego purchases of our products, which could reduce our sales and lengthen the sales cycle for our products or result in the loss of current clients to open source solutions. If we are unable to differentiate our products from competitive products based on open source software, demand for our products and services may decline, and we may face pressure to reduce the prices of our products.

 

Because most of our licenses are renewable on an annual basis, a reduction in our license renewal rate could significantly reduce our revenues.

 

Our clients have no obligation to renew their licenses for our products after the expiration of the initial license period, which is typically one year, and some clients have elected not to do so. A decline in license renewal rates could cause our revenues to decline. We have limited historical data with respect to rates of renewals, so we cannot

accurately predict future renewal rates. Our license renewal rates may decline or fluctuate as a result of a number of factors, including client dissatisfaction with our products and services, our failure to update our products to maintain their attractiveness in the market or budgetary constraints or changes in budget priorities faced by our clients.

 

We may experience difficulties that could delay or prevent the successful development, introduction and sale of new products under development. If introduced for sale, the new products may not adequately meet the requirements of the marketplace and may not achieve any significant degree of market acceptance, which could cause our financial results to suffer. In addition, during the development period for the new products, our customers may defer or forego purchases of our products and services.

 

If our newest product, the Blackboard Outcomes System, does not gain widespread market acceptance, our financial results could suffer.

 

We introduced our newest software application, the Blackboard Outcomes System, in December 2006. Our ability to grow our business will depend, in part, on client acceptance of this product, which is currently unproven. If we are not successful in gaining market acceptance of this product, our revenues may fall below our expectations.

 

Because we generally recognize revenues ratably over the term of our contract with a client, downturns or upturns in sales will not be fully reflected in our operating results until future periods.

 

We recognize most of our revenues from clients monthly over the terms of their agreements, which are typically 12 months, although terms can range from one month to over 60 months. As a result, much of the revenue we report in each quarter is attributable to agreements entered into during previous quarters. Consequently, a decline in sales, client renewals, or market acceptance of our products in any one quarter will not necessarily be fully reflected in the revenues in that quarter, and will negatively affect our revenues and profitability in future quarters. This ratable revenue recognition also makes it difficult for us to rapidly increase our revenues through additional sales in any period, as revenues from new clients must be recognized over the applicable agreement term.

 

Our operating margins may suffer if our professional services revenues increase in proportion to total revenues because our professional services revenues have lower gross margins.

 

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

 

If our products contain errors or if new product releases are delayed, we could lose new sales and be subject to significant liability claims.

 

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

 

 

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

 

The length and unpredictability of the sales cycle for our software could delay new sales and cause our revenues and cash flows for any given quarter to fail to meet our projections or market expectations.

 

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

 

 

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

 

Our sales cycle with international postsecondary education providers and U.S. K-12 schools may be longer than our historic U.S. postsecondary sales cycle, which could cause us to incur greater costs and could reduce our operating margins.

 

As we target more of our sales efforts at international postsecondary education providers and U.S. K-12 schools, we could face greater costs, longer sales cycles and less predictability in completing some of our sales, which may harm our business. A potential client’s decision to use our products and services may be a decision involving multiple institutions and, if so, these types of sales would require us to provide greater levels of education to prospective clients regarding the use and benefits of our products and services. In addition, we expect that potential international postsecondary and U.S. K-12 clients may demand more customization, integration services and features. As a result of these factors, these sales opportunities may require us to devote greater sales support and professional services resources to individual sales, thereby increasing the costs and time required to complete sales and diverting sales and professional services resources to a smaller number of international and U.S. K-12 transactions.

 

We may have exposure to greater than anticipated tax liabilities.

 

We are subject to income taxes and other taxes in a variety of jurisdictions and are subject to review by both domestic and foreign taxation authorities. The determination of our provision for income taxes and other tax liabilities requires significant judgment and the ultimate tax outcome may differ from the amounts recorded in our consolidated financial statements, which may materially affect our financial results in the period or periods for which such determination is made.

 

Our ability to utilize our net operating loss carryforwards may be limited.

 

Our federal net operating loss carryforwards are subject to limitations on how much may be utilized on an annual basis. The use of the net operating loss carryforwards may have additional limitations resulting from certain future ownership changes or other factors under Section 382 of the Internal Revenue Code.

If our net operating loss carryforwards are further limited, and we have taxable income which exceeds the available net operating loss carryforwards for that period, we would incur an income tax liability even though net operating loss carryforwards may be available in future years prior to their expiration, which may adversely affect our future cash flow, financial position and financial results.

 

Our future success depends on our ability to continue to retain and attract qualified employees.

 

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

 

If we do not maintain the compatibility of our products with third-party applications that our clients use in conjunction with our products, demand for our products could decline.

 

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

 

If we are unable to protect our proprietary technology and other rights, it will reduce our ability to compete for business.

 

If we are unable to protect our intellectual property, our competitors could use our intellectual property to market products similar to our products, which could decrease demand for our products. In addition, we may be unable to prevent the use of our products by persons who have not paid the required license fee, which could reduce our revenues. We rely on a combination of copyright, patent, trademark and trade secret laws, as well as licensing agreements, third-party nondisclosure agreements and other contractual provisions and technical measures, to protect our intellectual property rights. These protections may not be adequate to prevent our competitors from copying or reverse-engineering our products and these protections may be costly and difficult to enforce. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology. To protect our trade secrets and other proprietary information, we require employees, consultants, advisors and collaborators to enter into confidentiality agreements. These agreements may not provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. The protective mechanisms we include in our products may not be sufficient to prevent unauthorized copying. Existing copyright laws afford only limited protection for our intellectual property rights and may not protect such rights in the event competitors independently develop products similar to ours. In addition, the laws of some countries in which our products are or may be licensed do not protect our products and intellectual property rights to the same extent as do the laws of the United States.

If we are found to infringe the proprietary rights of others, we could be required to redesign our products, pay significant royalties or enter into license agreements with third parties.

 

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

 

 

Expansion of our business internationally will subject our business to additional economic and operational risks that could increase our costs and make it difficult for us to operate profitably.

 

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

 

 

Unauthorized disclosure of data, whether through breach of our computer systems or otherwise, could expose us to protracted and costly litigation or cause us to lose clients.

 

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

general public loss of confidence in the use of the Internet, which could significantly diminish the attractiveness of our products and services.

 

Operational failures in our network infrastructure could disrupt our remote hosting service, could cause us to lose current hosting clients and sales to potential hosting clients and could result in increased expenses and reduced revenues.

 

Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of the hosting service we provide to some of our clients. We provide remote hosting through computer hardware that is currently located in third-party co-location facilities in Virginia, The Netherlands and Canada. We do not control the operation of these co-location facilities. Lengthy interruptions in our hosting service could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems at the co-location facilities or if these co-location facilities were to close without adequate notice. Although we have multiple transmission lines into the co-location facilities through two telecommunications service providers, we have experienced problems of this nature from time to time in the past, and we will continue to be exposed to the risk of network failures in the future. We currently do not have adequate computer hardware and systems to provide alternative service for most of our hosted clients in the event of an extended loss of service at the co-location facilities. Each Virginia co-location facility provides data backup redundancy for the other Virginia co-location facility. However, they are not equipped to provide full disaster recovery to all of our hosted clients. If there are operational failures in our network infrastructure that cause interruptions, slower response times, loss of data or extended loss of service for our remotely hosted clients, we may be required to issue credits or pay penalties, current hosting clients may terminate their contracts or elect not to renew them, and we may lose sales to potential hosting clients. If we determine that we need additional hardware and systems, we may be required to make further investments in our network infrastructure.

 

We could lose revenues if there are changes in the spending policies or budget priorities for government funding of colleges, universities, schools and other education providers.

 

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

 

U.S. and foreign government regulation of the Internet could cause us to incur significant expenses, and failure to comply with applicable regulations could make our business less efficient or even impossible.

 

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

 

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

 

 

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

 

We may be subject to state and federal financial services regulation, and any violation of any present or future regulation could expose us to liability, force us to change our business practices or force us to stop selling or modify our products and services.

 

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

 

 

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

 

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Blackboard Inc.

 

Michael J. Beach

Chief Financial Officer

(On behalf of the registrant and as Principal

Financial Officer)

 

Dated: November 8, 2007

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