BBBB Blackboard (MM)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

 

Commission file number 000-50784

 

 

Blackboard Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

 

Registrant’s Telephone Number, Including Area Code:

(202) 463-4860

 

 

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

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, 2008

INDEX

 

 

 

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

 

 

BLACKBOARD INC.

 

 

See notes to unaudited consolidated financial statements.

BLACKBOARD INC.

 

 

See notes to unaudited consolidated financial statements.

BLACKBOARD INC.

 

 

See notes to unaudited consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Nine Months Ended September 30, 2007 and 2008

 

In these Notes to Unaudited Consolidated Financial Statements, the terms “the Company” and “Blackboard” refer to Blackboard Inc. and its subsidiaries .

 

 

Blackboard Inc. (the “Company”) is a leading provider of enterprise software applications and related services to the education industry. The Company’s 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 , Blackboard One ^tm , and Blackboard Connect ^tm .

 

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the full fiscal year. The consolidated balance sheet at December 31, 2007 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements.

 

These consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of December 31, 2006 and 2007 and for each of the three years in the period ended December 31, 2007 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 20, 2008.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany balances and transactions.

 

Foreign Currency Translation

 

The functional currency of the Company’s foreign subsidiaries is the U.S. dollar. The Company remeasures the monetary assets and liabilities of its foreign subsidiaries, which are maintained in the local currency ledgers, at the rates of exchange in effect at month end. Revenues and expenses recorded in the local currency during the period are translated using average exchange rates for each month. Non-monetary assets and liabilities are translated using historical rates. Resulting adjustments from the remeasurement process are included in other income (expense) in the accompanying consolidated statements of operations.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Reclassifications

 

Certain amounts in the prior period financial statements have been reclassified to conform to the current year presentation.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Fair Value Measurements

 

As of January 1, 2008, the Company adopted the Financial Accounting Standards Board (“FASB”) Statement No. 157, “Fair Value Measurements” (“FAS 157”). The adoption of FAS 157 did not have a material impact on the Company’s consolidated results of operations and financial condition. FAS 157 defines fair value, establishes a fair value hierarchy for assets and liabilities measured at fair value and expands required disclosure about fair value measurements. The FAS 157 hierarchy ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value and requires financial assets and liabilities carried at fair value to be classified and disclosed in one of the following three categories:

 

Level 1 — quoted prices in active markets for identical assets and liabilities

Level 2 — inputs other than Level 1 quoted prices that are directly or indirectly observable

Level 3 — unobservable inputs that are not corroborated by market data

 

The Company evaluates assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level to classify them for each reporting period. This determination requires significant judgments to be made by the Company. The following table sets forth the Company’s financial assets and liabilities that were measured at fair value on a recurring basis as of September 30, 2008, by level within the fair value hierarchy (unaudited, in thousands):

 

 

 

 

Common Stock Warrant

 

The Company held a common stock warrant in an entity that provides technology support services to educational institutions, including the Company’s customers, to purchase 19.9% of the shares of the entity. This common stock warrant meets the definition of a derivative as defined by FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activity.” Other income of approximately $4.0 million was recorded in the Company’s consolidated statements of operations during the three months ended June 30, 2008 related to the fair value adjustment of the common stock warrant. On July 1, 2008, in connection with an equity transaction between this entity and a venture capital firm, the Company exercised approximately one-half of its warrant and sold the related shares to the venture capital firm for approximately $2.0 million and entered into an amended common stock warrant agreement in which the Company can purchase up to 9.9% of the shares of the entity. The fair value of the common stock warrant of approximately $2.0 million is recorded as investment in common stock warrant on the Company’s consolidated balance sheet as of September 30, 2008. The Company will continue to evaluate the fair

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

value of this instrument in subsequent reporting periods and any changes in value will be recognized in the consolidated statements of operations.

 

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 or benefit includes U.S. federal, state and local and foreign income taxes and is based on pre-tax income or loss. 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 and foreign income taxes and the ability of the Company to use tax credits and net operating loss carryforwards.

 

The Company follows the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 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 on January 1, 2007, the Company recognized an increase of $0.6 million in the unrecognized tax benefit liability, which was accounted for as an increase to the January 1, 2007 accumulated deficit balance. All of the Company’s unrecognized tax benefit liability would affect the Company’s effective tax rate if recognized. The Company recognizes interest and penalties related to income tax matters in income tax expense. Prior to adoption of FIN 48, accruals for tax contingencies were provided for in accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies.” Although the Company believes it had appropriate support for the positions taken on its tax returns for those years, the Company recorded a liability for its best estimate of the probable loss on certain of those positions. The Company does not expect its unrecognized tax benefit liability to change significantly over the next 12 months. All tax years since 1998 are subject to examination.

 

Revenue Recognition and Deferred Revenue

 

The Company’s revenues are derived from two sources: product sales and professional services sales. Product revenues include software license, subscription fees from customers accessing its on-demand application services, hardware, premium support and maintenance, and hosting revenues. Professional services revenues include training and consulting services. Revenue from software licenses and maintenance is recorded 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.” The Company’s software does not require significant modification and customization services. Where services are not essential to the functionality of the software, the Company begins 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.

 

The Company does not have vendor-specific objective evidence (“VSOE”) of fair value for support and maintenance separate from software for the majority of its products. Accordingly, when licenses are sold in conjunction with the Company’s support and maintenance, license revenue is recognized over the term of the maintenance service period. When licenses of certain offerings are sold in conjunction with support and

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

maintenance where the Company does have VSOE, the Company recognizes the license revenue upon delivery of the license and recognizes the support and maintenance revenue over the term of the maintenance service period.

 

The Company’s hardware revenues are derived from two types of transactions: sales of hardware in conjunction with the Company’s software licenses, which are referred 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. VSOE of the fair value for the separate components of bundled hardware-software systems has not been determined. 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 the Company’s 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.” Accordingly, hosting fees and set-up fees are recognized ratably over the term of the hosting agreement.

 

The Company’s sales arrangements may include professional services sold separately under professional services agreements that include training and consulting services. Revenues from these arrangements are accounted for separately from the license revenue because they meet the criteria for separate accounting, as defined in SOP 97-2. The more significant factors considered in determining whether revenues should be accounted for separately include the nature of the professional services, such as consideration of whether the professional services are essential to the functionality of the licensed product, degree of risk, availability of professional services from other vendors and timing of payments. Professional services that are sold separately from license revenue are recognized as the professional services are performed on a time-and-materials basis.

 

The Company does 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 revenues can be recognized. Deferred revenues represent the excess of amounts invoiced over amounts recognized as revenues. Non-specified upgrades of the Company’s product are provided 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.

 

Cost of Revenues and Deferred Cost of Revenues

 

Cost of revenues includes all direct materials, direct labor, telecommunication costs related to the Blackboard Connect product, and those indirect costs related to revenue such as indirect labor, materials and supplies, equipment rent, and amortization of software developed internally and software license rights. Cost of product revenues excludes amortization of acquired technology intangibles resulting from acquisitions, which is included as amortization of intangibles acquired in acquisitions. Amortization expense related to acquired technology was $2.9 million and $4.6 million for the three months ended September 30, 2007 and 2008, respectively, and $8.7 million and $13.2 million for the nine months ended September 30, 2007 and 2008, respectively. The Company does not have transactions in which the deferred cost of revenues exceed deferred revenues.

 

Deferred cost of revenues represents the cost of hardware (if sold as part of a complete system) and software that is purchased and has been sold in conjunction with the Company’s products. These costs are recognized as cost of revenues proportionally and over the same period that deferred revenue is recognized as revenues in accordance with SAB Topic 13.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Basic and Diluted Net Income (Loss) per Common Share

 

Basic net income (loss) per common share excludes dilution for potential common stock issuances and is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income (loss) per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

 

The following schedule presents the calculation of basic and diluted net income (loss) per common share:

 

 

The dilutive effect of 1,023,836 options were not included in the computation of diluted net loss per share for the nine months ended September 30, 2008 as their effect would be anti-dilutive.

 

Stock-Based Compensation

 

The Company accounts for stock-based compensation expense in accordance with FASB Statement No. 123 (revised 2005), “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires the measurement and recognition of compensation expense for share-based awards based on the estimated fair value on the date of grant. The Company estimates the fair value of each share-based award on the date of grant using the Black-Scholes option-pricing model. This model is affected by the Company’s stock price as well as estimates regarding a number of variables including expected stock price volatility over the term of the award and projected employee stock option exercise behaviors.

 

Comprehensive Net Income (Loss)

 

Comprehensive net income (loss) includes net income (loss), 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 income (loss) and comprehensive net income (loss) for the three and nine months ended September 30, 2007 and 2008.

 

Recent Accounting Pronouncements

 

In December 2007, the FASB issued Statement No. 141(R), a revised version of FASB Statement No. 141, “Business Combinations”. The revision is intended to simplify existing guidance and converge rulemaking under

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

U.S. generally accepted accounting principles with international accounting rules. This statement applies prospectively to business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is prohibited. The Company is currently evaluating the impact of the provisions of the revision on its consolidated results of operations and financial condition.

 

In December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests. This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company does not believe the provisions of SFAS 160 will have a material impact on its consolidated results of operations and financial condition.

 

In February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 deferred the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The Company is currently evaluating the impact of FSP 157-2 for nonfinancial assets and nonfinancial liabilities on its consolidated results of operations and financial condition.

 

In October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active” (“FSP 157-3”). FSP 157-3 provides guidance for determining the fair value of a financial asset in an inactive market. The adoption of FSP 157-3 did not have a significant impact on the Company’s consolidated results of operations and financial condition.

 

In May 2008, the FASB issued Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion.” (“APB 14-1”). APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period. The Company is currently evaluating the impact of the provisions of APB 14-1 on its consolidated results of operations and financial condition.

 

 

On January 31, 2008, the Company completed its merger with The NTI Group, Inc. (“NTI”) pursuant to the Agreement and Plan of Merger dated January 11, 2008. Pursuant to the Agreement and Plan of Merger, the Company paid merger consideration of approximately $184.8 million, which includes $132.1 million in cash and $52.7 million in the Company’s common stock, or approximately 1.5 million shares of common stock. The effective cash portion of the purchase price of NTI before transaction costs was approximately $130.5 million, net of NTI’s January 31, 2008 cash balance of approximately $1.6 million. The Company has included the financial results of NTI in its consolidated financial statements beginning February 1, 2008. Up to an additional 0.5 million shares in the Company’s common stock may be issued contingent on the achievement of certain performance milestones. Since the completion of the merger, The NTI Group, Inc. was renamed Blackboard Connect Inc.

 

NTI is a provider of mass messaging and notifications solutions for educational and government organizations via voice, email, short message service (SMS) and other text-receiving devices. The Company believes the merger with NTI supports the Company’s long-term strategic direction and that the demands for innovative technology in

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

the education industry continue to accelerate at a rapid pace. Management believes that the merger with NTI will help the Company meet the growing demands of its clients, including the ability to send mass communications via various means.

 

The merger was accounted for under the purchase method of accounting in accordance with FASB Statement No. 141, “Business Combinations” (“SFAS 141”). Assets acquired and liabilities assumed were recorded at their fair values as of January 31, 2008. The total preliminary purchase price was $187.8 million, including the estimated acquisition related transaction costs of approximately $3.0 million. Acquisition-related transaction costs include investment banking, legal and accounting fees, and other external costs directly related to the merger.

 

Preliminary Purchase Price Allocation

 

Under the purchase method of accounting, the total estimated purchase price is allocated to NTI’s net tangible and intangible assets based on their estimated fair values as of January 31, 2008. The excess of the purchase price over the net tangible and identifiable intangible assets was recorded as goodwill. The preliminary allocation of the purchase price as shown in the table below was based upon management’s preliminary valuation, which was based on estimates and assumptions that are subject to change. The areas of the purchase price allocation that are not yet finalized relate primarily to income and non-income based taxes. The preliminary estimated purchase price is allocated as follows (in thousands):

 

 

Definite-lived intangible assets of $60.3 million consist of the value assigned to NTI’s customer relationships of $42.1 million, developed and core technology of $17.4 million and trademarks of $0.8 million.

 

The value assigned to NTI’s customer relationships was determined by discounting the estimated cash flows associated with existing customers as of January 31, 2008 taking into consideration expected attrition of the existing customer base. The estimated cash flows were based on revenues for those existing customers net of operating expenses and net of contributory asset charges associated with servicing those customers. The projected revenues were based on revenue growth rates and customer renewal rates. Operating expenses were estimated based on the supporting infrastructure expected to sustain the assumed revenue growth rates. Net contributory asset charges were based on the estimated fair value of those assets that contribute to the generation of the estimated cash flows. A discount rate of 19% was deemed appropriate for valuing the existing customer base. Blackboard amortizes the value of NTI’s customer relationships proportionally to the respective discounted cash flows over an estimated useful life of five years. Customer relationships are not deductible for tax purposes.

 

The value assigned to NTI’s developed and core technology was determined by discounting the estimated future cash flows associated with the existing developed and core technologies to their present value. Developed and

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

core technology, which are comprised of products that have reached technological feasibility, includes products in NTI’s current product line. The revenue projections used to value the developed and core technology were based on estimates of relevant market sizes and growth factors, expected trends in technology and the nature and expected timing of new product introductions by NTI and its competitors. A discount rate of 19% was deemed appropriate for valuing developed and core technology and was based on the risks associated with the respective cash flows taking into consideration the Company’s weighted average cost of capital. Blackboard amortizes the developed and core technology on a straight-line basis over an estimated useful life of three years. Developed and core technology are not deductible for tax purposes.

 

The value assigned to NTI’s trademarks was determined by discounting the estimated royalty savings associated with an estimated royalty rate for the use of the trademarks to their present value. The trademarks are comprised of NTI’s trade name and various trademarks related to its existing product lines. The royalty rates used to value the trademarks were based on estimates of prevailing royalty rates paid for the use of similar trade names and trademarks in market transactions involving licensing arrangements of companies that operate in service-related industries. A discount rate of 19% was deemed appropriate for valuing NTI’s trademarks and was based on the risks associated with the respective royalty savings taking into consideration the Company’s weighted average cost of capital. Blackboard amortizes the trademarks on a straight-line basis over an estimated useful life of three years. Trademarks are not deductible for tax purposes.

 

Of the total estimated purchase price, approximately $143.1 million has been allocated to goodwill. Goodwill represents the excess of the purchase price of an acquired business over the fair value of the net tangible and intangible assets acquired. Goodwill is not deductible for tax purposes.

 

In accordance with FASB Statement No. 142, “Goodwill and Other Intangible Assets ,” goodwill will not be amortized but instead will be tested for impairment at least annually (more frequently if certain indicators are present). In the event that management determines that the goodwill has become impaired, the Company will incur an accounting charge for the amount of impairment during the fiscal quarter in which the determination is made.

 

As a result of the NTI merger, the Company recorded net deferred tax liabilities of approximately $16.8 million in its preliminary purchase price allocation. This balance is comprised primarily of approximately $24.1 million in deferred tax liabilities resulting primarily from the related intangibles identified from the merger. The deferred tax liabilities are offset by approximately $7.3 million in deferred tax assets that relate primarily to federal and state net operating losses and certain amortization and depreciation expenses.

 

Deferred Revenue

 

In connection with the preliminary purchase price allocation, the estimated fair value of the support obligation assumed from NTI in connection with the merger was determined utilizing a cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligation plus a normal profit margin. The sum of the costs and operating profit approximates the amount that the Company would be required to pay a third party to assume the support obligation. The estimated costs to fulfill the support obligation were based on the historical direct costs related to providing the support services and to correct any errors in NTI’s software products. These estimated costs did not include any costs associated with selling efforts or research and development or the related fulfillment margins on these costs. Profit associated with selling efforts is excluded because NTI had concluded the selling effort on the support contracts prior to January 31, 2008. The estimated normal profit margin was determined to be approximately 22%. As a result, in allocating the purchase price, the Company recorded an adjustment to reduce the carrying value of NTI’s January 31, 2008 deferred support revenue by approximately $10.1 million to $10.0 million which represents the Company’s estimate of the fair value of the support obligation assumed. As former NTI customers renew these support contracts, the Company will recognize revenue for the full value of the support contracts over the remaining term of the contracts, the majority of which are one year.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Pro Forma Financial Information

 

The unaudited financial information in the table below summarizes the combined results of operations of Blackboard and NTI on a pro forma basis, as though the companies had been combined as of the beginning of each of the periods presented. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition and the Company’s public offering of $165.0 million aggregate principal amount of 3.25% Convertible Senior Notes due 2027 (see Note 7) had taken place at the beginning of each of the periods presented. The pro forma financial information for all periods presented also includes amortization expense from acquired intangible assets, adjustments to interest expense, interest income and related tax effects. The three and nine months ended September 30, 2007 exclude the negative revenue impact related to the reduction of NTI’s deferred revenue balance.

 

The unaudited pro forma financial information for the nine months ended September 30, 2008 combines the historical results for Blackboard for the nine months ended September 30, 2008 and the historical results for NTI for the one month ended January 31, 2008. The unaudited pro forma financial information for the three and nine months ended September 30, 2007 combines the historical results for Blackboard for the three and nine months ended September 30, 2007 and the historical results for NTI for the same period.

 

 

 

Stock Incentive Plans

 

As of September 30, 2008, approximately 3.6 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. Awards granted under the 2004 Plan generally vest over a three to four-year period and have an eight to ten-year expiration period. On June 5, 2008, 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 5.8 million to 8.7 million. In October 2008, 1,500 stock options were granted under the 2004 Plan.

 

The compensation cost that has been recognized in the consolidated statements of operations for the Company’s stock incentive plans was $8.8 million and $11.1 million for the nine months ended September 30, 2007 and 2008, respectively. The total income tax benefit recognized in the consolidated statements of operations for stock-based compensation arrangements was $6.2 million and $1.9 million for the nine months ended September 30, 2007 and 2008, respectively. For stock subject to graded vesting, the Company has utilized the “straight-line” method for allocating compensation cost by period.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Stock Options

 

A summary of stock option activity under the Company’s stock incentive plans as of September 30, 2008, and changes during the nine months then ended are as follows (aggregate intrinsic value in thousands):

 

 

The Company has utilized the Black-Scholes valuation model to estimate the fair value of stock options during all periods. As follows are the weighted-average assumptions used in valuing the equity grants during the nine months ended September 30, 2007 and 2008 and a discussion of the Company’s inputs.

 

 

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 used a blended volatility to best estimate expected volatility for the nine months ended September 30, 2007. The blended volatility included the average of the Company’s 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. Beginning January 1, 2008, the Company used the Company’s daily historical volatility since January 1, 2006 to calculate the expected volatility.

 

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 equity grants are expected to remain outstanding. For the nine months ended September 30, 2007, the Company used the short-cut method to determine the expected life of the options as prescribed under the provisions of Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment.” Beginning January 1, 2008, as prescribed by SAB No. 107, the Company gathered more detailed historical information about specific exercise behavior of its grantees, which it used to determine the expected term. For grants that have been exercised, the Company uses actual exercise data to estimate option exercise timing within the valuation model. For grants that have not been exercised, the Company generally uses the

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

midpoint between the end of the vesting period and the contractual life of the grant to estimate option exercise timing within the valuation model. Options granted during the nine months ended September 30, 2008 have a maximum term of eight years.

 

Forfeiture rate  — This is the estimated percentage of equity grants 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, level of employee receiving the equity grant, vesting terms 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 weighted average remaining contractual life for all options outstanding under the Company’s stock incentive plans at September 30, 2008 was 6.0 years. The weighted average remaining contractual life for exercisable stock options at September 30, 2008 was 4.9 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, 2008 was $12.66 per share.

 

As of September 30, 2008, there was approximately $33.5 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.

 

Restricted Stock

 

Restricted stock is a stock award that entitles the holder to receive shares of the Company’s common stock as the award vests. A summary of restricted stock activity under the Company’s stock incentive plans as of September 30, 2008, and changes during the nine months then ended are as follows (aggregate intrinsic value in thousands):

 

 

The fair value of each restricted stock award is estimated using the intrinsic value method which is based on the closing price on the date of grant. Compensation expense for restricted stock awards is recognized ratably over the vesting period on a straight-line basis. The weighted average fair market value of restricted stock at the date of grant for awards granted during the nine months ended September 30, 2008 was $29.19.

 

As of September 30, 2008, there was approximately $1.8 million of total unrecognized compensation cost related to unvested restricted stock awards granted under the Company’s stock incentive plans. The cost is expected to be recognized through July 2012 with a weighted average recognition period of approximately 2.4 years.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The carrying amounts of inventories as of December 31, 2007 and September 30, 2008 are as follows:

 

 

 

The carrying amounts of goodwill and intangible assets as of December 31, 2007 and September 30, 2008 are as follows:

 

 

Intangible assets from acquisitions are amortized over three to five years. Amortization expense related to intangible assets resulting from acquisitions was approximately $16.4 million and $28.1 million for the nine months ended September 30, 2007 and 2008, respectively.

 

During the nine months ended September 30, 2007 and 2008, the Company capitalized $3.1 million and $2.6 million, respectively, in costs of defending and protecting patents, due to costs incurred in a suit against Desire2Learn, Inc. (“Desire2Learn”) in which the Company has alleged infringement of one of its patents. Any change in the Company’s estimates based on ongoing litigation could materially reduce the valuation of these assets. Amortization expense related to patent and related costs was approximately $0.1 million and $0.4 million for the nine months ended September 30, 2007 and 2008, respectively.

 

 

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 of $19.4 million outstanding pursuant to the borrowings under a $70.0 million senior secured credit facilities agreement with Credit Suisse (the “Credit Agreement”) and to pay all fees and expenses incurred in connection with the termination. The Company was not required to pay any prepayment premium or penalties in connection with the early termination of the Credit Agreement.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 through July 1, 2011, the first redemption date of the Notes. During the nine months ended September 30, 2008, the Company recorded total amortization expense of approximately $1.3 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 Company made interest payments of $2.8 million and $2.7 million on December 31, 2007 and July 1, 2008, respectively. 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. In accordance with the earnings per share method outlined in EITF 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share” , the diluted earnings per share effect of the shares that would be issued will be accounted for only if the average market price of the Company’s common stock price during the period is greater than the Notes’ conversion price.

 

Because the Notes contain an adjusting conversion rate provision based on the Company’s common stock price and anti-dilution adjustment provisions, at each reporting period, the Company evaluates whether any adjustments to the conversion price would alter the effective conversion rate from the stated conversion rate and result in an “in-the-money” conversion. Whenever an adjustment to the conversion rate results in a number of shares of common stock in excess of approximately 4.1 million shares under the Notes, the Company would recognize a beneficial conversion feature in the period such a determination is made and amortize it over the remaining life of the Notes. As of September 30, 2008, a beneficial conversion feature under the Notes did not exist.

 

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; (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; or (4) other events or circumstances as specifically defined in 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.

 

BLACKBOARD INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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.

 

 

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.

 

On July 26, 2006, the Company filed a complaint in the United States District Court for the Eastern District of Texas alleging that Desire2Learn infringes on U.S. Patent No. 6,988,138. On February 22, 2008, the jury returned a verdict in favor of the Company on infringement and validity. On May 7, 2008, the court entered judgment for the Company in the amount of $3.3 million plus post-judgment interest accruing at 6% per annum. On June 11, 2008, Desire2Learn paid the Company the sum of $3.3 million, which consisted of the judgment amount plus accrued interest. This amount is recorded as proceeds from patent judgment on our consolidated statements of operations for the nine months ended September 30, 2008. The parties also entered into an agreement that the Company would repay the full sum plus 6% interest within a prenegotiated time period in the event of a final, non-appealable mandate of a court that entirely disposes of the Company’s claims in the suit. Both parties have pending appeals of the final judgment at the United States Court of Appeals for the Federal Circuit.

 

On May 19, 2008, TechRadium, Inc. (“TechRadium”) filed an action in the United States District Court for the Eastern District of Texas against Blackboard Inc. and Blackboard Connect Inc. (collectively “Blackboard”) alleging that Blackboard infringes three United States patents owned by TechRadium relating to notification technologies. TechRadium seeks unspecified monetary damages, injunctive relief and other damages to which TechRadium may be entitled in law or in equity.

 

 

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; a superintendant sending mass communications via voice, email and text messages to parents and students; 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, textbook publishers, student-focused merchants, and corporate and government clients.

 

On January 31, 2008, we completed our merger with NTI pursuant to the Agreement and Plan of Merger dated January 11, 2008. Pursuant to the Agreement and Plan of Merger, we acquired all the outstanding common stock of NTI in a transaction for approximately $184.8 million, which includes $132.1 million in cash and $52.7 million in our common stock. The effective cash purchase price of NTI before transaction costs was approximately $130.5 million, net of NTI’s January 31, 2008 cash balance of approximately $1.6 million. We have included the financial results of NTI in our consolidated financial statements beginning February 1, 2008. Up to an additional 0.5 million shares in our common stock may be issued contingent on the achievement of certain performance milestones.

 

On July 26, 2006, we filed a complaint in the United States District Court for the Eastern District of Texas alleging that Desire2Learn, Inc. (“Desire2Learn”) infringes on U.S. Patent No. 6,988,138. On February 22, 2008, the jury returned a verdict in favor of us on infringement and validity. On May 7, 2008, the court entered judgment for us in the amount of $3.3 million plus post-judgment interest accruing at 6% per annum. On June 11, 2008, Desire2Learn paid us the sum of $3.3 million, which consisted of the judgment amount plus accrued interest. The parties also entered into an agreement that we would repay the full sum plus 6% interest within a prenegotiated time period in the event of a final, non-appealable mandate of a court that entirely disposes of our claims in the suit. Both parties have pending appeals of the final judgment at the United States Court of Appeals for the Federal Circuit.

 

We generate revenues from sales and licensing of products and from professional services. Our product revenues consist principally of revenues from annual software licenses, subscription fees from customers accessing our on-demand application services, 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 one of our product suites, the Blackboard Academic Suite ^tm , the Blackboard Commerce Suite ^tm and Blackboard Connect ^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 , Blackboard One ^tm , and Blackboard Connect ^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, telecommunication costs related to the Blackboard Connect product, 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 amortization of acquired technology intangibles resulting from acquisitions, which is included as amortization of intangibles acquired in acquisitions. Amortization expense related to acquired technology was $2.9 million and $4.6 million for the three months ended September 30, 2007 and 2008, respectively, and $8.7 million and $13.2 million for the nine months ended September 30, 2007 and 2008, respectively.

 

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. All of these costs are expensed as incurred.

 

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.

 

We held a common stock warrant in an entity that provides technology support services to educational institutions, including our customers, to purchase 19.9% of the shares of the entity. This common stock warrant

meets the definition of a derivative as defined by FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activity.” Other income of approximately $4.0 million was recorded in our consolidated statements of operations during the three months ended June 30, 2008 related to the fair value adjustment of the common stock warrant. On July 1, 2008, in connection with an equity transaction between this entity and a venture capital firm, we exercised approximately one-half of our warrant and sold the related shares to the venture capital firm for approximately $2.0 million and entered into an amended common stock warrant agreement in which we can purchase up to 9.9% of the shares of the entity. The fair value of the common stock warrant of approximately $2.0 million is recorded as investment in common stock warrant on our consolidated balance sheet as of September 30, 2008. We will continue to evaluate the fair value of this instrument in subsequent reporting periods and any changes in value will be recognized in the consolidated statements of operations.

 

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, fair value measures, 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, subscription fees from customers accessing our on-demand application services, 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 (“VSOE”) of fair value for our support and maintenance separate from our software for the majority of our products. 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. When licenses of certain offerings are sold in conjunction with our support and maintenance where we do have VSOE, we recognize the license revenue upon delivery of the license and recognize the support and maintenance 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.” Accordingly, we recognize hosting fees and set-up fees ratably over the term of the hosting agreement.

 

Our sales arrangements may include professional services sold separately under professional services agreements that include training and consulting services. Revenues from these arrangements are accounted for separately from the license revenue because they meet the criteria for separate accounting, as defined in SOP 97-2. The more significant factors considered in determining whether revenue should be accounted for separately include the nature of the professional services, such as consideration of whether the professional services are essential to the functionality of the licensed product, degree of risk, availability of professional services from other vendors and timing of payments. Professional services that are sold separately from license revenue are recognized as the professional services are performed on a time-and-materials basis.

 

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.

 

Fair Value Measurements.   As of January 1, 2008, we adopted the Financial Accounting Standards Board (“FASB”) Statement No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a fair value hierarchy for assets and liabilities measured at fair value and expands required disclosure about fair value measurements. The FAS 157 hierarchy ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value and requires financial assets and liabilities carried at fair value to be classified and disclosed in one of the following three categories:

 

Level 1 — quoted prices in active markets for identical assets and liabilities

 

Level 2 — inputs other than Level 1 quoted prices that are directly or indirectly observable

 

Level 3 — unobservable inputs that are not corroborated by market data

 

We evaluate assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level to classify them for each reporting period. This determination requires significant judgments to be made by us.

 

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 FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We evaluate these assets by examining estimated future cash flows to determine if their current recorded value is impaired. We evaluate these cash flows by using weighted probability techniques as well as comparisons of past performance against projections. Assets may also be evaluated by identifying independent market values. If we determine that an asset’s carrying value is impaired, we will record a write-down of the carrying value of the identified asset and charge the impairment as an operating expense in the period in which the determination is made. Although we believe that the carrying values of our long-lived assets are appropriately stated, changes in strategy or market

conditions or significant technological developments could significantly impact these judgments and require adjustments to recorded asset balances.

 

Goodwill and intangible assets.   As the result of acquisitions, any excess purchase price over the net tangible and identifiable intangible assets acquired is 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 FASB Statement 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.

 

The costs of defending and protecting patents are capitalized. All costs incurred prior to filing a patent application are expensed as incurred.

 

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 or benefit includes U.S. federal, state and local and foreign income taxes and is based on pre-tax income or loss. The 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 and foreign income taxes and our ability to use tax credits and net operating loss carryforwards. All tax years since 1998 are subject to examination.

 

We follow the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 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. We recognize interest and penalties related to income tax matters in income tax expense. As a result of the implementation of FIN 48 on January 1, 2007, we recognized an increase of $0.6 million in the unrecognized tax benefit liability, which was accounted for as an increase to the January 1, 2007 accumulated deficit balance. All of our unrecognized tax benefit liability would affect our effective tax rate if recognized. Prior to adoption of FIN 48, accruals for tax contingencies were provided for in accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies.” Although we believe we had appropriate support for the positions taken on our tax returns for those years, we had recorded a liability for its best estimate of the probable loss on certain of those positions. We do not expect our unrecognized tax benefit liability to change significantly over the next 12 months. All tax years since 1998 are subject to examination.

 

Stock-Based Compensation.   We account for stock-based compensation expense in accordance with FASB Statement No. 123 (revised 2005), “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires the measurement and recognition of compensation expense for share-based awards based on estimated fair values on the date of grant. We estimate the fair value of each option-based award on the date of grant using the Black-Scholes option-pricing

model. This model is affected by our stock price, as well as estimates regarding a number of variables including expected stock price volatility over the term of the award and projected employee stock option exercise behaviors.

 

Recent Accounting Pronouncements.   In December 2007, the FASB issued Statement No. 141(R), a revised version of FASB Statement No. 141, “Business Combinations”. The revision is intended to simplify existing guidance and converge rulemaking under U.S. generally accepted accounting principles with international accounting rules. This statement applies prospectively to business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is prohibited. We are currently evaluating the impact of the provisions of the revision on our consolidated results of operations and financial condition.

 

In December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests. This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. We do not believe that the provisions of SFAS 160 will have a material impact on our consolidated results of operations and financial condition.

 

In February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 deferred the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. We are currently evaluating the impact of FSP 157-2 for nonfinancial assets and nonfinancial liabilities on our consolidated results of operations and financial condition.

 

In October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active” (“FSP 157-3”). FSP 157-3 provides guidance for determining the fair value of a financial asset in an inactive market. The adoption of FSP 157-3 did not have a significant impact on our consolidated results of operations and financial condition.

 

In May 2008, the FASB issued Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion.” (“APB 14-1”). APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period. We are currently evaluating the impact of the provisions of APB 14-1 on our consolidated results of operations and financial condition.

 

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.

 

Results of Operations

 

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

 

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007

 

Our total revenues for the three months ended September 30, 2008 were $83.1 million, representing an increase of $21.5 million, or 35.0%, as compared to $61.6 million for the three months ended September 30, 2007.

 

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, 2008 were $74.3 million, representing an increase of $20.3 million, or 37.7%, as compared to $54.0 million for the three months ended September 30, 2007. Recurring ratable product revenues increased by $19.2 million, or 42.5%, for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007. This increase was primarily due to a $10.2 million increase in revenues recognized for subscription fees from customers accessing our on-demand application services primarily related to Blackboard Connect , which we acquired from NTI in January 2008. The increase was also due to a $6.0 million increase in revenues from Blackboard Learning System enterprise licenses, which was attributable to current and prior period sales to new and existing clients, 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 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 remaining increase in recurring ratable product revenues primarily resulted from a $2.5 million increase in hosting revenues.

 

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

 

The increase in other product revenues was primarily due to an increase in sales related to certain of our content management software products offset in part by a decrease in sales of certain third-party software and hardware products.

 

Of our total revenues, our total international revenues for the three months ended September 30, 2008 were $15.5 million, representing an increase of $2.3 million, or 17.5%, as compared to $13.2 million for the three months ended September 30, 2007. International product revenues, which consist primarily of recurring ratable product revenues, were $14.2 million for the three months ended September 30, 2008, representing an increase of $2.3 million, or 18.8%, as compared to $11.9 million for the three months ended September 30, 2007. The increase in international recurring ratable product revenues was primarily due to an increase in international revenues from Blackboard Academic Suite enterprise 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, 2008 were $8.8 million, representing an increase of $1.2 million, or 15.7%, as compared to $7.6 million for the three months ended September 30, 2007. 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, 2008 were 10.5% as compared to 12.3% for the three months ended September 30, 2007. This decrease in professional service revenues as a percentage of total revenues is primarily due to the increase in product revenues.

 

Cost of product revenues.   Our cost of product revenues for the three months ended September 30, 2008 was $19.6 million, representing an increase of $7.6 million, or 64.2%, as compared to $12.0 million for the three months ended September 30, 2007. The increase in cost of product revenues was primarily due to $3.4 million in expenses incurred related to our Blackboard Connect product, including related telecommunication costs, and a $1.9 million increase in expenses related to hosting services due to the increase in the number of clients contracting for new hosting services or existing clients expanding their existing hosting arrangements. The remaining increase is primarily due to increases in our technical support expenses associated with increased headcount and personnel costs to support increase in licenses held by new and existing clients. Cost of product revenues as a percentage of product revenues increased to 26.4% for the three months ended September 30, 2008 from 22.1% for the three months ended September 30, 2007. This decrease in product revenues margin is due primarily to the fair value adjustment to the acquired NTI deferred revenue balances recorded in purchase accounting.

 

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 $2.9 million and $4.6 million for the three months ended September 30, 2007 and 2008, respectively. Cost of product revenues, including amortization of acquired technology, as a percentage of product revenues was 32.6% for the three months ended September 30, 2008 as compared to 27.6% for the three months ended September 30, 2007. This increase relates to the increase in amortization expense resulting from the NTI merger and the fair value adjustment to the acquired NTI deferred revenue balances.

 

Cost of professional services revenues.   Our cost of professional services revenues for the three months ended September 30, 2008 was $5.0 million, representing an increase of $0.6 million, or 12.6%, as compared to $4.4 million for the three months ended September 30, 2007. The increase in cost of professional services revenues margin was primarily attributable to an increase in personnel-related costs due to higher average headcount during the three months ended September 30, 2008 as compared to the three months ended September 30, 2007. Cost of professional services revenues as a percentage of professional services revenues decreased to 57.0% for the three months ended September 30, 2008 from 58.6% for the three months ended September 30, 2007. The increase in professional services revenues margin was primarily attributable to an increase in professional services revenues from new professional service engagements in current and prior periods.

 

Research and development expenses.   Our research and development expenses for the three months ended September 30, 2008 were $10.5 million, representing an increase of $3.6 million, or 51.8%, as compared to $6.9 million for the three months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

 

Sales and marketing expenses.   Our sales and marketing expenses for the three months ended September 30, 2008 were $24.1 million, representing an increase of $5.9 million, or 32.2%, as compared to $18.2 million for the three months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

 

General and administrative expenses.   Our general and administrative expenses for the three months ended September 30, 2008 were $12.7 million, representing an increase of $2.3 million, or 22.5%, as compared to $10.4 million for the three months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

Net interest expense.   Our net interest expense for the three months ended September 30, 2008 was $1.5 million, representing an increase of $2.0 million, or 391.8%, as compared to net interest income of $0.5 million for the three months ended September 30, 2007. This increase was primarily attributable to higher interest income earned on higher average cash and cash equivalents balances during 2007 as compared to 2008 resulting from proceeds received in connection with the 3.25% Convertible Senior Notes due 2027 (the “Notes”) issued in June 2007, a portion of which was used to fund the NTI merger during 2008. The further decrease in interest income was due to lower interest yields on our cash and cash equivalent balances during the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 due to the economic disruption experienced in the U.S. and globally.

 

Other income (expense).   Our other expense for the three months ended September 30, 2008 was $0.2 million, representing a decrease of $1.2 million, or 122.8%, as compared to other income of $1.0 million for the three months ended September 30, 2007 and pertains to the remeasurement of our foreign subsidiaries ledgers, which are maintained in the respective subsidiary’s local foreign currency, into the U.S. dollar. During the three months ended September 30, 2007, we recognized a translation gain primarily related to our wholly-owned Canadian subsidiary as a result of the favorable change in the exchange rate of the Canadian dollar into the U.S. dollar.

 

Provision (benefit) for income taxes.   Our benefit for income taxes for the three months ended September 30, 2008 was $2.4 million as compared to our provision for income taxes of $2.4 million for the three months ended September 30, 2007. This benefit for income taxes was due to the mix of domestic and international earnings and losses generated by our subsidiaries.

 

Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007

 

Our total revenues for the nine months ended September 30, 2008 were $227.1 million, representing an increase of $50.9 million, or 28.9%, as compared to $176.2 million for the nine months ended September 30, 2007.

 

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, 2008 were $205.8 million, representing an increase of $49.5 million, or 31.7%, as compared to $156.3 million for the nine months ended September 30, 2007. Recurring ratable product revenues increased by $45.8 million, or 34.9%, for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007. This increase was primarily due to a $20.9 million increase in revenues recognized for subscription fees from customers accessing our on-demand application services primarily related to Blackboard Connect , which we acquired from NTI in January 2008. The increase was also due to a $16.4 million increase in revenues from Blackboard Learning System enterprise licenses which was attributable to current and prior period sales to new and existing clients, 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 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

remaining increase in recurring ratable product revenues primarily resulted from an $8.5 million increase in hosting revenues.

 

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

 

The increase in other product revenues was primarily due to an increase in sales related to certain of our content management software products offset in part by a decrease in sales of certain third-party software and hardware products.

 

Of our total revenues, our total international revenues for the nine months ended September 30, 2008 were $44.8 million, representing an increase of $6.2 million, or 16.1%, as compared to $38.6 million for the nine months ended September 30, 2007. International product revenues, which consist primarily of recurring ratable product revenues, were $41.2 million for the nine months ended September 30, 2008, representing an increase of $6.4 million, or 18.4%, as compared to $34.8 million for the nine months ended September 30, 2007. The increase in international recurring ratable product revenues was primarily due to an increase in international revenues from Blackboard Academic Suite enterprise 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, 2008 were $21.3 million, representing an increase of $1.3 million, or 6.6%, as compared to $20.0 million for the nine months ended September 30, 2007. The increase in professional services revenues 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, 2008 were 9.4% as compared to 11.3% for the nine months ended September 30, 2007. This decrease in professional service revenues as a percentage of total revenues is primarily due to the increase in product revenues.

 

Cost of product revenues.   Our cost of product revenues for the nine months ended September 30, 2008 was $53.6 million, representing an increase of $18.0 million, or 50.5%, as compared to $35.6 million for the nine months ended September 30, 2007. The increase in cost of product revenues was primarily due to $9.1 million in expenses incurred related to our Blackboard Connect product, including related telecommunication costs, and a $5.2 million increase in expenses related to hosting services due to the increase in the number of clients contracting for new hosting services or existing clients expanding their existing hosting arrangements. The remaining increase is primarily due to increases in our technical support expenses associated with increased headcount and personnel costs to support increase in licenses held by new and existing clients. Cost of product revenues as a percentage of product revenues increased to 26.0% for the nine months ended September 30, 2008 from 22.8% for the nine months ended September 30, 2007. This decrease in product revenues margin is due primarily to the fair value adjustment to the acquired NTI deferred revenue balances.

 

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 $8.7 million and $13.2 million for the nine months ended September 30, 2007 and 2008, respectively. Cost of product revenues, including amortization of acquired technology, as a percentage of product revenues was 32.5% for the nine months ended September 30, 2008 as compared to 28.3% for the nine months ended September 30, 2007. This increase relates to the increase in amortization expense resulting from the NTI merger and the fair value adjustment to the acquired NTI deferred revenue balances.

 

Cost of professional services revenues.   Our cost of professional services revenues for the nine months ended September 30, 2008 was $15.1 million, representing an increase of $2.8 million, or 22.2%, as compared to $12.3 million for the nine months ended September 30, 2007. The increase in cost of professional services revenues was primarily attributable to an increase in personnel-related costs due to higher average headcount during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007. Cost of professional services revenues as a percentage of professional services revenues increased to 70.8% for the nine months ended September 30, 2008 from 61.8% for the nine months ended September 30, 2007. The decrease in professional

services revenues margin was primarily attributable to the increase in costs and a decrease in new professional service engagements in prior periods.

 

Research and development expenses.   Our research and development expenses for the nine months ended September 30, 2008 were $30.2 million, representing an increase of $9.4 million, or 44.9%, as compared to $20.8 million for the nine months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

 

Sales and marketing expenses.   Our sales and marketing expenses for the nine months ended September 30, 2008 were $67.7 million, representing an increase of $18.3 million, or 37.0%, as compared to $49.4 million for the nine months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

 

General and administrative expenses.   Our general and administrative expenses for the nine months ended September 30, 2008 were $37.9 million, representing an increase of $9.7 million, or 34.3%, as compared to $28.2 million for the nine months ended September 30, 2007. This increase was primarily attributable to increased personnel-related costs due to higher average headcount during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 primarily due to the increased headcount following the NTI merger.

 

Proceeds from patent judgment.   Our operating expenses were reduced during the nine months ended September 30, 2008 due to the $3.3 million payment from Desire2Learn on June 11, 2008 in satisfaction of the judgment amount plus accrued interest arising from the patent litigation between us and Desire2Learn.

 

Net interest expense.   Our net interest expense for the nine months ended September 30, 2008 was $4.1 million, representing an increase of $3.6 million, or 706.8%, as compared to $0.5 million for the nine months ended September 30, 2007. Interest expense recorded during the nine months ended September 30, 2008 included nine months of expense which resulted from the 3.25% Convertible Senior Notes due 2027 (the “Notes”) issued in June 2007 as compared to the nine months ended September 30, 2007 which included approximately three months of expense which resulted from the Notes. Additionally, this increase was attributable to interest income earned on higher average cash and cash equivalents balances during 2007 as compared to 2008 resulting from proceeds received in connection with the Notes, a portion of which was used to fund the NTI merger during 2008. The further decrease in interest income was due to lower interest yields on our cash and cash equivalent balances during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 due to the economic disruption experienced in the U.S. and globally.

 

Other income.   Our other income for the nine months ended September 30, 2008 was $3.9 million, representing an increase of $1.9 million, or 95.8%, as compared to other income of $2.0 million for the nine months ended September 30, 2007. As of September 30, 2008, we held a common stock warrant in an entity that provides technology support services to educational institutions, including our customers, to purchase 19.9% of the shares of the entity. Other income of approximately $4.0 million was recorded during the nine months ended September 30, 2008 related to the fair value adjustment of the common stock warrant. In connection with an equity transaction between this entity and a venture capital firm, we exercised approximately one-half of our warrant and sold the related shares to the venture capital firm for approximately $2.0 million on July 1, 2008. The fair value of the common stock warrant of approximately $2.0 million is recorded as investment in common stock warrant on our consolidated balance sheet as of September 30, 2008. On July 1, 2008, we entered into an amended common stock warrant agreement in which we can purchase up to 9.9% of the shares of the entity. We will continue to evaluate the fair value of this instrument in subsequent reporting periods and any changes in value will be recognized in the consolidated statements of operations.

 

The remaining change in other income is related to the remeasurement of our foreign subsidiaries ledgers, which are maintained in the respective subsidiary’s local foreign currency, into the U.S. dollar. During the nine months ended September 30, 2007, we recognized a translation gain primarily related to our wholly-owned Canadian subsidiary as a result of the favorable change in the exchange rate of the Canadian dollar into the U.S. dollar.

(Provision) benefit for income taxes.   Our benefit for income taxes for the nine months ended September 30, 2008 was $2.2 million as compared to our provision for income taxes of $6.2 million for the nine months ended September 30, 2007. This change was due to our loss before benefit for income taxes during the nine months ended September 30, 2008 as compared to our income before provision for income taxes during the nine months ended September 30, 2007. Further, the benefit for income taxes for the nine months ended September 30, 2008 was due to the mix of domestic and international earnings and losses generated by our subsidiaries.

 

Liquidity and Capital Resources

 

Our cash and cash equivalents were $118.7 million at September 30, 2008 as compared to $206.6 million at December 31, 2007. The decrease in cash and cash equivalents was primarily due to the payment of the cash portion of the consideration in the NTI merger we completed on January 31, 2008. Pursuant to the Agreement and Plan of Merger, we acquired all the outstanding common stock of NTI in a transaction for approximately $184.8 million, which includes $132.1 million in cash and $52.7 million in our common stock, or approximately 1.5 million shares of our common stock. The effective cash portion of the purchase price of NTI before transaction costs was approximately $130.5 million, net of NTI’s January 31, 2008 cash balance of approximately $1.6 million. We have included the financial results of NTI in our consolidated financial statements beginning February 1, 2008. Up to an additional 0.5 million shares in our common stock may be issued contingent on the achievement of certain performance milestones.

 

Cash and cash equivalents consist of highly liquid investments, which are readily convertible into cash, have original maturities of six months or less, and are generally issued or backed by the U.S. Treasury.

 

Net cash provided by operating activities was $55.4 million during the nine months ended September 30, 2008 as compared to $39.8 million during the nine months ended September 30, 2007. This change for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 was due in part to the $3.3 million in proceeds from the patent judgment against Desire2Learn. Further, accounts receivable increased $41.8 million during the nine months ended September 30, 2008, net of the impact of acquired receivables related to the NTI merger, due to an increase in invoicing associated with sales to new and existing clients and an increased number of renewing licenses during the third quarter of 2008 as compared to the fourth quarter of 2007. This increase was expected and was due to seasonal variations in our business due to the timing of our clients’ budget cycles and the renewal dates for our existing clients’ annual licenses. Amortization of intangibles resulting from acquisitions increased to $28.1 million during the nine months ended September 30, 2008 related to the amortization of identified intangibles resulting from the NTI merger. We recognize revenues on annually renewable agreements, which results in deferred revenues. Deferred revenues increased $51.9 million during the nine months ended September 30, 2008, net of the impact of acquired deferred revenues related to the NTI merger, 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 $156.4 million during the nine months ended September 30, 2008 as compared to $15.7 million during the nine months ended September 30, 2007. During the nine months ended September 30, 2008, we paid $133.0 million for acquisitions which primarily related to the NTI merger and excludes certain NTI merger costs that were paid in 2007. During the nine months ended September 30, 2008, cash expenditures for purchases of property and equipment were $22.3 million, which represents approximately 9.8% of total revenues, and we made $3.1 million in payments related to patent enforcement costs. Cash expenditures for purchases of property and equipment include payments related to the build-out of our new global corporate headquarters in Washington, DC which we occupied at the end of June 2008. On July 1, 2008, we received $2.0 million in proceeds related to our sale of shares upon exercise of a common stock warrant we held in an entity.

 

Net cash provided by financing activities was $13.2 million during the nine months ended September 30, 2008 as compared to $153.1 million during the nine months ended September 30, 2007. The decrease was due primarily to the issuance of $165 million of our 3.25% Convertible Senior Notes during the nine months ended September 30, 2007, described below. During the nine months ended September 30, 2008, we received $10.7 million in proceeds from exercise of stock options as compared to $11.2 million during the nine months ended September 30, 2007.

 

In June 2007, we issued and sold the 3.25% Convertible Senior Notes due 2027 (the “Notes”) in a public offering. We used a portion of the proceeds to terminate and satisfy in full our existing indebtedness outstanding of $19.4 million

pursuant to the senior secured credit facilities agreement, which we entered into in connection with our acquisition of WebCT, Inc. (“WebCT”) in 2006, 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 through July 1, 2011, the first redemption date under the Notes. During the nine months ended September 30, 2008, we recorded total amortization expense of approximately $1.3 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. We made a $2.7 million interest payment on July 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. In accordance with the earnings per share method outlined in EITF 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share” , the diluted earnings per share effect of the shares that would be issued will be accounted for only if the average market price of our common stock price during the period is greater than the Notes’ conversion price.

 

Because the Notes contain an adjusting conversion rate provision based on our common stock price and anti-dilution adjustment provisions, at each reporting period, we evaluate whether any adjustments to the conversion price would alter the effective conversion rate from the stated conversion rate and result in an “in-the-money” conversion. Whenever an adjustment to the conversion rate results in a number of shares of common stock in excess of approximately 4.1 million shares under the Notes, we would recognize a beneficial conversion feature in the period such a determination is made and amortize it over the remaining life of the Notes. As of September 30, 2008, a beneficial conversion feature under the Notes did not exist.

 

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 our 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; (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 our common stock and the then applicable conversion rate of the Notes; or (4) other events or circumstances as specifically defined in 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. From time to time we may use our existing cash to repurchase shares of our common stock, outstanding indebtedness or other outstanding securities. Any such repurchases would depend on market conditions, the market price of our common stock, and management’s assessment of our liquidity and cash flow needs.

 

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.

 

 

Interest income on our cash and cash equivalents is subject to interest rate fluctuations. For the quarter ended September 30, 2008, a one percentage point decrease in interest rates would have reduced our interest income by approximately $0.2 million.

 

We have accounts on our foreign subsidiaries’ ledgers which are maintained in the respective subsidiary’s local foreign currency and remeasured into the U.S. dollar. As a result, we are exposed to movements in the exchange rates of various currencies against the U.S. dollar and against the currencies of other countries in which we sell products and services including the Canadian dollar, Euro, British pound, Japanese yen, Australian dollar and others. Because of such foreign currency exchange rate fluctuations, other expense of $0.2 million was recorded during the quarter ended September 30, 2008. For the quarter ended September 30, 2008, a one percentage point adverse change in these various exchange rates into the U.S. dollar as of September 30, 2008 would not have had a material effect on the consolidated results of operations and financial condition.

 

 

 

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2008. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports 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, 2008, 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.

 

 

No changes 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, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

On May 19, 2008, TechRadium, Inc. (“TechRadium”) filed an action in the United States District Court for the Eastern District of Texas against Blackboard Inc. and Blackboard Connect Inc. (collectively “Blackboard”) alleging that Blackboard infringes three United States patents owned by TechRadium relating to notification technologies. Specifically, TechRadium alleges that Blackboard infringes on TechRadium’s U.S. patents 7,130,389, 7,174,005, and 7,362,852. TechRadium seeks unspecified monetary damages, injunctive relief and other damages to which TechRadium may be entitled in law or in equity.

 

 

We describe our business risk factors below. This description includes any material changes to and supersedes the description of the risk factors previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

 

Our merger with The NTI Group, Inc. (“NTI”) presents many risks, and we may not realize the financial and strategic goals that were contemplated at the time of the transaction.

 

We completed the merger with NTI on January 31, 2008. We entered into this transaction with the expectation that it would result in various long-term benefits including 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 NTI 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, if any, acquired in any acquisitions 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 3.25% Convertible Senior Notes due 2027 (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 or a combination of cash and our common stock on July 1, 2011, July 1, 2017 or 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.

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, has changed.

 

In May 2008, the FASB issued new guidance which requires certain components of convertible debt instruments, like the Notes, to be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate. This will result in additional non-cash interest expense over the period the Notes are expected to be outstanding. The new guidance is effective for us beginning January 1, 2009. Retrospective application to all financial periods presented in our financial statements is required. This change will have an adverse impact to our previous financial results and will contribute to volatility in future financial results. We are currently evaluating the impact on our consolidated results of operations and financial condition.

 

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 for some of our products 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. If our newest products, the Blackboard Outcomes System and Blackboard Connect , do not gain widespread market acceptance, our financial results could suffer. We introduced our newest software application, the Blackboard Outcomes System , in December 2006 and acquired the technology underlying Blackboard Connect through our merger with NTI in January 2008. Our ability to grow our business will depend, in part, on client acceptance of these products. If we are not successful in gaining market acceptance of these products, our revenues may fall below our expectations. In addition, the economic disruption experienced in the U.S. and globally during the second half of 2008 and any continuing unfavorable changes in economic conditions may result in lower overall spending, including information technology spending, by our current and potential clients, and adversely affect our consolidated results of operations and financial condition. Our client base is diverse and each component faces a unique set of risks, including, for example, the possibility of state and local budget cuts for K-12 institutions or reduced enrollment in higher education, which may affect our revenues and our ability to grow our business. If the economic downturn is prolonged, we may have difficulty in establishing a market for our new products and our new products may not gain market acceptance as a result.

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, content management, transaction systems and mass notification 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. Our competitors for Blackboard Connect include a variety of competitors which provide mass notification technologies including voice, email and/or text messaging communications.

 

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. Similarly, our competitors may also be acquired by larger and more well-funded companies which have more resources than our current competitors. These larger companies 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, in particular our Blackboard Academic Suite 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. Following acquisitions in which clients are contracted under renewable licenses, such as WebCT and NTI, for several years after such acquisitions we may experience a decrease in the renewal rate from historical levels which could reduce revenues 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, new product releases are delayed or our services are disrupted, 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. In addition, service offerings which we provide may be disrupted causing delays or interruptions in the services provided to our clients. Significant errors in our products or disruptions in the provision of our services could lead to:

 

 

 

Because our clients use our products to store, retrieve and utilize critical information, we may be subject to significant liability claims if our products do not work properly or if the provision of our services is disrupted. Such an event could result in significant expenses, disrupt sales and affect our reputation and that of our products. 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, and our insurance may not cover all or any of the claims. 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. In light of the economic disruption experienced in the U.S. and globally during the second half of 2008, we have experienced some lengthening of sales cycles and, depending on the future economic climate, may see a continuation of this trend. Our client base is diverse and each component faces a unique set of risks, including, for example, the possibility of state and local budget cuts for K-12 institutions or reduced enrollment in higher education, which may affect our revenues and our ability to grow our business. If the economic downturn worsens or is prolonged, our clients and prospective clients may defer or cancel their purchases with us which would negatively impact our consolidated results of operations and financial condition.

 

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.

 

The investment of our cash balances are subject to risks which may cause losses and affect the liquidity of these investments.

 

We hold our cash in a variety of marketable investments denominated in U.S. dollars which are generally investment grade, liquid, short-term fixed-income securities, money market instruments and issued or backed by the U.S. Treasury. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to further write down the value of our investments, which could materially harm our results of operations and financial condition. With the current unstable credit environment, we might incur significant realized, unrealized or impairment losses associated with these investments.

 

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 in connection with our acquisitions of WebCT and NTI. 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 may become more common. Any claims, including the TechRadium action described above, 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 services, could cause us to lose clients and sales to potential 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 services 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 various locations in the United States, The Netherlands and Australia. 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. Certain of our co-location facilities are served by data backup redundancy at other facilities. 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 clients may terminate their contracts or elect not to renew them, and we may lose sales to potential 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. In light of the

economic disruption experienced in the U.S. and globally during the second half of 2008, our clients may have budgetary impacts arising out of such disruption, which may have a negative impact on sales of our products. Any continuing unfavorable changes in economic conditions may result in budget cuts and lead to lower overall spending, including information technology spending, by our current and potential clients, and adversely affect our consolidated results of operations and financial condition. A prolonged economic downturn may impact both new sales and renewals of our products by our clients if their budgets are impacted by economic conditions.

 

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.

 

 

(a) Exhibits:

 

 

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 5, 2008

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