10-Q 1 y83536e10vq.txt EDISON SCHOOLS INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2002 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 000-27817 EDISON SCHOOLS INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 13-3915075 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 521 Fifth Avenue, 11th Floor, New York, NY 10175 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (212) 419-1600 Former name, former address and former fiscal year, if changed since last report 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. (1) Yes X No (2) Yes X No The number of shares outstanding of each of the Registrant's classes of common stock: 50,807,855 (Number of shares of Class A Common Stock Outstanding as of January 31, 2003) 1,805,132 (Number of shares of Class B Common Stock Outstanding as of January 31, 2003) EDISON SCHOOLS INC. INDEX TO QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 2002

2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS EDISON SCHOOLS INC. CONDENSED CONSOLIDATED BALANCE SHEETS -UNAUDITED (DOLLARS IN THOUSANDS)

The accompanying notes are an integral part of these condensed consolidated financial statements. 3 EDISON SCHOOLS INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED FOR THE THREE AND SIX MONTHS ENDED DECEMBER 31, 2002 AND 2001 (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)

The accompanying notes are an integral part of these condensed consolidated financial statements. 4 EDISON SCHOOLS INC. CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS - UNAUDITED FOR THE SIX MONTHS ENDED DECEMBER 31, 2002 AND 2001 (DOLLARS IN THOUSANDS)

The accompanying notes are an integral part of these condensed consolidated financial statements. 5 EDISON SCHOOLS INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The unaudited condensed consolidated financial statements have been prepared by Edison Schools Inc. (the "Company") in accordance with generally accepted accounting principles ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments, consisting of normal recurring items necessary to present fairly the financial position and results of operations have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules and regulations. These financial statements should be read in conjunction with the financial statements and related notes included in the Company's Annual Report on Form 10-K/A for the year ended June 30, 2002. The June 30, 2002 financial statements shown in the condensed consolidated financial statements in this Form 10-Q were derived from the audited financial statements included in the Company's Form 10-K/A filed on October 02, 2002. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include revenues, certain district paid school expenses, recoverability of long-lived assets and notes receivable, liabilities incurred from workers' compensation, commercial and other claims and losses on school contracts. Other estimates include useful lives of property and equipment and the valuation allowance on deferred income taxes. Actual results could differ from these estimates. Because new schools are opened in the first fiscal quarter of each year, trends in the Company's business, whether favorable or unfavorable, will tend not to be reflected in the Company's quarterly financial results, but will be evident primarily in year-to-year comparisons. The first quarter of our fiscal year has historically reflected less revenue and lower expenses than the other three quarters. The Company generally has a lower gross site margin in the first fiscal quarter than in the remaining fiscal quarters. The Company also recognizes pre-opening costs primarily in the first and fourth quarters. Summer school revenues and expenses are also recognized in the first and fourth quarters. Since inception, the Company has incurred losses from operations and has had negative cash flow from operations. The cash needs of the business have been financed through a combination of debt and equity financing. In the first quarter of fiscal 2003, the Company entered into additional financings (see Note 5). The Company's principal revolving credit facility matures in July 2003. The Company plans to refinance certain of its debt in the third quarter of fiscal 2003. In order to achieve its operating plan in fiscal year 2003, the Company has begun to improve the gross site contribution margins at the individual schools it manages while maintaining education quality and continuing to reduce operating expenses as a percentage of net revenue. The Company continues its "reengineering" process to increase efficiency and help attain profitability while improving client service. Part of this initiative includes the streamlining of processes within the Company, reductions in personnel and the implementation of cost control measures. In addition to the above, the Company is dependent upon the continuation of its school management agreements for recurring revenues and growth. Some of the management agreements may be terminated at will by the school district or charter board. The Company may also seek the early termination of, or not seek to renew, a limited number of management agreements in any year. The Company's ability to meet its operating plan for fiscal 2003 is dependent upon the management actions described above. If the Company is unable to meet its operating plan, it may not be able to meet the terms of the financings discussed above, resulting in the borrowings becoming due. If this were to occur, the Company may be forced to restructure or refinance its indebtedness, seek additional equity capital, sell assets or reduce its growth plan. The Company cannot be certain that it will be able to obtain additional financing on favorable terms, if at all. 6 2. DESCRIPTION OF BUSINESS The Company manages elementary and secondary public schools under contracts with school districts and charter schools located in 22 states, and Washington, D.C. The Company opened its first four schools in the fall of 1995 and, as of December 31, 2002, is operating 149 schools with approximately 80,000 students. The Company provides the education program, recruits and manages personnel, and maintains and operates the facilities at each school it manages. The Company also assists charter schools in obtaining facilities and related financing for such facilities. As compensation for its services, the Company earns gross student funding comparable to the funding spent on other public schools in the school district in which the school is located. 3. RECENTLY ISSUED ACCOUNTING STANDARDS In June 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("FAS 146"). FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred rather than at the date of a commitment to an exit or disposal plan. Costs covered by FAS 146 include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing or other exit or disposal activity. FAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 clarifies the accounting for, and disclosure of, the issuance of certain types of guarantees. The Company has not issued or modified any guarantees affected by FIN 45. In December 2002, the FASB issued FAS 148, " Accounting For Stock Based Compensation - Transition And Disclosure - An Amendment of FAS 123." FAS 148 does not change the provisions of FAS 123 that permit the Company to continue to apply the intrinsic value method of APB 25, "Accounting For Stock Issued To Employees" ("APB 25"). Under FAS 148, companies that choose to adopt the accounting provisions of FAS 123 may choose from three transition methods: the prospective method, modified prospective method and retroactive restatement method. The Company continues to account for stock compensation under APB 25, and therefore under FAS 148 will be required to disclose the net income and earnings per share (basic and diluted), the compensation expense net of tax included in net income, compensation that would have been included in net income had the company adopted FAS 123 for all awards granted, modified or settled since December 14, 1994 and pro forma net income and earnings per share beginning with the quarter ending March 31, 2003. The Company is currently assessing the impact of this statement. 4. NET LOSS PER SHARE In accordance with FAS 128, "Earnings per Share", basic earnings per share is computed using the weighted-average number of common shares outstanding during the period. Diluted earnings per share is computed using the weighted-average number of common and common stock equivalent shares outstanding during the period. Common stock equivalent shares, such as convertible preferred stock, stock options, and warrants, have been excluded from the computation, as their effect is antidilutive for all periods presented. The calculations of basic and fully diluted net loss per share for the three and six-month periods ended December 31, 2002 and 2001 are as follows (in thousands, except for per share amounts): 7

5. FINANCING On October 3, 2001, the Company formed Edison Receivables Company LLC ("Edison Receivables"), for the purpose of purchasing and financing certain receivables of the Company. The Company owns all of the membership interests in Edison Receivables, a Delaware limited liability company with a separate legal existence from the Company. The Company has sold or contributed certain accounts receivable arising from the Company's provision of school management services in the ordinary course of its business and related security to Edison Receivables. Edison Receivables has its own separate creditors who are entitled to be satisfied out of Edison Receivables' assets prior to any value in it becoming available to the Company. The Company has no right, title or interest in Edison Receivables' assets, including the accounts receivable assigned to it by the Company. In November 2001, Edison Receivables entered into a $35.0 million revolving credit facility with Merrill Lynch Mortgage Capital Inc. ("MLMCI"), collateralized by certain accounts receivable purchased from or contributed by the Company. Borrowings are limited to specified percentages of eligible accounts receivable, as defined. The line of credit had a term of one year. Interest is determined on a Eurodollar or prime rate basis at the Company's option. The Company has agreed to pay a commitment fee of .50% per annum on the unused portion of the commitment. On July 31, 2002, the revolving credit agreement with MLMCI was amended to add School Services, LLC ("School Services") as an additional lender and MLMCI as agent of the lenders, increase the line to $55.0 million, and extend the term of the agreement and the line of credit provided thereunder to June 30, 2003. The agreement and the line of credit were subsequently extended to July 15, 2003. As of December 31, 2002, $49.3 million was outstanding under this line of credit bearing interest at LIBOR plus 8.7% and was collateralized by receivables of $79.2 million that were sold in a true sale to Edison Receivables by the Company. The agreement requires the Company to observe certain financial covenants and restrictions including a minimum consolidated tangible net worth and a maximum consolidated debt to equity ratio. In addition, the Company separately entered into a Credit and Security Agreement, dated as of July 31, 2002, with School Services, pursuant to which the Company had the right to borrow up to $20.0 million, at an interest rate of 12% per annum, net of certain fees and costs which the Company paid School Services and its affiliates. The agreement provided for a 8 $10 million term loan collateralized by certain real property owned by the Company, and a $10 million revolving line of credit collateralized by notes receivable from charter schools and other debtors of the Company. Such borrowings are also collaterized by substantially all the other assets of the Company. The facility matures on June 30, 2004 but has prepayment obligations tied to refinancings of the notes receivable from charter schools and such other debtors and to any sale or transfer of the real property. At the time the loans were made, the Company did not have commitment dates for such refinancings or sales or transfers of real property. The agreement requires the Company to meet certain financial covenants including a minimum consolidated tangible net worth, a maximum consolidated debt to equity ratio and a minimum EBITDA requirement for fiscal 2003. In December 2002, a note receivable in the amount of $7.5 million was refinanced. Proceeds from this refinancing were paid directly to School Services and applied to amounts outstanding under the revolving line of credit. Of this amount, $1.3 million represented a permanent reduction in the line of credit and $4.0 million was subsequently reborrowed by the Company. In addition, the Company made a $1.0 million payment on the revolving line of credit pursuant to an amendment to reduce the line of credit commitment by $1.0 million to obtain the release of certain collateral. As of December 31, 2002, $17.7 million was outstanding under these facilities reflecting the maximum amount available under the terms of the facilities. In connection with the establishment of the credit facilities described above, the Company also issued warrants for the purchase of up to an aggregate of 10,710,973 shares of class A common stock of the Company, which at such time equaled 16.6% of the total outstanding shares of common stock of the Company, including the shares issuable upon exercise of the warrants. The warrants have an exercise price of $1.00 per share and are exercisable at any time following their issuance and prior to July 31, 2007. The value of the warrants on the date of issuance, determined using the Black Scholes model, amounted to approximately $6.6 million. This amount has been credited to additional paid-in capital and deducted and reflected as a discount in the related indebtedness. The discount will be amortized over the respective terms of the related financing agreements, based on a constant effective interest rate. Also in connection with the establishment of the credit facilities, the Company paid or agreed to pay approximately $9.2 million in fees and costs associated with the facility, including a $1.6 million payment due upon maturity of the School Services facility. Such fees and costs have been deferred and are being amortized over the respective term of the facilities, based on a constant effective interest rate. 6. STOCK REPURCHASE PLAN During the quarter ended December 31, 2002, the Company commenced a stock repurchase plan to buy back up to 5.4 million shares representing approximately 10% of the common stock outstanding. As of December 31, 2002, the Company had repurchased approximately 1.4 million shares at a cost of $2.0 million. As of January 31, 2003, the Company had repurchased approximately 1.7 million shares representing approximately 32% of the total authorized under the repurchase plan. 7. STOCK-BASED COMPENSATION During the quarter ended December 31, 2002, the Company's stockholders approved an amendment to the 1999 Stock Incentive Plan increasing the number of shares reserved for issuance from 6.5 million shares to 8.5 million shares of Class A common stock. Stock option plans, stock appreciation rights (SARs), restricted stock and other stock based awards are described in the Company's proxy statement for its annual meeting of stockholders held on December 5, 2002. With certain restrictions, requirements for stock option shares and other stock awards can be met from either unissued common stock or treasury shares. For financial reporting purposes, the Company accounts for stock-based compensation in accordance with the intrinsic value method of accounting prescribed by APB 25. In accordance with this method, no compensation expense is recognized in the accompanying financial statements in connection with the awarding of stock option grants to employees provided that, as of the grant date, all terms associated with the award are fixed and the fair value of the company's stock, as of the grant date, is not greater than the amount an employee must pay to acquire the stock as defined. To the extent that stock options are granted to employees with variable terms or if the fair value of the Company's stock as of the measurement date is greater than the amount an employee must pay to acquire the stock, then the Company will recognize compensation expense. 9 At June 30, 2002, there were no restricted stock grants. During the quarter ended December 31, 2002, 1.0 million shares of Class A restricted common stock were issued of which 0.5 million were vested and outstanding. As of December 31, 2002 the Company had approximately 2.9 million shares of Class A common stock reserved for future grants under the Stock Incentive Plan. Any unused portion, in addition to shares allocated to awards that are canceled or forfeited, is available for grant or award in later years. Restricted stock grants vest as specified in the respective grants. 8. NOTES RECEIVABLE The Company provides financing in the form of interest and non-interest bearing loans and advances to charter school boards to assist in the purchase or renovation of charter school facilities. Certain of the loans are evidenced by notes and other advances which are made in concert with a management contract or without fixed repayment terms. In order for the notes to be repaid, the Company generally assists charter school boards in obtaining third party lender financing. Often third party financing requires the Company to guarantee loans on behalf of these charter schools. A default by any charter school under a credit facility that is guaranteed by the Company may result in a claim against the Company for the full amount of the borrowings. Of the approximately $81.8 million of notes and other financing at December 31, 2002, approximately $61.7 million was collateralized and the remaining balance of $20.1 million balance was uncollateralized and in some cases subordinated to other senior debt. Of the approximately $80.9 million in notes receivable, net at June 30, 2002, approximately $61.1 million was collateralized and the remaining balance of $19.8 million was uncollateralized and, in some cases, subordinated to other senior debt. Although the Company intends to refinance many of these notes, should the Company be required to foreclose on the collateral to these notes, it might not be able to liquidate such collateral for proceeds sufficient to cover the notes. Notes receivable consist of the following:

9. COMMITMENTS AND CONTINGENCIES GUARANTEES The Company has guaranteed certain debt obligations of charter school boards with which it has management agreements. As of December 31, 2002, the Company had provided guarantees totaling approximately $27.4 million. These debt obligations mature from June 2003 to December 2005. All of the guarantees were issued or modified prior to the effective date of FIN 45, therefore the fair market value of the guarantees are not recorded on the balance sheet or disclosed in the notes. As of December 31, 2002, the debt obligations of the charter school boards were current. Under the guarantor agreements, the Company is also required to maintain minimum cash balances that may increase under certain circumstances, as well as satisfy certain financial covenants. The Company was not in compliance with a financial covenant under a guarantee of a charter school board debt obligation with an outstanding balance of approximately $3.5 million at December 31, 2002. The Company has received notification from the lender that it is not immediately making demand under the guaranty while the lender works with the Company to evaluate options. Notwithstanding the foregoing, the lender reserves all 10 its rights and remedies under the guaranty. The Company's debt obligations and underlying covenants are unaffected by the above default. The Company has an agreement to indemnify a charter board lender from any liability or obligations related to the presence of any hazardous substance at a charter school site. The Company does not expect that any sums it may have to pay in connection with this liability would have a materially adverse effect on its consolidated financial position, or results of operation for fiscal 2003. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain of its executives. Such agreements may be terminated by either the executive or the Company at any time and provide, among other things, certain termination benefits. As of December 31, 2002, the aggregate termination benefits of the executives and certain other employees approximated $2.5 million. Additionally, the Company has a severance arrangement with its Chairman that provides for the Chairman to receive a payment if his employment is terminated without cause or if he terminates his employment for good reason, including not being reappointed to the position of Chairman. The Chairman would not receive payment in the case of death, disability, or termination for cause. Included in accrued expenses at December 31, 2002 and June 30, 2002 is $3.2 million related to this severance arrangement. LITIGATION Between May 15, 2002 and July 3, 2002, ten class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of New York. These lawsuits are largely identical, and each alleges that the Company and certain of its officers and directors violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. In addition, one lawsuit alleges a claim against Edison for the violation of Section 11 of the Securities Act. They seek an unspecified amount of compensatory damages, costs and expenses related to bringing the actions, and in a few instances, injunctive relief. Plaintiffs allege that Edison's public disclosures from November 1999 to March 2002 regarding its financial condition were materially false and misleading because the Company allegedly improperly inflated its total revenues by including certain payments, including payments for teacher salaries, that were paid directly to third parties by local school districts and charter school boards that contracted with the Company. Several of the lawsuits also mention two restatements of the Company's financial statements, one regarding a warrant purchased in 1998 by a philanthropic organization and the other regarding a severance agreement between the Company and one of its senior officers, made by the Company as a result of the May 14, 2002 cease-and-desist order. On October 29, 2002, the Court consolidated all ten actions and appointed Hawaii Electricians Annuity Fund as lead plaintiff and Milberg Weiss Bershad Hynes & Lerach LLP as lead counsel. Pursuant to the Court's scheduling order, plaintiffs will have until March 6, 2003, to file a consolidated and amended complaint and the Company will have until May 7, 2003, to respond. The Company believes that it has strong defenses to the claims raised by these lawsuits, however the outcome of this litigation cannot be determined at this time. If the Company were not to prevail, the amounts involved could be material to the financial position, results of operations and cash flows of the Company. In addition, between May 15, 2002, and July 19, 2002, three lawsuits were filed derivatively on behalf of Edison against certain of Edison's officers and directors in the Supreme Court for the State of New York, County of New York. Plaintiffs in these lawsuits contend that Edison's officers and directors committed various common law torts against the Company in connection with the allegedly improper inflation of Edison's total revenues by including certain expenses, including teacher salaries, that were paid directly by local school districts. In particular, the plaintiffs allege that the officers and directors named as defendants violated their fiduciary duties to Edison by failing to implement and maintain an adequate internal accounting control system, causing Edison to conceal from the public its true financial condition, and using material non-public information to sell shares of Edison common stock and thereby reap millions of dollars in illegal insider trading gains. These lawsuits seek compensatory damages in the amount of the profits that the individual defendants allegedly made, as well as a constructive trust over such profits. On November 14, 2002, the Court consolidated these actions. The Company 11 has negotiated a stipulation in this consolidated action that allows (1) plaintiffs until March 24, 2003 to file a consolidated amended complaint and (2) defendants until May 26, 2003 to file a responsive pleading. The Company believes that Edison's officers and directors also have strong defenses to these lawsuits. See "Additional Risk Factors That May Affect Future Results -- We have been named in several shareholder class action and shareholder derivative lawsuits." The Company is also involved in various legal proceedings from time to time incidental to the conduct of its business. For example, we are currently involved in lawsuits filed in Baltimore, Maryland and Peoria, Illinois questioning the authority of these school districts to enter into management agreements with the Company. In addition, the school district of York, Pennsylvania has appealed the decision of the state charter-granting authority to grant a charter to one of the Company's customers. We currently believe that any ultimate liability arising out of such proceedings will not have a material adverse effect on the Company's financial position, results of operations or cash flows. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain of the matters and subject areas discussed in this Quarterly Report on Form 10-Q contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical information provided herein are forward-looking statements and may contain information about financial results, economic conditions, trends and known uncertainties based on our current expectations, assumptions, estimates and projections about our business and our industry. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of several factors, as more fully described under the caption "Additional Risk Factors that May Affect Future Results" and elsewhere in this Quarterly Report. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis, judgment, belief or expectation only as of the date hereof. The forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to publicly update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future. OVERVIEW We are the nation's largest private operator of public schools serving students from kindergarten through 12th grade. We contract with local school districts and public charter school boards to assume educational and operational responsibility for individual schools in return for per-pupil funding that is generally comparable to that spent on other public schools in the area. We opened our first four schools in August 1995 and have grown rapidly in every subsequent year, currently serving approximately 80,000 students in 149 schools located in 22 states and the District of Columbia. From our formation in 1992 until opening our first schools in fiscal 1996, we were a development stage company focused on research, development and marketing of the Edison school design and curriculum and raising capital to support our business plan. From 1992 until 1995, Edison's team of leading educators and scholars developed an innovative, research-backed curriculum and school design. We operated as a partnership prior to November 1996, when we converted to a corporation. As of December 31, 2002, our accumulated deficit since November 1996 was approximately $285.4 million. In addition, prior to November 1996, we incurred losses of approximately $61.8 million, which are reflected in our additional paid-in capital. Edison's curriculum expenses include the ongoing costs to maintain and support Edison's educational design. These expenses include the salaries and wages of trained educators in our central office curriculum department, the costs of providing professional training to our staff and teachers, including materials, and the ongoing costs of maintaining and updating the teaching methods and educational content of our program. We make a significant investment in each school we open. The investment generally includes: - Initial staff training and professional development; - Technology, including laptop computers for teachers; - Books and other materials to support the Edison curriculum and school design; and - Upgrades in facilities. 12 GROSS STUDENT FUNDING Gross student funding represents the gross contractual funding for our schools before all expenses. The difference between gross student funding and net revenues consists of costs that Edison is not primarily obligated to pay. Gross student funding is not equivalent to revenue as defined by generally accepted accounting principles. NET REVENUE Revenues are principally earned from contractual agreements to manage and operate contract and charter schools. The Company also earns revenue from summer school and after-school program fees. The Company recognizes revenue for each managed school pro rata over the eleven months from August through June, typically the period over which we perform our services, in accordance with Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements." Most of our management agreements provide that we earn a fee based upon the number of children that attend our schools and, therefore, we only earn revenue to the extent students attend our schools. In most instances, there is a "base" fee per pupil and several "categorical" fee components paid only for students in certain categories (e.g., low-income, English as a second language, etc.). In some of our charter schools, our fee has a fixed component and variable component. Even in contracts where we have a fixed fee component, we have generally agreed to forego or reduce our fee if there is a budget shortfall at the charter school. The Company is generally responsible to its clients for all aspects of the management of its schools including but not limited to the academic achievement of the students; selection, training and compensation of school personnel; procurement of curriculum and equipment necessary for operations of the school; and the safe operation of the school facilities. Gross student funding represents gross contractual funding for our schools before all costs. Net revenue represents gross student funding less costs that we are not primarily obligated to pay. The Company follows the guidance of EITF 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent," and EITF 01-14, "Income Statement Characterization of Reimbursements Received for 'Out-of-Pocket' Expenses Incurred" regarding classification of revenues. Specifically, the Company recognizes revenues net of expenses that the Company is not primarily obligated to pay. The Company recognizes per-pupil funding from local, state and federal sources, including Title I and special education funding. Significant management estimates and assumptions are required to determine these funding levels, particularly in interim periods. On a quarterly basis, the Company records adjustments to revenue, if necessary, for enrollment fluctuations, changes to per-pupil funding estimates, and changes to estimates for federal and state categorical grant funding. Anticipated losses on contracts are charged to earnings when identified. In January 2002, the Emerging Issues Task Force ("EITF") issued EITF 01-14 "Income Statement Characterization of Reimbursements Received for 'Out-of-Pocket' Expenses Incurred." EITF 01-14 clarifies EITF 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent," which provides guidance on whether revenues should be presented gross or net of certain costs. After consultation with its independent auditors, the Company believes that EITF 01-14 should be interpreted to require it to present as revenue and expense only those direct site expenses that the Company is primarily obligated to pay. In accordance with the transition provisions of EITF 01-14, the Company adopted EITF 01-14 effective January 1, 2002 and has reclassified all historical periods to conform with the new presentation and, in the interest of transparency, added a "gross student funding" line to its statements of operations. Gross student funding is not equivalent to revenue as defined by GAAP. In November 2001, the EITF issued EITF 01-09, "Accounting for Consideration Given by a Vendor to a Customer." EITF 01-09 addresses the appropriate income statement characterization of consideration given by a vendor to a customer, specifically whether that consideration should be presented in the vendor's income statements as a reduction of revenue or as an expense. In consultation with its independent auditors the Company determined that consideration given to two customers was, in effect, an adjustment of the Company's contract price and should be accounted for as a reduction in revenue rather than as an expense subsequent to the promulgation of EITF 01-09. In accordance with the transition provisions of EITF 01-09, the Company adopted EITF 01-09 effective January 1, 2002 and has reclassified all historical periods to conform with the new presentation. 13 DIRECT SITE EXPENSES Direct site expenses include most of the expenses incurred on-site at our schools. The largest component of this expense is salaries and wages, primarily for principals and teachers, which are often paid for by our clients on our behalf, in which case they are disclosed as "direct site expense -- client paid." The remaining direct site expenses include on-site administration, facility maintenance, utilities and, in some cases, student transportation. Once staffing levels for the school year are determined, most of these expenses are fixed, and accordingly, variations in enrollment will generally not change the overall cost structure of a school for that year. Direct site expenses do not include teacher training and other pre-opening expenses associated with new schools, financing costs or depreciation and amortization related to technology, including computers for teachers and students, curriculum materials and capital improvements to school buildings. GROSS SITE CONTRIBUTION We define gross site contribution as net revenue less direct site expenses. Gross site contribution is a measurement of ongoing site-level operating performance of our schools. We believe it serves as a useful operating measurement when evaluating our schools' financial performance. Gross site contribution does not reflect all site-related costs, including depreciation and amortization or interest expense and principal repayment related to site-level investments, or on-site pre-opening expenses, and accordingly gross site contribution does not represent site-level profitability. ADMINISTRATION, CURRICULUM AND DEVELOPMENT EXPENSES Support from our central office is important for the successful delivery of our curriculum and school design. Administration, curriculum and development expenses include those amounts related to the creation and enhancement of our curriculum, and our general, administrative and sales and marketing functions. These costs include costs for curriculum, assessment and training professionals, sales and marketing personnel, financial reporting, legal, technological support, travel expenses and other development activities. PRE-OPENING EXPENSES Pre-opening expenses consist principally of various administrative and personnel costs incurred prior to the opening of a new school or the expansion of an existing school, particularly the costs for the initial training and orientation of professional staff, recruitment and travel expenses and expenses for temporary offices and staff. In connection with the establishment of a new school, we seek to hire the school's principal several months in advance of the school's opening. This allows the principal to hire staff, most of whom receive substantial professional training in the Edison education design prior to the first day of school. Pre-opening expenses generally are first incurred in the fourth quarter of the fiscal year prior to the school's opening or expansion and generally continue into the first or second quarter of the fiscal year in which the school opens. These costs are expensed as incurred. DEPRECIATION AND AMORTIZATION Depreciation and amortization relates primarily to the investments we make in each school for books and other educational materials, including enrollment fees for the Success for All program, computers and other technology, and facility improvements. These investments support the Edison curriculum and school design and relate directly to our provision of educational services. The depreciation and amortization of investments in our central office is also included. ENROLLMENT Our annual budgeting process establishes site-specific revenue and expense objectives, which include assumptions about enrollment and anticipated per-student funding. Our budgets are designed to achieve both financial and academic goals, both of which we believe are critical to the success of our business. Therefore, our budgets are designed to achieve the proper balance between financial performance and academic standards. We implement various strategies to achieve optimal enrollment, including local recruiting, media advertising, and coordinating with our school district partners and community groups. Since some site costs are partially fixed, incremental enrollment can positively affect profitability. Further, due to the closely correlated relationship of site revenue and expenses, school personnel closely manage expenses based upon actual enrollment. 14 REENGINEERING On August 21, 2002, the Company announced several initiatives emerging from a company-wide "reengineering" effort. The initiatives are intended to redesign Edison's infrastructure to improve service delivery to its schools; increase student achievement and customer satisfaction; and accelerate Edison's path to profitability. Among other changes, the Company announced significant improvements in its headquarters operations including an enhanced customer service function; strengthening of its financial reporting and facilities financing unit; a ramp up of its communications function; a more efficient organization of its general financial function, and an alignment of its internal functions with a consolidated and streamlined regional structure. The Company has incurred expenses related to this reengineering in the first and second quarters of approximately $2.3 million. LOANS TO EXECUTIVES Benno C. Schmidt, Jr. borrowed $1.6 million from the Company on June 5, 1992 and $200,000 from the Company on January 23, 1996, as evidenced by promissory notes. The loans were recourse and were collateralized by a life insurance policy on Mr. Schmidt. The amounts due from Mr. Schmidt under these loans could be offset by the Company against the amount owed by the Company to Mr. Schmidt under his severance agreement. In October 1999, the promissory notes were amended to change the interest rate to the prime rate in effect from time to time and to extend the date for payment of all principal and accrued interest until the earlier of February 15, 2002 or the termination of Mr. Schmidt's employment with the Company. Prior to this amendment, the notes bore interest at an annual compound rate of 5.83%, and all principal and accrued interest payable under the notes were due on the earlier of February 15, 2000 or the termination of Mr. Schmidt's employment with the Company. In February 2002, the term of the loans was extended to June 15, 2002. In June 2002, the term of the loans was extended to August 31, 2002. Mr. Schmidt made a payment of $1.1 million in October 2002, which was applied toward outstanding interest. The Company has given notice to Mr. Schmidt that the remainder of the loans is due, and with his cooperation is working to expedite collection of the outstanding balance of principal and interest under the loans, which totaled $1.8 million and $0.2 million, respectively. RESULTS OF OPERATIONS FISCAL QUARTER ENDED DECEMBER 31, 2002 COMPARED TO FISCAL QUARTER ENDED DECEMBER 31, 2001 Net Revenue. Our net revenue decreased to $109.6 million for the three months ended December 31, 2002 from $115.6 million for the same period in the prior year, a decrease of 5.2%. The decrease in revenue was primarily due to the ending of certain unprofitable relationships and the deferral of revenue for certain unsigned contracts together totaling approximately $15.8 million offset by new revenue of approximately $10.0 million from an 8.1% increase in student enrollment (excluding summer school students). The student enrollment increased from approximately 74,000 in the 2001-2002 school year to approximately 80,000 in the 2002-2003 school year, reflecting both the opening of new schools and the expansion of existing schools. Direct Site Expenses. Our direct site expenses decreased to $87.7 million for the three months ended December 31, 2002 from $95.9 million for the same period in the prior year, a decrease of 8.6%. The decrease in direct site expenses was primarily due to the ending of certain unprofitable relationships and the deferral of expenses for certain unsigned contracts together totaling approximately $17.6 million offset by increased expenses of $9.6 million related to new schools opened and the expansion of existing schools. Gross Site Contribution. Our gross site contribution was $21.9 million for the three months ended December 31, 2002 compared to $19.7 million for the same period in the prior year, an increase of 11.2%. The increase in gross site contribution was due to the above discussed changes in Net Revenue and Direct Site Expenses. Administration, Curriculum and Development Expenses. Our administration, curriculum and development expenses decreased to $18.2 million for the three months ended December 31, 2002 from $20.8 million for the three months ended December 31, 2001, a decrease of 12.5%. Excluding non-cash stock compensation charges in both periods, our administration, curriculum and development expenses increased to $18.0 million for the three months ended December 31, 2002 from $17.3 million for the three months ended December 31, 2001, an increase of 4.0%. The increase was due, primarily, to the costs of our re-engineering efforts, which totaled $0.7 million for the three months ended December 31, 2002. Depreciation and Amortization. Our depreciation and amortization decreased to $8.0 million for the three months ended December 31, 2002 from $9.7 million for the three months ended December 31, 2001, a decrease of 17.5% . The decreased depreciation and amortization resulted from a decrease of $0.9 million in depreciation resulting from fewer acquisitions and a decrease of $0.8 million resulting from the net effect of the change in the average useful life of the depreciable fixed assets. Pre-Opening Expenses. Our pre-opening expenses decreased to $1.0 million for the three months ended December 31, 2002 from $1.5 million for the three months ended December 31, 2001, a decrease of 33.3%. This decrease was associated primarily with opening new schools, of which all but two were in Philadelphia. As all training was conducted in Philadelphia, the Company spent significantly less in airfare, hotels and meals as compared to the same period in the prior year. Education and Operating Expenses. Our total education and operating expenses decreased to $114.8 million for the three months ended December 31, 2002 from $127.9 million for three months ended December 31, 2001. 15 EBITDA. EBITDA means the net gain or loss we would have shown if we did not take into consideration our interest expense, interest income, income tax expense, depreciation and amortization. These costs are discussed above. This amount for the three months ended December 31, 2002 was $2.7 million compared to a negative $2.6 million for the three months ended December 31, 2001. Excluding stock based compensation charges in both periods, EBITDA for the three months ended December 31, 2002 was $2.9 million compared to $0.9 million for the three months ended December 31, 2001. The increase in EBITDA, resulted primarily from site-based operational improvements and lower pre-opening costs. On a per-student basis (excluding summer school students), EBITDA improved to $36 in the three months ended December 31, 2002 compared to $13 for the same period of the prior year. Loss from Operations. Our loss from operations decreased to $5.3 million for the three months ended December 31, 2002 from $12.3 million for the three months ended December 31, 2001, an improvement of 56.9%. Excluding stock-based compensation charges, our loss from operations decreased to $5.1 million for the three months ended December 31, 2002 from $8.8 million for the same period of the prior year, an improvement of 42.1%. Other Income and Expense. Other income, net, was a negative $3.8 million for the three months ended December 31, 2002 compared to $0.8 million in the three months ended December 31, 2001. The decline was primarily due to a $4.6 million increase in interest expense. Net Loss and Net Loss Attributable to Common Stockholders. Our net loss decreased to $9.1 million for the three months ended December 31, 2002 from $11.7 million for the three months ended December 31, 2001, a decrease of 22.2%. Excluding stock compensation charges, our net loss increased to $9.0 million for the second quarter of fiscal 2003 from $8.1 million for the second quarter of fiscal 2002, an increase of 11.1%. THE SIX MONTHS ENDED DECEMBER 31, 2002 COMPARED TO THE SIX MONTHS ENDED DECEMBER 31, 2001 Net Revenue. Our net revenue decreased to $182.7 million for the six months ended December 31, 2002 from $205.4 million for the same period in the prior year, a decrease of 11.1%. The decrease in revenue was primarily due to the ending of certain unprofitable relationships and the deferral of revenue for certain unsigned contracts together totaling approximately $33.7 million and a non-recurring fee of $2.7 million from a one time consulting engagement in fiscal 2002. These charges are offset by new revenue of approximately $13.9 million from an 8.1% increase in student enrollment (excluding summer school students) from approximately 74,000 in the 2001-2002 school year to approximately 80,000 in the 2002-2003 school year, reflecting both the opening of new schools and the expansion of existing schools. Direct Site Expenses. Our direct site expenses decreased to $152.3 million for the six months ended December 31, 2002 from $176.3 million for the same period in the prior year, a decrease of 13.5%. The decrease in direct site expenses was primarily due to the ending of certain unprofitable relationships and the deferral of expenses for certain unsigned contracts together totaling approximately $33.9 million offset by increased expenses of $11.8 million related to new schools opened and the expansion of existing schools. Gross Site Contribution. Our gross site contribution was $30.4 million for the six months ended December 31, 2002 compared to $29.1 million for the same period in the prior year. The increase in gross site contribution was due to the above discussed changes in Net Revenue and Direct Site Expenses. Administration, Curriculum and Development Expenses. Our administration, curriculum and development expenses increased to $34.1 million for the six months ended December 31, 2002 from $32.0 million for the six months ended December 31, 2001, an increase of 6.6%. Excluding non-cash stock compensation charges and credits in both periods and non-recurring charges in connection with a consulting engagement in fiscal 2002, our administration, curriculum and development expenses increased to $33.8 million for the six months ended December 31, 2002 from $31.3 million for the six months ended December 31, 2001, an increase of 8.0%. The increase was due primarily to the costs of our re-engineering efforts, which totaled $2.3 million for the six months ended December 31, 2002. Depreciation and Amortization. Our depreciation and amortization decreased to $17.1 million for the six months ended December 31, 2002 from $17.6 million for the six months ended December 31, 2001, a decrease of 2.8%. The decreased depreciation and amortization resulted from a decrease of $0.5 million in depreciation resulting from fewer asset acquisitions. 16 Pre-Opening Expenses. Our pre-opening expenses decreased to $3.0 million for the six months ended December 31, 2002 from $5.2 million for the six months ended December 31, 2001, a decrease of 42.3%. This decrease was associated primarily with opening new schools, of which all but two were in Philadelphia. As all training was conducted in Philadelphia, the Company spent significantly less in airfare, hotels and meals as compared to the same period for the prior year. Education and Operating Expenses. Our total education and operating expenses decreased to $206.4 million for the six months ended December 31, 2002 from $231.0 million for six months ended December 31, 2001. EBITDA. EBITDA, means the net gain or loss we would have shown if we did not take into consideration our interest expense, interest income, income tax expense, depreciation and amortization. These costs are discussed above. This amount for the six months ended December 31, 2002 was negative $6.7 million compared to negative $8.1 million for the six months ended December 31, 2001. Excluding stock compensation charges and credits in both periods, EBITDA for the six months ended December 31, 2002 was a negative $6.4 million compared to a negative $9.9 million for the six months ended December 31, 2001. The increase in EBITDA, resulted primarily from site-based operational improvements and lower pre-opening costs. On a per-student basis (excluding summer school students), EBITDA, improved to negative $80 in the six months ended December 31, 2002 compared to negative $133 for the same period of the prior year. Loss from Operations. Our loss from operations decreased to $23.7 million for the six months ended December 31, 2002 from $25.6 million for the six months ended December 31, 2001, a decrease of 7.4%. Excluding stock compensation charges and credits and non-recurring charges in connection with a consulting engagement in fiscal 2002, our loss from operations decreased to $23.5 million for the first half of fiscal 2003 from $24.9 million for the first half of fiscal 2002, a decrease of 3.8%. Other Income and Expense. Other income, net, was a negative $4.7 million for the six months ended December 31, 2002 compared to $1.6 million in the six months ended December 31, 2001. The decline was primarily due to the $6.3 million increase in interest expense. Net Loss and Net Loss Attributable to Common Stockholders. Our net loss increased to $28.8 million for the six months ended December 31, 2002 from $24.3 million for the six months ended December 31, 2001, an increase of 18.5%. Excluding stock compensation charges, our net loss increased to $28.6 million for the six months ended December 31, 2002 from $26.1 million for the six months ended December 31, 2001, an increase of 9.6%. LIQUIDITY AND CAPITAL RESOURCES We have historically operated in a negative cash flow position. To date we have financed our cash needs through a combination of equity and debt financing. We have also utilized debt and equipment leasing arrangements to finance computers and other technology investments in our schools. On October 3, 2001, the Company formed Edison Receivables Company LLC ("Edison Receivables") for the purpose of purchasing and financing certain receivables of the Company. The Company owns all of the membership interests in Edison Receivables, a Delaware limited liability company with a separate legal existence from the Company. The Company has sold or contributed certain accounts receivable arising from the Company's provision of school management services in the ordinary course of its business and related security to Edison Receivables. Edison Receivables has its own separate creditors who are entitled to be satisfied out of Edison Receivables' assets prior to any value in it becoming available to the Company. The Company has no right, title or interest in Edison Receivables' assets, including the accounts receivable assigned to it by the Company. In November 2001, Edison Receivables entered into a $35.0 million revolving credit facility (the "MLMCI Facility") with MLMCI, collateralized by certain accounts receivable purchased from or contributed by the Company. Borrowings are limited to specified percentages of eligible accounts receivable, as defined. The MLMCI Facility originally had a term of one year, with interest determined on a Eurodollar or prime rate basis at the Company's option and a commitment fee of .50% per annum on the unused portion of the commitment. On July 31, 2002, the MLMCI Facility was amended to add School Services as an additional lender and MLMCI as agent of the lenders, increase the line of credit to $55.0 million, and extend the term of the agreement and the line of credit 17 provided thereunder to June 30, 2003. The agreement and the line of credit were subsequently extended to July 15, 2003. The interest rate under the amended MLMCI Facility was increased to LIBOR plus 8.7% or prime plus 4.5% at the Company's option. We paid certain fees and costs related to the MLMCI Facility, aggregating approximately $3.2 million. As of December 31, 2002, $49.3 million was outstanding under this line of credit bearing interest at LIBOR plus 8.7% and was collateralized by receivables of $79.2 million that were sold in a true sale to Edison Receivables by the Company. The agreement requires that the Company observe certain financial covenants and restrictions including a minimum consolidated tangible net worth and a maximum consolidated debt to equity ratio. In January 2003, the Company paid down an additional $7.5 million on this facility. Additionally, on July 31, 2002 the Company entered into a two-year Credit and Security Agreement (the "New Credit Facility") with School Services, which provides for a term loan in the amount of $10.0 million, collateralized by property held by 110th and 5th Associates, LLC, a wholly owned subsidiary of the Company, and a revolving loan not to exceed $10.0 million, collateralized by substantially all of the Company's assets other than the property collateralizing the term loan. Interest on both the term and revolving loans was set at 12.0% per annum. The facility was reduced by the amount of certain fees and costs which the Company paid to School Services and its affiliates, aggregating approximately $2.8 million. Additionally, we agreed to pay a fee of $1.6 million at loan maturity or the earlier prepayment of the term loan component of the facility. This facility is collaterized by certain real property owned by the Company and certain of its subsidiaries, notes receivable from charter schools and other debtors of the Company and substantially all of the other assets of the Company. However, the loan commitment is to be reduced by an agreed upon percentage of the net proceeds of any refinancing paid to the Company. The agreement requires the Company to observe certain financial covenants and restrictions including a minimum consolidated tangible net worth, a maximum consolidated debt to equity ratio and a minimum EBITDA requirement for fiscal 2003. As of December 31, 2002, $17.7 million was outstanding under these facilities, which represents the maximum amount available for borrowing. In connection with the establishment of the amended MLMCI Facility and the New Credit Facility, the Company also issued warrants for the purchase of up to 10,710,973 shares of Class A common stock of the Company, which at such time equaled 16.6% of the total outstanding shares of common stock of the Company, including the shares issuable upon exercise of the warrants. The warrants have an exercise price of $1.00 per share and are exercisable at any time following their issuance and prior to July 31, 2007. For the six months ended December 31, 2002, we used approximately $3.7 million for operating activities. This use primarily resulted from $28.8 million of net loss offset by $23.6 million of depreciation and amortization and other non-cash operating charges including the changes in the working capital accounts. For the six months ended December 31, 2002, we used approximately $10.6 million in investing activities. During this period, we invested approximately $9.9 million in our schools and central office. This amount includes the investments we made in technology and curriculum in each of the schools we opened. We have also advanced funds of $7.8 million to our charter board clients or their affiliates to help obtain, renovate and complete school facilities. During this same period, we also received approximately $6.1 million on proceeds from notes receivable and advances due from charter schools. In October 2002, we received $1.1 million payment toward an executive's loan. For the six months ended December 31, 2002, we received, approximately $10.7 million from our financing activities. This amount includes borrowings under our lines of credit of $17.4 million and borrowings under our term loan of $10.0 million. These proceeds were partially offset by costs in connection with our equity financing of $1.5 million and the repayment of notes payable and capital lease obligations totaling $12.0 million and purchase of treasury stock of $0.5 million. The Company also increased the amount of restricted cash by $2.7 million to comply with certain agreements. 18 Our debt obligations as of June 30, 2002, September 30,2002 and December 31, 2002 is summarized in the table below:

We expect our cash on hand, together with borrowings under financing arrangements, as mentioned above, expected reimbursements of advances we have made to charter boards and acceleration of collections of our accounts receivable will be sufficient to meet our working capital needs to operate our existing schools through fiscal 2003. Our near-term capital needs are generally growth related and are dependent upon our rate of growth and our mix of charter schools and contract schools, as charter schools usually require us to advance funds to help charter boards obtain, renovate and complete school facilities. Our plan for fiscal year 2003 is to continue to refinance, with third-party lenders, a minimum of $23 million of loans we have made to charter boards to fund our current growth plans for the 2003-2004 school year. While we have completed such financings in the past, we cannot be certain we will obtain such financing on favorable terms, if any. To the extent we cannot raise sufficient funds through the refinancing of our loans to charter boards with third-party lenders, we may seek to expand our financing arrangements or reduce our growth plans. Depending on the terms of any financing arrangements, such funding may be dilutive to existing shareholders, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. Notwithstanding the above statements, management does not presently have any intention of issuing any substantial incremental equity in the near term other than equity associated with management compensation plans. Additionally, given the general improvement in our financial position, we intend to refinance certain debt which we took on last summer. This will decrease our future cost of capital and therefore improve our earnings per share. However, this refinancing would require us to take a one-time charge for any unamortized financing cost related to the debt refinancing remaining at the time of refinancing. Our longer term cash requirements are for capital to fund capital expenditures related to growth, anticipated working capital needs and general corporate purposes. We expect to fund such expenditures and other longer term liquidity needs with cash generated from operations, the proceeds from offerings of debt or equity securities and expanded financing arrangements. Depending on the terms of any financing arrangements, such funding may be dilutive to existing shareholders, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. We ran summer school programs for 51 districts in the state of Missouri during May, June and July of 2002. We spent approximately $19 million, which includes teachers' salaries, curriculum and other educational/promotional materials, over the two month period. The payment terms of the related billings ranged from 12 to 18 months, therefore, cash receipts of revenue will lag outlay of cash for expenditures by more than one year. As of September 30, 2002, we had accounts receivables of $66.8 million for managed schools and $28.1 million for our summer school program of which $22.8 million was classified as long term. For the quarter ended December 31, 2002 our accounts receivable were $59.0 million for managed schools and $16.0 million for our summer program, a decline of 11.6% and 43.4% respectively. In general, our ability to achieve positive cash flow will be dependent on the volume of schools with positive gross site contribution to offset central office and overhead expenses. Because gross site contribution is the difference between site revenue and site expenditures, positive gross site contribution can be achieved at a range of enrollment levels. While higher enrollment tends to have a positive effect on gross site contribution, our growth and cash flow do not depend totally on 100% enrollment. Capital expenditures for fiscal 2003 are expected to be approximately $15.0 million, which includes approximately 19 $5.0 million for computers and other technology at our schools, approximately $7.0 million for curriculum materials, approximately $1.0 million for the purchase and improvement of property at our schools, and $2.0 million for technology, leasehold improvements, and other capital items at our headquarters. Additionally, we expect to make additional advances or loans approximating $3.5 million to new charter board clients to help secure and renovate school properties during the remainder of the 2002-2003 school year. Pursuant to our philanthropic commitments, a portion of which we expect will be refinanced through third parties, we expect to make charitable donations of approximately $2.3 million to benefit certain clients over the remainder of this fiscal school year. ADDITIONAL RISK FACTORS THAT MAY AFFECT FUTURE RESULTS Our business, operating results or financial condition could be materially adversely affected by any of the following factors. You should also refer to the information set forth in this report, including our financial statements and the related notes. WE HAVE A HISTORY OF LOSSES AND MAY NOT ACHIEVE PROFITABILITY IN THE FUTURE We have incurred substantial net losses in every fiscal period since we began operations. For the quarter ended December 31, 2002, our net loss was $9.1 million. As of December 31, 2002, our accumulated deficit since November 1996, when we converted from a partnership to a corporation, was approximately $285.4 million. In addition, prior to November 1996, we incurred losses of approximately $61.8 million, which are reflected in our additional paid-in capital. We have not yet demonstrated that we can profitably manage public schools. In order to achieve profitability, we believe it will be necessary to improve gross site margin while maintaining educational quality and continuing to reduce central expenses as a percentage of net revenue. We have undertaken a "reengineering" process intended to increase our efficiency and help us attain profitability while improving client service. There can be no assurance, however, that we will be successful in meeting the objectives of the reengineering. Even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis. Failure to become and remain profitable may adversely affect the market price of our class A common stock and our ability to raise additional capital and continue operations. THE PRIVATE, FOR-PROFIT MANAGEMENT OF PUBLIC SCHOOLS REMAINS A RELATIVELY NEW AND UNCERTAIN INDUSTRY, AND IT MAY NOT BECOME PUBLICLY ACCEPTED Our future is highly dependent upon the development, acceptance and expansion of the market for private, for-profit management of public schools. This market has only recently developed, and we are among the first companies to provide these services on a for-profit basis. We believe the first meaningful example of a school district contracting with a private company to provide core instructional services was in 1992, and we opened our first schools in August 1995. The development of this market has been accompanied by significant press coverage and public debate concerning for-profit management of public schools. If this business model fails to gain acceptance among the general public, educators, politicians and school boards, we may be unable to grow our business and the market price of our class A common stock would be adversely affected. THE SUCCESS OF OUR BUSINESS DEPENDS ON OUR ABILITY TO IMPROVE THE ACADEMIC ACHIEVEMENT OF THE STUDENTS ENROLLED IN OUR SCHOOLS AND WE MAY FACE DIFFICULTIES IN DOING SO IN THE FUTURE We believe that our growth will be dependent upon our ability to demonstrate general improvements in academic performance at our schools. Our management agreements contain performance requirements related to test scores. To the extent average student performance at our schools increases, whether due to improvements in achievement over time by individual students in our schools or changes in the average performance levels of new students entering our schools, aggregate absolute improvements in student performance will be more difficult to achieve. If academic performance at our schools declines, is perceived to decline, or simply fails to improve, we could lose business and our reputation could be seriously damaged, which would impair our ability to gain new business or renew existing school management agreements. WE COULD INCUR LOSSES AT OUR SCHOOLS IF WE ARE UNABLE TO ENROLL ENOUGH STUDENTS Because the amount of revenue we earn for operating each school primarily depends on the number of students enrolled, and because many facility and on-site administrative costs are fixed, achieving site-specific enrollment objectives is an important factor in our ability to achieve satisfactory financial performance at a school. We may be unable to recruit 20 enough students to attend all grades in our new schools or maintain enrollment at all grades in our existing schools. We sometimes do not have enough students to fill some grades in some schools, particularly the higher grades. It is sometimes more difficult to enroll students in the higher grades because older students and their parents are reluctant to change schools. To the extent we are unable to meet or maintain enrollment objectives at a school, the school will be less financially successful and our financial performance will be adversely affected. WE MAY NOT BE ABLE TO ATTRACT AND RETAIN HIGHLY SKILLED PRINCIPALS AND TEACHERS IN THE NUMBERS REQUIRED TO GROW OUR BUSINESS Our success depends to a very high degree on our ability to attract and retain highly skilled school principals and teachers. Currently, there is a well-publicized nationwide shortage of teachers and other educators in the United States. In addition, we may find it difficult to attract and retain principals and teachers for a variety of reasons, including, but not limited to, the following: - we generally require our teachers to work a longer day and a longer year than most public schools; - we tend to have a larger proportion of our schools in challenging locations, such as low-income urban areas, which may make attracting principals and teachers more difficult; and - we believe we generally impose more accountability on principals and teachers than do public schools as a whole. These factors may increase the challenge we face in an already difficult market for attracting principals and teachers. We have also experienced higher levels of turnover among teachers than is generally found in public schools nationally, which we attribute in part to these factors. If we fail to attract and retain highly skilled principals and teachers in sufficient numbers, we could experience client dissatisfaction and lost growth opportunities, which would adversely affect our business. WE MUST OPEN A LARGE NUMBER OF NEW SCHOOLS IN A SHORT PERIOD OF TIME AT THE BEGINNING OF EACH SCHOOL YEAR AND, IF WE ENCOUNTER DIFFICULTIES IN THIS PROCESS, OUR BUSINESS AND REPUTATION COULD SUFFER It is the nature of our business that virtually all of the new schools we open in any year must be opened within a few weeks of each other at the beginning of the school year. Each new school must be substantially functional when students arrive on the first day of school. This is a difficult logistical and management challenge, and the period of concentrated activity preceding the opening of the school year places a significant strain on our management and operational functions. We expect this strain will increase if we are successful in securing larger numbers of school management agreements in the future. If we fail to successfully open schools by the required date, we could lose school management agreements, incur financial losses and our reputation as well as our ability to attract future clients would be damaged. WE DEPEND UPON COOPERATIVE RELATIONSHIPS WITH TEACHERS' UNIONS, BOTH AT THE LOCAL AND NATIONAL LEVELS Union cooperation at the local level is often critical to us in obtaining new management agreements and renewing existing management agreements. In those school districts subject to collective bargaining, provisions of collective bargaining agreements must typically be modified in areas such as length of school day, length of school year, negotiated compensation policies and prescribed methods of evaluation in order to implement the Edison design at a contract school. We regularly encounter resistance from local teachers' unions during school board debates over whether to enter into a management agreement with us. In addition, local teachers' unions have occasionally, albeit ultimately unsuccessfully, initiated litigation challenging our management agreements. If we fail to achieve and maintain cooperative relationships with local teachers' unions, we could lose business and our ability to grow could suffer. In addition, at the national level, the American Federation of Teachers and the National Education Association have substantial financial and other resources that could be used to influence legislation, local teachers' unions and public opinion in a way that would hurt our business. WE COULD BE LIABLE FOR EVENTS THAT OCCUR AT OUR SCHOOLS We could become liable for the actions of principals, teachers and other personnel in our schools. In the event of on-site accidents, injuries or other harm to students, we could face claims alleging that we were negligent, provided inadequate supervision or were otherwise liable for the injury. We could also face allegations that teachers or other personnel committed child abuse, sexual abuse or other criminal acts. In addition, if our students commit acts of violence, we could face allegations 21 that we failed to provide adequate security or were otherwise responsible for their actions, particularly in light of certain highly publicized incidents of school violence. Although we maintain liability insurance, this insurance coverage may not be adequate to fully protect us from these kinds of claims. In addition, we may not be able to maintain our liability insurance in the future at reasonable prices or at all. A successful liability claim could injure our reputation and hurt our financial results. Even if unsuccessful, such a claim could cause unfavorable publicity, entail substantial expense and divert the time and attention of key management personnel, which could cause our financial results to suffer. OUR MANAGEMENT AGREEMENTS WITH SCHOOL DISTRICTS AND CHARTER BOARDS ARE TERMINABLE UNDER SPECIFIED CIRCUMSTANCES AND GENERALLY EXPIRE AFTER A TERM OF FIVE YEARS Our management agreements generally have a term of five years. We cannot be assured that any management agreements will be renewed at the end of their terms. In addition, some of our management agreements may be terminated by the school district or charter board at will, with or without good reason, and all of our management agreements may be terminated for cause, including in some cases for failure to meet specified educational standards, such as academic performance based on standardized test scores. As a result of payment disputes or changes within a school district, such as changes in the political climate, we do from time to time face pressure to permit a school district or charter board to terminate our management agreement even if they do not have a legal right to do so. We may also seek the early termination of, or not seek to renew, a limited number of management agreements in any year. If a significant number of management contracts are not renewed or are terminated, it could have a material adverse effect on our financial condition and results of operations. OUR LARGEST MANAGEMENT AGREEMENT TO DATE IS TERMINABLE "AT WILL" BY THE CLIENT AND UNDER OTHER SPECIFIED CIRCUMSTANCES On August 1, 2002, the company signed an agreement to manage 26 schools in Philadelphia. It is our largest cluster of schools to date. This agreement has been and continues to be the subject of substantial attention in education and business circles as well as in the local and national press. The contract is subject to termination at will by the school district. The contract is also subject to termination if we fail to meet our obligations, including meeting specified student achievement targets. If the contract is terminated, or if we fail to successfully deliver the program, raise student achievement or manage the program's costs, our financial results, operations and reputation may be adversely affected. OUR MANAGEMENT AGREEMENTS INVOLVE FINANCIAL RISK Under the majority of our management agreements, we agree to operate a school in return for per-pupil funding that generally does not vary with our actual costs. To the extent our actual costs under a management agreement exceed our budgeted costs, or our actual revenue is less than planned because we are unable to enroll as many students as we anticipated or for any other reason, we could lose money at that school. In addition, from time to time we have disagreements with our clients as to the actual amount of, or the method of calculating, the revenue owed to us under the terms of the management agreements, resulting in lower revenue than planned. We are generally obligated by our management agreements to continue operating a school for the duration of the contract even if it becomes unprofitable to do so. WE HAVE LIMITED EXPERIENCE OPERATING FOUR-YEAR HIGH SCHOOLS An element of our strategy is to increase our business with existing customers by opening new schools in school districts which we have an existing relationship. An important aspect of this strategy is to open Edison high schools in districts where we operate elementary and middle schools. Because we have limited experience operating high schools, our complete high school curriculum, school design and operating plan are not fully tested. In addition, school districts typically spend more per pupil on high school education than on elementary education. By contrast, some of our management agreements provide that we recognize for each student, regardless of grade level, the average per-pupil funding spent by the school district for all grade levels. For this reason, in these schools we recognize less funding per high school student than is spent by the school district for each of its high school students. In these situations, our success depends upon our ability to deliver our high school design based on the same per-pupil spending as in our elementary schools. If we are unable to successfully and profitably operate high schools, our ability to pursue our growth strategy will be impaired, which could adversely affect the market price of our class A common stock. 22 OUR LENGTHY SALES CYCLE AND UNCERTAINTIES INHERENT IN THE PROCESS THROUGH WHICH WE DEVELOP NEW BUSINESS COULD DELAY NEW BUSINESS AND AFFECT OUR RATE OF GROWTH The time between initial contact with a potential contract or charter client and the ultimate opening of a school, and related recognition of revenue, typically ranges between 9 and 27 months. Our sales cycle for contract schools is generally lengthy due to the approval process at the local school board level, the political sensitivity of converting a public school to private management and the need, in some circumstances, for cooperation from local unions. We also have a lengthy sales cycle for charter schools for similar reasons, as well as the need to arrange for facilities to house the school. In addition, we are occasionally presented with potential opportunities to take over the management of several schools in a single district or area at the same time, which likewise have a lengthy sales cycle. The outcome of these opportunities can have a meaningful effect on our rate of growth. As a result of our lengthy sales cycle, we have only a limited ability to forecast the timing of new management agreements. Any delay in completing, or failure to complete, management agreements could hurt our financial performance. Press speculation concerning the outcome of these processes may adversely affect our stock price from time to time. WE COULD LOSE MONEY IF WE UNDERESTIMATE THE REAL ESTATE COSTS ASSOCIATED WITH ACQUIRING OR RENOVATING A CHARTER SCHOOL If we incur unexpected real estate cost overruns in acquiring or renovating a charter school, we could lose money in operating the school. Our decision to enter into a management agreement for a charter school and our estimate of the financial performance of the charter school, are based, in part, on the estimated facility financing cost associated with renovating an existing facility or building a new facility to house the charter school. This cost varies widely from minimal amounts for minor upgrades to larger amounts for a new construction, which typically range from $4.0 million to $10.0 million, per facility. If these expenses exceed our estimates for the charter school, the charter school could lose money and our financial results would be adversely affected. WE HAVE ADVANCED AND LOANED MONEY TO CHARTER SCHOOL BOARDS THAT MAY NOT BE REPAID As of December 31, 2002, we have outstanding loans or advances to charter boards of $81.8 million, net of allowances, to finance the purchase or renovation of school facilities we manage. Approximately $20.1 million of these loans, representing 18 schools, are uncollateralized or subordinated to a senior lender. In addition, with respect to the loans that are collateralized, if we were required to foreclose on the collateral securing those loans, we might not be able to liquidate the collateral for proceeds sufficient to cover the loan amount. If any of these advances or loans are not repaid when due, our financial results could be adversely affected. Some of our charter schools have obtained tax-exempt financing to repay these loans and advances, but there can be no assurance that our other charter schools will continue to obtain such tax-exempt financing. While we are currently exploring a variety of other financing structures to assist charter schools in repaying these loans and advances, there can be no assurance that we will be able to implement any of these financing structures. WE COULD BECOME LIABLE FOR FINANCIAL OBLIGATIONS OF CHARTER BOARDS We could have facility financing obligations for charter schools we no longer operate, because the terms of our facility financing obligations for some of our charter schools exceeds the term of the management agreement for those schools. For nine of our charter schools, we have entered into a long-term lease for the school facility that exceeds the current term of the management agreement by as much as 15 years. If our management agreements were to be terminated or not renewed in these charter schools, our obligations to make lease payments would continue, which could adversely affect our financial results. For example, as of December 2001, we terminated a management agreement covering three schools for which we continue to have a long-term lease obligation in connection with the school's facilities. Although we have signed a lease with the school covering the 2002-2003 school year, we have no assurance that the lease will be renewed or that we will be able to find other tenants to lease the facility. As of December 31, 2002, our aggregate future lease obligations totaled $48.0 million, with varying maturities over the next 18 years. In nine of our charter schools, we have provided some type of permanent credit support for the school building, typically in the form of loan guarantees or cash advances. As of December 31, 2002 the amount of loans we had guaranteed totaled $27.4 million. Although the term of these arrangements is coterminous with the term of the corresponding management agreement, our guarantee does not expire until the loan is repaid in full. The lenders under these facilities are not committed to release us from our obligations unless replacement credit support is provided. The default by any charter school under a credit facility that we have guaranteed could result in a claim against us for the full amount of the borrowings. 23 Furthermore, in the event any charter board becomes insolvent or has its charter revoked, our loans and advances to the charter board may not be recoverable, which could adversely affect our financial results. In addition, we have generally indemnified our charter school and contract school partners from any liability or damages occurring or allegedly occurring or arising out of any environmental conditions at the school site, if such conditions were caused or created by substances brought on the site by Edison. OUR FINANCIAL RESULTS ARE SUBJECT TO SEASONAL PATTERNS AND OTHER FLUCTUATIONS FROM QUARTER TO QUARTER We expect our results of operations to experience seasonal patterns and other fluctuations from quarter to quarter. The factors that could contribute to fluctuations, which could have the effect of masking or exaggerating trends in our business and which could hurt the market price of our class A common stock, include: - Because new schools are opened in the first fiscal quarter of each year, increases in student enrollment and related revenue and expenses will first be reflected in that quarter. Subsequent to the first quarter, student enrollment is expected to remain relatively stable throughout a school year, and, accordingly, trends in our business, whether favorable or unfavorable, will tend not to be reflected in our quarterly financial results, but will be evident primarily in year-to-year comparisons. - We recognize revenue for each managed school pro rata over the 11 months from August through June, typically the period over which we perform our services, and except for revenue related to our summer school programs, we recognize no school revenue in July. Most of our site costs are also recognized over the 11 months from August through June. For this reason, the first quarter of our fiscal year has historically reflected less revenue and lower expenses than the other three quarters, and we expect this pattern to continue. - Our recognition of site-related expenses in the first fiscal quarter is proportionally greater than the revenue recognition because some site expenses are incurred in July and no revenue is recorded in July, with the exception of revenue related to our summer school programs. This results in lower gross site margin in the first fiscal quarter than in the remaining fiscal quarters. We also recognize pre-opening costs primarily in the first and fourth quarters. - We recognize revenue from our summer school programs during the first and fourth fiscal quarters. To the extent our summer school program becomes a more significant part of our business, this could significantly alter seasonal patterns. Our financial results can vary among the quarters within any fiscal year for other reasons, including unexpected enrollment changes, greater than expected costs of opening schools or delays in opening new schools. WE EXPECT OUR MARKET TO BECOME MORE COMPETITIVE We expect the market for providing private, for-profit management of public schools will become increasingly competitive. Currently, we compete with a relatively small number of companies that provide these services, and they have to date primarily focused on the operation of charter schools. Some of these companies have begun to compete with us for contract schools. In addition, a variety of other types of companies and entities could enter the market, including colleges and universities, private companies that operate higher education or professional education schools. Our existing competitors and new market entrants could have financial, marketing and other resources significantly greater than ours. We also compete for public school funding with existing public schools, who may elect not to enter into management agreements with private managers or who may pursue alternative reform initiatives, such as magnet schools and inter-district choice programs. In addition, in jurisdictions where voucher programs have been authorized, we will begin to compete with existing private schools for public tuition funds. Voucher programs provide for the issuance by local or other governmental bodies of tuition vouchers to parents worth a certain amount of money that they can redeem at any approved school of their choice, including private schools. If we are unable to compete successfully against any of these existing or potential competitors, our revenues could be reduced, resulting in increased losses. 24 FAILURE TO RAISE NECESSARY ADDITIONAL CAPITAL COULD RESTRICT OUR GROWTH AND HINDER OUR ABILITY TO COMPETE We have had negative cash flow in every fiscal period since we began operations. We have regularly needed to raise funds in order to operate our business and fund our growth, including the construction and renovation of charter school facilities, and may need to raise additional funds in the future. We cannot be certain that we will be able to obtain additional financing on favorable terms, if at all, or that our charter clients will be able to repay our loans and advances to them. If we issue additional equity or convertible debt securities, stockholders may experience dilution or the new equity or convertible debt securities may have rights, preferences or privileges senior to those of existing holders of class A common stock. If we cannot raise funds on acceptable terms, if and when needed, or if our charter clients are unable to repay our loans and advances to them, or if we are required to repay any loans that we have guaranteed, we may not be able to take advantage of future opportunities, grow our business or respond to competitive pressures or unanticipated requirements, which could seriously harm our business. THE TERMS OF OUR CREDIT AGREEMENTS IMPOSE SIGNIFICANT RESTRICTIONS ON OUR BUSINESS Under the MLMCI Facility and the New Credit Facility, we are required to comply with certain financial covenants, including maintaining specified financial ratios. Our ability to meet future financial ratios and comply with other covenants can be affected by events beyond our control, such as general economic conditions. Our failure to comply with such covenants would prevent us from borrowing additional amounts under our credit facilities and could result in a default under those facilities, which could cause the indebtedness outstanding under the facilities to become immediately due and payable. If we are unable to meet our debt obligations, we could be forced to restructure or refinance our indebtedness, seek additional equity capital or sell assets. We may be unable to obtain financing or sell assets on satisfactory terms, or at all. WE HAVE ISSUED WARRANTS FOR THE PURCHASE OF CLASS A COMMON STOCK IN CONNECTION WITH CERTAIN CREDIT FACILITIES THAT, IF EXERCISED, WILL DILUTE OUR CURRENT EQUITY HOLDERS AND COULD HAVE AN ADVERSE EFFECT ON THE MARKET PRICE FOR THE SHARES OF CLASS A COMMON STOCK Warrants issued in connection with the establishment of the Credit Facilities are for the purchase of up to 10,710,973 shares of class A common stock at $1 per share. The shares to be issued in connection with the warrants equaled at such time approximately 16.6% of the total outstanding shares of common stock of the Company, (including the shares issuable upon exercise of the Warrants but prior to any resale of such shares by the holders). The issuance of such shares will dilute the current stockholders of the Company and could have an adverse effect on the market price for the shares of class A common stock. In addition, the shares issuable upon exercise of the warrants are registered pursuant to a registration statement, and any sales of such shares may have a further adverse effect on the market price for the shares of the class A common stock. WE MAY NOT BE ABLE TO RECOVER THE PROPERTY VALUE ASSOCIATED WITH OUR TERMINATION OF THE EDISON CORPORATE HEADQUARTERS PROJECT We previously purchased property in New York, New York for the purchase price of $10 million, and entered into an agreement with the Museum of African Art to develop the property for a mixed use project consisting of our new corporate headquarters, a charter school and a facility to house the Museum. We recently terminated our plans to develop this property and construct new corporate headquarters. Accordingly, we may choose to sell the property to the Museum or another third party. While we hope to be able to sell the property at a price equal to or greater than our purchase price, we have no guarantee that we will be able to do so, and may choose to sell the property at a loss. WE RELY ON GOVERNMENT FUNDS FOR SPECIFIC EDUCATION PROGRAMS, AND OUR BUSINESS COULD SUFFER IF WE FAIL TO COMPLY WITH RULES CONCERNING THE RECEIPT AND USE OF THE FUNDS We benefit from funds from federal and state programs to be used for specific educational purposes. Funding from the federal government under Title I of the Elementary and Secondary Education Act, which provides federal funds for children from low-income families, accounted for approximately 4% of our gross student funding revenue for fiscal 2002. During the same period, we estimate that funding from other federal and state programs accounted for approximately an additional 10% of our total revenue. A number of factors relating to these government programs could lead to adverse effects on our business and financial results: 25 - These programs have strict requirements as to eligible students and allowable activities. If we or our school district and charter board clients fail to comply with the regulations governing the programs, we or our clients could be required to repay the funds or be determined ineligible to receive these funds. - If the income demographics of a district's population were to change over the life of our management agreement for a school in the district, resulting in a decrease in Title I funding for the school, we would recognize less revenue for operating the school. - Funding from federal and state education programs is allocated through formulas. If federal or state legislatures or, in some case, agencies were to change the formulas, we could receive less funding. - Federal, state and local education programs are subject to annual appropriations of funds. Federal or state legislatures or local officials could drastically reduce the funding amount of appropriation for any program, thus decreasing the amount of funding available to us. - The company's Edison Extra summer school program, which served approximately 35,000 students in Missouri during the summer of 2002, is funded through state summer school funds. If the Missouri state government fails to maintain current funding levels for summer school programs, Edison Extra revenue would be adversely affected. - Most federal education funds are administered through state and local education agencies, which allot funds to school boards and charter boards. These state and local education agencies are subject to extensive government regulation concerning their eligibility for federal funds. If these agencies were declared ineligible to receive federal education funds, the receipt of federal education funds by our school board or charter board clients could be delayed, which could in turn delay our payment from our school board and charter board clients. - The federal No Child Left Behind Act of 2001, which includes the Title I program referenced above, contains a range of new accountability measures for public schools. Schools that fail to make adequate yearly progress (AYP) toward meeting state standards may lose some of their student enrollment due to school choice provisions, may be required to allocate a portion of their Title I funding toward the provision of supplemental services to some students, and may be subject to state takeover or other forms of district or state intervention. If schools run by the company fail to make AYP, these new requirements could adversely affect the company's revenue and/or reputation. WE ARE SUBJECT TO EXTENSIVE GOVERNMENT REGULATION BECAUSE WE BENEFIT FROM FEDERAL FUNDS, AND OUR FAILURE TO COMPLY WITH GOVERNMENT REGULATIONS COULD RESULT IN THE REDUCTION OR LOSS OF FEDERAL EDUCATION FUNDS Because we benefit from federal funds, we must also comply with a variety of federal laws and regulations not directly related to any federal education program, such as federal civil rights laws and laws relating to lobbying. Our failure to comply with these federal laws and regulations could result in the reduction or loss of federal education funds. In addition, our management agreements are potentially covered by federal procurement rules and regulations because our school district and charter board clients pay us, in part, with funds received from federal programs. Federal procurement rules and regulations generally require competitive bidding, awarding contracts based on lowest cost and similar requirements. If a court or federal agency determined that a management agreement was covered by federal procurement rules and regulations and was awarded without compliance with those rules and regulations, then the management agreement could be voided and we could be required to repay any federal funds we received under the management agreement. FAILURE OF OUR CHARTER BOARD CLIENTS TO OBTAIN FEDERAL TAX-EXEMPT STATUS COULD JEOPARDIZE THE SCHOOL'S CHARTER AND RESTRICT OUR ABILITY TO FINANCE THE SCHOOL Many of our charter school clients apply for federal tax-exempt status. One state in which we currently operate seven charter schools and hope to open additional charter schools in the future, and one other state, requires charter schools to secure federal tax-exempt status. One of our charter school clients in the first state received notice from the Internal Revenue Service of an appealable denial of its application for federal tax-exempt status. While this charter school client was ultimately successful in obtaining tax-exempt status, there can be no assurance that other charter school clients will not experience 26 difficulty in obtaining such status. Any failure to receive or delay in receiving federal tax-exempt status by a charter school in this state could jeopardize the school's charter and its ability to repay amounts owed to us. The failure to receive federal tax-exempt status by a charter school in any state could also, among other things, inhibit that charter school's ability to solicit charitable contributions or participate in tax-exempt financing. WE EARN ALL OF OUR REVENUE FROM PUBLIC SOURCES AND ANY REDUCTION IN GENERAL FUNDING LEVELS FOR EDUCATION COULD HURT OUR BUSINESS All of our revenue is derived from public sources. If general levels of funding for public education were to decline, the field of school districts in which we could profitably operate schools would likewise diminish, and our ability to grow by adding new schools would suffer. In addition, our management agreements generally provide that we bear the risk of lower levels of per-pupil funding, which would be directly reflected in lower revenue to us, even if our costs do not decline accordingly, thus adversely affecting our financial results. RESTRICTIONS ON GOVERNMENT FUNDING OF FOR-PROFIT SCHOOL MANAGEMENT COMPANIES COULD HURT OUR BUSINESS Any restriction on the use of federal or state government educational funds by for-profit companies could hurt our business and our ability to grow. From time to time, a variety of proposals have been introduced in state legislatures to restrict or prohibit the management of public schools by private, for-profit entities like us. For example, a recently-passed bill in California prohibits the state department of education from contracting with a private, for-profit education manager to manage public schools for which the state assumes control pursuant to a new state educational reform measure. Additionally, Idaho's charter school law may, subject to interpretation, restrict our ability to manage schools in that state. To the extent that states or the federal government were to adopt legislation prohibiting for-profit entities from operating public schools, the market for our services would decline and our business results could suffer. THE OPERATION OF OUR CHARTER SCHOOLS DEPENDS ON THE MAINTENANCE OF THE UNDERLYING CHARTER GRANT Our charter schools operate under a charter that is typically granted by a state authority to a third-party charter holder, such as a community group or established non-profit organization. Our management agreement in turn is with the charter holder. If the state charter authority were to revoke the charter, which could occur based on actions of the charter holder outside of our control, we would lose the right to operate that school. In addition, many state charter school statutes require periodic reauthorization. Charter schools accounted for 33.0% of our gross student funding in fiscal 2002, or approximately $171.0 million. If state charter school legislation were not reauthorized or were substantially altered in a meaningful number of states, our business and growth strategy would suffer and we could incur additional losses. OUR STOCK PRICE HAS BEEN VOLATILE AND WE EXPECT IT TO CONTINUE TO BE VOLATILE IN THE FUTURE The market price of our class A common stock has fluctuated significantly in response to the risks discussed above, as well as other factors, some of which are beyond our control. These other factors include: - variations in our quarterly operating results; - changes in securities analysts' estimates of our financial performance; - changes in the public perception of our schools' academic performance; - termination or non-renewal of existing management agreements; - changes in market valuations of similar companies; - speculation in the press or investment community; - actions by institutional shareholders; - pending and potential litigation; 27 - future sales of our class A common stock or other securities; and - general stock market volatility. Since our class A common stock has been publicly traded, its market price has fluctuated over a wide range and we expect it to continue to do so in the future. WE HAVE BEEN NAMED IN SEVERAL SHAREHOLDER CLASS ACTION AND SHAREHOLDERS DERIVATIVE LAWSUITS We have been named in several putative class actions lawsuits filed in the Southern District of New York, and a few shareholder derivative actions, also filed in New York. We intend to vigorously defend these lawsuits. However, there can be no assurance that the Company will be successful, and an adverse resolution of the lawsuits could have a material adverse effect on our financial position and results of operations in the period in which the lawsuits are resolved. We are not presently able to reasonably estimate potential losses, if any, related to the lawsuits. Lawsuits may cause defaults under our material agreements, prevent us from obtaining additional funds under our existing line of credit or obtain additional financing, and such litigation could result in substantial costs and divert management's attention and resources. WE MAY FACE ADDITIONAL SECURITIES LITIGATION OR OTHER LITIGATION In addition to the securities class action litigation currently being brought against us as more fully described in the risk factor above, we may also in the future be the target of similar litigation. Additional securities litigation could result in substantial costs and divert management's attention and resources. We may also face other types of litigation. For example, the Company and a private pension fund were unable to close a proposed financing transaction and the Company chose instead to do a transaction with School Services LLC. The Company could face litigation in connection with that decision. While we intend to vigorously defend against any such lawsuit, there can be no assurance that the Company will be successful, and an adverse resolution of any lawsuit could have a material adverse effect on our financial position, shareholder equity, and results of operations in the period in which the lawsuits are resolved. WE MUST COMPLY WITH THE TERMS OF A SETTLEMENT AGREEMENT ENTERED INTO BY THE COMPANY AND THE SECURITIES AND EXCHANGE COMMISSION On May 14, 2002, the Company entered into a settlement agreement with the Securities and Exchange Commission, pursuant to which the Company agreed to enhance disclosure of its revenue recognition practices, by adopting a statement of operations presentation that includes a line item for "Gross Student Funding," as well as full disclosure of all expenses paid by Edison and all expenses paid by the local districts, and improve its internal accounting system by creating an Internal Audit Department. The Company intends to fully comply with the terms and conditions of the settlement agreement. However, if we fail to comply with the settlement agreement, or are perceived by the Securities and Exchange Commission to have failed to comply, we may face additional scrutiny from the Commission, which could have a material adverse effect on our financial condition and results of operations. WE MAY BE DELISTED FROM THE NASDAQ NATIONAL MARKET, WHICH COULD RESULT IN A LIMITED PUBLIC MARKET FOR OUR CLASS A COMMON STOCK On August 27, 2002, we received notice from Nasdaq that the price of our class A common stock had closed below the minimum $1.00 per share for 30 consecutive trading days as required for continued listing under Nasdaq's marketplace rules. We subsequently reestablished compliance with the rule which requires our stock to close above the minimum $1.00 per share price for ten (10) consecutive trading days. However, we have no assurance that we will continue to trade above the minimum $1.00 per share price as required under Nasdaq's marketplace rules for continued listing. Delisting from the Nasdaq market could adversely affect the liquidity and price of our class A common stock and could have long-term impact on our ability to raise future capital. Additionally, Nasdaq's listing requirements provide that a listed company must have an audit committee comprised of at least three independent directors. The Company's audit committee is currently comprised of two independent board members, one of whom serves as chairman. The Company is in the process of recruiting a third independent board member to serve on the committee and has reviewed this situation with Nasdaq. Until the audit committee has three independent directors 28 as members, the Company will be in violation of the Nasdaq listing requirements. ANTI-TAKEOVER PROVISIONS OF DELAWARE LAW AND OUR CHARTER AND BYLAWS COULD PREVENT OR DELAY A CHANGE IN CONTROL Provisions of Delaware law, our charter and our bylaws could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions could limit the price that certain investors might be willing to pay in the future for shares of class A common stock, and could have the effect of delaying, deferring or preventing a change in control of us. These provisions include: - the high-vote nature of our class B common stock; - restrictions on removal of directors, which may only be effected for cause and only by a vote of the holders of 80% of our class of common stock that elected the director; - Section 203 of the General Corporation Law of Delaware which could have the effect of delaying transactions with interested stockholders; - a prohibition of stockholder action by written consent; and procedural and notice requirements for calling and bringing action before stockholder meetings ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We currently have market risk sensitive instruments related to interest rates. We had outstanding long-term notes payable of $24.3 million at December 31, 2002. Interest rates on the notes are fixed and range from 9.5% to 16.7% per annum and have terms of 24 to 48 months. We do not believe that we have significant exposure to changing interest rates on long-term debt because interest rates for our debt is fixed. We have not undertaken any additional actions to cover interest rate market risk and are not a party to any other interest rate market risk management activities. Additionally, we do not have significant exposure to changing interest rates on invested cash, which was approximately $37.0 million at December 31, 2002. We invest cash mainly in money market accounts and other investment-grade securities. We do not purchase or hold derivative financial instruments for trading purposes. ITEM 4. CONTROLS AND PROCEDURES (a) Within the 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Executive Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company's Chief Executive Officer and Executive Vice President and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings. (b) There were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls subsequent to the Evaluation Date and, subsequent to such date, no corrective actions with regard to significant deficiencies and material weaknesses were taken. PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Please refer to Note 9 to the condensed consolidated financial statements contained in Part I, Item 1 of this report. 29 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS On December 5, 2002, the Company held its Annual Meeting of Stockholders. Of 52,018,855 shares of Class A Common Stock entitled to vote, 45,919,962 were present at the meeting or represented by proxy, and of 1,805,132 shares of Class B Common Stock entitled to vote, 1,721,351 were present at the meeting or represented by proxy. The following sets forth a description of each matter voted on and the votes cast. 1) A proposal to elect 11 directors for the following year. The holders of Class A Common Stock and Class B Common Stock voted separately in the election of directors, with the holders of Class A Common Stock entitled to elect four directors and the holders of Class A Common Stock entitled to elect seven directors. Directors elected by the holders of Class A Common Stock: Number of Shares of Class A Common Stock

30 Directors elected by the holders of Class B Common Stock: Number of Shares of Class B Common Stock

For the following matters, both classes of common stock voted together as a single class, with each share of Class A Common Stock entitled to cast one vote and each share of Class B Common Stock entitled to cast ten votes. 2) A proposal to approve an amendment to the Company's 1999 Stock Incentive Plan to increase the total number of shares of Class A Common Stock authorized for issuance thereunder from 6,500,000 shares to 8,500,000 shares. For the above referenced proposal, 45,107,537 votes were cast in favor of the proposal, 17,990,381 votes were cast against the proposal, and 35,554 votes were withheld. 3) A proposal to ratify Board of Directors' selection of PricewaterhouseCoopers LLP as Edison's independent auditors for the current year. For the above referenced proposal, 59,158,064 votes were cast in favor of the proposal, 3,947,598 votes were cast against the proposal, and 27,810 votes were withheld. ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. Exhibits: 10.56 Amendment to Letter Agreement between H. Christopher Whittle and Edison Schools Inc. Dated December 18, 2001 10.57 Amendment to Letter Agreement between Christopher D. Cerf and Edison Schools Inc. Dated July 1, 1999 99.1 Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Reports on Form 8-K: The company did not file any reports on Form 8-K during the quarter for which this report is filed. 31 SIGNATURES 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. EDISON SCHOOLS INC. Date February 14, 2002 /s/ H. Christopher Whittle -------------------------------------- H. Christopher Whittle Chief Executive Officer Date February 14, 2002 /s/ Christopher J. Scarlata -------------------------------------- Christopher J. Scarlata Executive Vice President and Chief Financial Officer (Principal Accounting Officer) 32 CERTIFICATIONS I, H. Christopher Whittle, Chief Executive Officer of Edison Schools Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Edison Schools Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: February 14, 2003 /s/ H. Christopher Whittle ------------------------------------- H. Christopher Whittle Chief Executive Officer 33 I, Christopher J. Scarlata, Executive Vice President and Chief Financial Officer of Edison Schools Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Edison Schools Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: February 14, 2003 /s/ Christopher J. Scarlata ------------------------------------- Christopher J. Scarlata Executive Vice President and Chief Financial Officer 34

EDISON SCHOOLS INC 10-Q