This report contains forward-looking statements. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as "may," "will," "should," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue" and variations and negatives of these words and similar expressions are used to identify forward-looking statements. Statements regarding our expectations for our future business results and financial position, our business strategies and objectives, and trends in our market are forward-looking statements. Forward-looking statements are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management's Discussion and in the Risk Factors section of this report. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

Scientific Learning Corporation develops and distributes the Fast ForWord® family of software. These patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. On January 7, 2008, we completed the acquisition of substantially all of the assets of Soliloquy Learning, including the Reading Assistant™ product, for $10.7 million in cash. The Scientific Learning Reading Assistant combines advanced speech recognition technology with scientifically based intervention to help students strengthen reading fluency, vocabulary and comprehension to become proficient life-long readers. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. We sell primarily to K-12 schools in the United States through a direct sales force. Since our inception, learners have used our Fast ForWord products over 1.3 million times and approximately 5,700 schools have purchased at least $10,000 of our Fast ForWord product licenses and services. As of September 30, 2008 we had 218 full-time equivalent employees, compared to 215 at December 31, 2007.

Business Highlights

We market our Fast ForWord products primarily as a reading intervention solution for struggling, at-risk, English Language Learners, and special education students. Approximately 70% of the estimated 55 million public and private school K-12 students in the United States test as not proficient in reading. While our installed base is growing, the approximately 5,700 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 125,000 K-12 schools in the U.S.

Federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants. In the federal government's fiscal year ended September 30, 2008 these programs totaled approximately $26.4 billion and are projected to total approximately $30.4 billion in fiscal 2009. In addition, schools receive significant funding from state and local governments. State and local governments are forecasting shortfalls in their taxation revenues for their fiscal 2009 because of significant adverse events in the credit and housing markets and a potential protracted national and global recession. Given such an environment, current economic conditions could have an adverse impact on future federal, state and local education spending, although we believe that education would remain among the top government priorities.

Sales of our products are included in the growing supplemental education materials segment of the overall education materials market. Simba Information's Publishing for the PreK-12 Market 2008 - 2009 (April 2008) estimates that:

† The total market for K-12 instructional materials is $9.36 billion, growing at 3.2%

† The electronic materials segment of that market is $2.04 billion

† The fastest growing electronic materials segment, which is where we compete, is electronic courseware at $928 million and expected to grow 9.3%.

Company Highlights

For the three months ended September 30, 2008, our total revenue increased by 12% compared to the same period in 2007 and for the nine months ended September 30, 2008 our total revenue increased by 1%. For the three months and nine months ended September 30, 2008, product revenue remained flat and declined by 12% respectively, compared to the same periods in 2007. Service and support revenue increased by 34% and 32% for the three months and nine months ended September 30, 2008 respectively, primarily due to a higher number of schools on support, more services delivered, higher revenue for the Reading Progress Indicator and OEM revenue from the operations we purchased in our acquisition of Soliloquy in January 2008. In the nine months ended September 30, 2008, revenue and booked sales from Reading Assistant were still a relatively minor part of our business. During this period, revenue and booked sales from the Reading Assistant product and related OEM products and services (excluding support and service to schools, which we do not track separately) were less than 10% of the overall totals.

For the three months ended September 30, 2008, we closed 23 transactions in excess of $100,000, compared to 37 in the third quarter of 2007. These large transactions frequently require school board approvals and their timing is often difficult to predict.

Deferred revenue, which represents revenue to be recognized in future periods, was $23.1 million on September 30, 2008 compared to $24.3 million on September 30, 2007.

For the three months ended September 30, 2008, our total booked sales increased by 4% and for the nine months ended September 30, 2008 our total booked sales decreased by 11% compared to the same periods in 2007. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenue below). The decrease in year to date booked sales is mainly because one large transaction for approximately $7.4 million was booked in the second quarter of 2007 and no similar-sized transaction was booked in the nine month period ending September 30, 2008.

For the three months and nine months ended September 30, 2008, gross profit increased 7% and decreased by 4% respectively over the comparable periods in the prior year. A shift in revenue mix and additional costs arising from the Soliloquy acquisition negatively impacted product margins, but this was more than offset by continued improvements in our service and support margins in the three months ended September 30, 2008. Operating expenses increased by 2% and 8% for the three months and nine months ended September 30, 2008, respectively, mostly due to the addition of the Reading Assistant development team, amortization expenses resulting from the Soliloquy acquisition, and an increase in bad debt expense, partially offset by a decrease in consulting expense.

We recorded net income of $590,000 for the three months ended September 30, 2008 compared to net income of $246,000 in the same period in 2007. We recorded a net loss of $4.5 million for the nine months ended September 30, 2008 compared to net income of $277,000 in the same period in 2007.

At September 30, 2008 and 2007 we had no outstanding debt.

Results of Operations

Revenues


                              Three Months Ended September 30,                Nine Months Ended September 30,
                         ------------------------------------------- -    --------------------------------------- -
(dollars in thousands)        2008         Change          2007               2008          Change        2007
---------------------- - -------------- -- ------- -- -------------- -    ------------- -- -------- -- ---------- -
Products                 $        7,475       0 %     $        7,456      $      21,009      -12 %     $   23,935
Service and support               5,220      34 %              3,894             14,252       32 %         10,805
---------------------- - -- ----------- -- ---- -- -- -- ----------- -    -- ---------- -- ----- -- -- -- ------- -
Total revenues           $       12,695      12 %     $       11,350      $      35,261        1 %     $   34,740
---------------------- - -- ----------- -- ---- -- -- -- ----------- -    -- ---------- -- ----- -- -- -- ------- -

Product revenues remained flat and decreased by 12% during the three months and nine months ended September 30, 2008 respectively, compared to the same periods in 2007. The decrease in the nine months ended September 30, 2008 was mainly because one large transaction for approximately $7.4 million was booked in the second quarter of fiscal 2007 and no similarly-sized transaction was booked in 2008. This transaction included approximately $3.2 million of product revenue that was recognized during the nine months ended September 30, 2007. Our largest transaction in the nine months ended September 30, 2008 was for approximately $2.2 million, including approximately $300,000 of product revenue that was recognized in the three months ended September 30, 2008.

Our service and support revenue increased significantly during both the three months and nine months ended September 30, 2008 compared to the same period in 2007 due to a higher number of schools on support, more services delivered, higher revenue for the Reading Progress Indicator and OEM revenue from the operations we purchased in our acquisition of Soliloquy in January 2008.

Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three and nine months ended September 30, 2008 and 2007:

                          Three Months Ended September 30,               Nine Months Ended September 30,
                      ----------------------------------------- -    --------------------------------------- -
(dollars in
thousands)                2008          Change         2007              2008         Change         2007
------------------- - ------------- -- --------- -- ----------- -    ------------ -- --------- -- ---------- -
Booked sales          $      15,185       4 %       $    14,535      $     35,417      (11 %)     $   39,856
Less revenue                 12,695      12 %            11,350            35,261        1 %          34,740
------------------- - -- ---------- -- ---- ---- -- -- -------- -    -- --------- -- ----- --- -- -- ------- -
Net increase in
deferred revenue              2,490                       3,185               156                      5,116
------------------- - -- ---------- -- ---- ---- -- -- -------- -    -- --------- -- ----- --- -- -- ------- -
Total deferred
revenue end of
period                $      23,111      (5 %)      $    24,275      $     23,111       (5 %)     $   24,275
------------------- - -- ---------- -- ---- ---- -- -- -------- -    -- --------- -- ----- --- -- -- ------- -

Booked sales in the K-12 sector increased 6% to $13.9 million during the three months ended September 30, 2008, and decreased by 14% to $31.3 million for the nine months ended September 30, 2008, compared to the same periods in 2007. As previously noted, one large transaction for approximately $7.4 million was booked in the nine months ended September 30, 2007, whereas the largest transaction booked in the nine months ended September 30, 2008 was for approximately $2.2 million. This latter sale occurred in the three months ended September 30, 2008, and is the main reason for the increase in sales in this period as compared to the three months ended September 30, 2007.

Booked sales to the K-12 sector for the three and nine months ended September 30, 2008 were respectively 91% and 88% of total booked sales, compared to 90% and 91% in the same periods in 2007. Booked sales to non-school customers, including both private practice clinicians and international customers, decreased by 11% for the three months ended September 30, 2008 compared to the same period in 2007. This decrease is primarily the result of one large transaction of $668,000 in the juvenile corrections market in the non-school sector in the third quarter of 2007, whereas no transaction of a similar size was booked in the same period in 2008. Booked sales to non-school customers increased by 20% for the nine months ended September 30, 2008 as a result of an increase in our international sales together with the OEM business that we acquired as a result of the Soliloquy acquisition in January 2008.

We believe large booked sales are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. During the third quarter of 2008, we closed 23 K-12 sales that had a contract value in excess of $100,000, compared to 37 for the same period in 2007. For both the three months and nine months ended September 30, 2008, approximately 60% of our K-12 booked sales were realized from booked sales over $100,000. For the comparable periods in 2007, these large booked sales accounted for approximately 66% and 67% of K-12 booked sales. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate. Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting. We cannot predict the size and number of large transactions in the future.

Although the current uncertain financial market, economic conditions, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 market. However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products' ease of use, their fit with school requirements, and our connection with classroom teachers and administrators. Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding. While federal funding for education has grown steadily over the last few decades, the current extraordinary federal commitments intended to stabilize the financial markets are likely to put pressure on all areas in the federal budget. States are forecasting shortfalls in their taxation revenues for their fiscal 2009 and 2010 because of the significant adverse conditions in the credit and housing markets and a potential protracted national and global recession. These conditions may impact education spending. In addition, the revenue recognized from our booked sales can be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. See "Management's Discussion and Analysis - Application of Critical Accounting Policies" for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time. See "Risk Factors" for a further discussion of some of the factors that affect our sales and revenue.

Gross Profit and Cost of Revenues


                             Three Months Ended September 30,               Nine Months Ended September 30,
(dollars in
thousands)                   2008                      2007                 2008                    2007
-------------------- - ---------------- -------- ---------------- -    --------------- ------- --------------- -
Gross profit on
products               $          6,876          $          6,997      $        19,323         $        22,676
Gross profit margin
on products                          92 %                      94 %                 92 %                    95 %
Gross profit on
service and support               2,809                     2,022                6,973         $         4,592
Gross profit margin
on services and
support                              54 %                      52 %                 49 %                    42 %
-------------------- - --- ------------ -------- --- ------------ -    -- ------------ ------- -- ------------ -
Total gross profit     $          9,685          $          9,019      $        26,296         $        27,268
Total gross profit
margin                               76 %                      79 %                 75 %                    78 %
-------------------- - --- ------------ -------- --- ------------ -    -- ------------ ------- -- ------------ -

The overall gross profit margin decreased in both the three months and nine months ended September 30, 2008 compared to the same periods in the prior year due to a revenue mix shift. Higher margin product revenues made up 59% and 60% of total revenues in the three and nine months ended September 30, 2008, respectively, compared to

66% and 69% in the same periods in 2007. Product margins also declined in both the three months and nine months ended September 30, 2008, mainly due to the impact of the amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant. Service and support gross margins improved because a larger proportion of these revenues arose from support and Progress Tracker, which have higher margins than training and implementation services.

Operating Expenses


                          Three Months Ended September 30,                Nine Months Ended September 30,
(dollars in
thousands)                2008         Change          2007              2008         Change         2007
------------------- - ------------ -- --------- -- ------------ -    ------------- -- ------- -- ------------- -
Sales and marketing   $      5,329       -13 %     $      6,143      $      18,461      -2 %     $      18,745
Research and
development                  1,545        52 %            1,016              5,267      56 %             3,385
General and
administrative               2,398        27 %            1,890              6,346      11 %             5,721
------------------- - -- --------- -- ------ -- -- -- --------- -    -- ---------- -- ---- -- -- -- ---------- -
Total operating
expenses              $      9,272         2 %     $      9,049      $      30,074       8 %     $      27,851
------------------- - -- --------- -- ------ -- -- -- --------- -    -- ---------- -- ---- -- -- -- ---------- -

Sales and Marketing Expenses: For the three and nine months ended September 30, 2008, our sales and marketing expenses decreased by 13% and 2%, respectively, compared to the same periods in 2007. The decrease in the three months ended September 30, 2008 is mostly as a result of our holding fewer marketing events. At September 30, 2008, we had 51 quota-bearing sales personnel compared to 50 at September 30, 2007.

Research and Development Expenses: Research and development expenses increased by 52% and 56% in the three and nine months ended September 30, 2008, compared to the same periods in 2007. The main cause of these large increases is that research and development expenses now include the costs of the Reading Assistant development team from the Soliloquy acquisition. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs.

General and Administrative Expenses: For the three and nine months ended September 30, 2008, our general and administrative expenses increased by 27% and 11%, respectively, compared to the same periods in 2007. The increase in the three months ended September 30, 2008 is mainly due to an increase in bad debt expense of $430,000 and severance costs of $266,000. The increase in the nine months ended September 30, 2008 is also mostly caused by higher bad debt expense of $461,000 and severance costs of $266,000.

Other Income from Related Party

In September 2003, we signed an agreement with Posit Science Corporation ("PSC"), transferring technology to PSC for use in the health field. During the three and nine months ended September 30, 2008, we recorded $55,000 and $150,000 in royalties receivable from PSC, respectively. For the comparable periods in 2007, we recorded $68,000 and $185,000. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.

Interest and Other Income


                            Three Months Ended September 30,                 Nine Months Ended September 30,
(dollars in
thousands)                2008          Change           2007               2008           Change         2007
------------------- - ------------- -- --------- -- ---------------    --------------- -- --------- -- ----------- -
Interest on
invested cash            $    13          -91 %        $     144          $      97          -78 %        $ 435
Reclassification of
service revenue               73          -14 %               85                217          -16 %          259
Miscellaneous                  0           NA                  1                  9           NA              7
------------------- - -- -- ---- -- -- ------ -- -- -- -- ------ --    -- -- ------ -- -- ------ -- -- -- - --- -- -
Interest and other
income, net              $    86          -63 %        $     230          $     323          -54 %        $ 701
------------------- - -- -- ---- -- -- ------ -- -- -- -- ------ --    -- -- ------ -- -- ------ -- -- -- - --- -- -

For the three months and nine months ended September 30, 2008, interest and other income consisted primarily of a reclassification of $73,000 and $217,000, respectively, of service and support revenue relating to two customers for

whom we are no longer performing services, and interest on our invested cash of $13,000 and $97,000. In the three months and nine months ended September 30, 2007, interest and other income comprised mainly the same reclassification from service and support revenue of $85,000 and $259,000 and interest earned on our invested cash of $144,000 and $435,000, respectively. Interest income decreased 91% and 78% respectively for the three and nine months ended September 30, 2008, primarily due to lower cash balances as a result of cash used in the purchase of Soliloquy in January 2008 as well as decreasing interest rates.

Provision for Income Taxes

In the nine months ending September 30, 2008, we recorded a year to date tax expense of $1.2 million. The total year to date tax expense consists of a $3,000 expense in the first quarter of 2008, a $1.2 million expense in the second quarter of 2008, and a $36,000 tax benefit in the current quarter. Total tax expense relates primarily to reestablishment of a full valuation allowance against deferred tax assets during Q2. The resulting year to date effective tax rate is (36.5)%. This nine-month period differs significantly from that of last year where no tax provision was recorded for the nine months ending September 30, 2007 due to taxes payable all being offset with released net operating losses. The effective tax rate for that period was 7.12%.

Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), provides for the recognition of deferred tax assets if realization of such assets is more likely than not. We intend to maintain the full valuation allowance until sufficient further positive evidence exists to support a reversal of the valuation allowance.

At September 30, 2008, we have unrecognized tax benefits of approximately $1.9 million. We have approximately $26,000 of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We do not believe there will be any material changes in our unrecognized tax positions over the next twelve months. Interest and penalty costs related to unrecognized tax benefits are insignificant and classified as a component of "Income Tax Expense" in the accompany statement of operations.

We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. We are subject to U.S. federal income tax examination for calendar tax years ending 2005 through 2007. In December 2007 we completed an audit from the I.R.S. for our 2004 and earlier tax years. Additionally, we are subject to various state income tax examinations from the 1997 through 2007 calendar tax years.

Liquidity and Capital Resources

Our cash, cash equivalents and short term investments were $6.1 million at September 30, 2008, compared to $21.2 million at December 31, 2007. Our cash balances decreased primarily because of the $10.1 million payment for the acquisition of Soliloquy Learning, including direct transaction costs. In addition, we used $5.2 million of cash in operating activities in the nine months ended September 30, 2008.

. . .