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2007LeapFrog Annual Report

Table of contents

  • Page 1
    J\\k_\C\Xie`e^ KD LeapFrog Annual Report 2007

  • Page 2

  • Page 3
    ... learn-to-read technology that can be used directly with real books and which will interact with the Internet so that parents can "see the learning." The Tag system will launch in June, but has already received much positive attention on the web, in consumer media, and from the retail trade. Our Tag...

  • Page 4
    ...the most innovative product features and sales tools in the educational toys and games arena-the LeapFrog Learning Path. The LeapFrog Learning Path is an online application that communicates each child's progress on his or her "learning journey" to the parent. Parents gain personalized insights into...

  • Page 5
    ...The aggregate market value of the common equity held by non-affiliates of the registrant as of June 30, 2007 calculated using the closing market price as of that day, was approximately $363,434,947. Shares of common stock held by each current executive officer and director and by each person who is...

  • Page 6

  • Page 7
    ... logo, the LeapFrog Connect logo, the LeapFrog School design, "LeapPad," "Leapster," "Leapster L-MAX," "Leapster TV," "LeapTrack," "Learn & Groove," the LeapFrog Learning Path logo, "Letter Factory," "Little Leaps," "LittleTouch," "Tag," the Tag logo, "didj," "Crammer," "See the Learning" and "Word...

  • Page 8
    ... and Related Party Transactions, and Director Independence ...Item 14. Principal Accountant Fees and Service ...PART IV ...Item 15. Exhibits and Financial Schedules ...Signatures ...Power of Attorney ...Index to Consolidated Financial Statements ...Reports of Independent Registered Public Accounting...

  • Page 9
    ... designs, develops and markets innovative, technology-based learning products and related proprietary content for the education of infant through grade school children at home and in schools around the world. Our goal is to create educational products that kids love, parents trust and teachers value...

  • Page 10
    ... products to a child's course of development. The LeapFrog Learning Path is based on LeapFrog School's LeapTrack system for instruction and assessment which has been used by educational institutions of our LeapFrog School business since 2002. Our LeapTrack system, which provides feedback to teachers...

  • Page 11
    ... age-appropriate learning categories that a child is being introduced to when interacting with our key web-connected products. Using the LeapFrog Learning Path is simple...1. Create an online account to launch the application 2. Connect a LeapFrog product, for example, a Tag reading product...

  • Page 12
    ...unable to successfully launch, market and operate our web-connected products and the software that is required for their use, the sales of our products and our business results could suffer," and "-System failures related to our web store or the websites that support our web-connected products could...

  • Page 13
    ... a web-connected product, the Tag reader will be LeapFrog Learning Path-enabled initially in the United States and Canada. • • Educational Gaming and Grade School Products: • The Leapster multimedia learning systems includes our screen-based, learning devices developed to encourage learning...

  • Page 14
    ... younger children, create customer entry points to our Reading Solutions and Educational Gaming families of products. • • For more information about the risks associated with our new products, and particularly LeapFrog's Learning Path software, see "Item 1A-Risk Factors-If we fail to predict...

  • Page 15
    ... lower research and development costs in 2008. • • • • • • • • Additional Information Segments of Our Business and Customer Concentration LeapFrog reports the financial results of the following operating segments: • U.S.Consumer: We market and sell our products directly to...

  • Page 16
    ... United Kingdom of $57.1 million. No other country accounted for more than 10% of LeapFrog's net sales in 2005. • School: We currently target the pre-kindergarten through fifth grade school market in the United States, including making sales directly to educational institutions and teacher supply...

  • Page 17
    ... use in their classrooms; and (4) direct consumer customers who purchase our products via our website. Retailers and distributors purchase our products either via FOB (freight on board) terms, in which case goods are picked up in China and the customer pays through pre-established letters of credit...

  • Page 18
    ... as new innovative products. We believe our learning toys, reading solutions and educational gaming platforms, software and other electronic learning aids compete favorably on the basis of performance, features, quality, brand recognition, price and learning content. Additionally, our products bring...

  • Page 19
    ...LeapFrog-branded products includes books from Scholastic Corporation, ride-on toys from Kiddieland, card and board games from Cardinal, puzzles from Masterpieces, and workbooks from Learning Horizons. Revenues from out-bound licensing were not material in 2007 or 2006. • Research and Development...

  • Page 20
    ... software from Anoto AB in our FLY Pentop Computer and our Tag reading system. In 2006, we completed consolidation of our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California, to better align our marketing...

  • Page 21
    ...." in this report. Advertising and Marketing Our advertising and marketing strategy is designed to position LeapFrog as a leader in providing engaging, effective, technology-based learning solutions primarily for children. Our communication supports a strong brand that parents and educators seek out...

  • Page 22
    ..., Product, Innovation, and Marketing since February 2007. From May 2005 through January 2007, Ms. MacIntyre served on the executive team at LucasArts, a LucasFilm company, most recently as Vice President of Global Sales and Marketing and prior to that as Senior Director, Online Gaming. Previously...

  • Page 23
    ... Computer Corporation, a manufacturer of personal computers, most recently as Managing Director of operations and strategic procurement for the Presario personal computer business. Mr. Dodd received his B.B.A. from Texas A&M University. Michael J. Lorion has served as our President, LeapFrog School...

  • Page 24
    ... of California, Berkeley. Mark A. Etnyre has served as our Vice President, Corporate Controller and Principal Accounting Officer since December 2007. Prior to joining the Company, Mr. Etnyre served in various financial-related capacities with Microsoft Corporation, a publicly held software company...

  • Page 25
    ... to download software onto their computers, connect to the Internet and create online accounts in order to access the full capabilities and features of these products and our Internet-based LeapFrog Learning Path. For example, while the title included with the purchase of our Tag reading system can...

  • Page 26
    System failures related to our web store or the websites that support our web-connected products could harm our business. Our web store on LeapFrog.com, the LeapFrog Learning Path application and our web-connected products depend upon the reliable performance of our web operations and the network ...

  • Page 27
    ...them or experience a future downturn in their business, our business and operating results could be harmed. Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the...

  • Page 28
    ... executives and technical, sales, marketing, manufacturing and administrative personnel. In 2007, we hired new executives in international sales, product innovation and marketing, and accounting and added substantially to our web services and web products teams. In addition to hiring new management...

  • Page 29
    ... performance will depend in part on our School segment, which may not be successful. In 1999, we launched our School segment, which was formerly known as LeapFrog SchoolHouse, to deliver classroom instructional programs to the pre-kindergarten through fifth grade market and explore adult learning...

  • Page 30
    ... sales and product development resources on reading curriculum for core grade levels. However, if we cannot increase market acceptance of our School segment's supplemental educational products, the segment's future sales and profitability could suffer, which would adversely affect our financial...

  • Page 31
    ...aspects of our business, including products and the importation of products. Regulations with which we must comply include accounting standards, taxation requirements (including changes in applicable income tax rates, new tax laws and revised tax law interpretations), trade restrictions, regulations...

  • Page 32
    ...over financial reporting is effective, investors may lose confidence in our reported financial information, which could result in the decrease of the market price of our Class A common stock. One stockholder controls a majority of our voting power as well as the composition of our board of directors...

  • Page 33
    ... additional dilution. Our stock price could become more volatile and your investment could lose value. All the factors discussed in this section could affect our stock price. The timing of announcements in the public markets regarding new products, product enhancements or product recalls by us or...

  • Page 34
    ...to all of its current patents and patent applications, as well as patents related to our business arising from applications filed by Tinkers & Chance or its principals through November 2014. On January 4, 2008, the parties executed a formal agreement that memorialized in writing, the terms agreed to...

  • Page 35
    ... and misleading statements about our business and forecasts about our financial performance, and that certain of our current and former individual officers and directors sold portions of their stock holdings while in the possession of adverse, non-public information. In September 2007, the federal...

  • Page 36
    PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Market Information and Holders Our Class A common stock is listed on the New York Stock Exchange, or the NYSE, under the symbol "LF." There is no established public trading market for the Class B common stock. On ...

  • Page 37
    ... Discretionary Index, for the period beginning on July 25, 2002 (based on the closing price of LeapFrog's Class A common stock on the date on which LeapFrog's Class A common stock began trading on the New York Stock Exchange) through December 31, 2007. The stockholder return shown on the graph below...

  • Page 38
    ... of Operations" and the consolidated financial statements and related notes thereto in this report. 2007 For the Year Ended December 31, 2006 2005 2004 (In thousands, except per share data) 2003 Consolidated Statements of Operations Data: Net sales ...Gross profit ...Income (loss) from operations...

  • Page 39
    ... the Tag reading system, new educational gaming offerings with the Leapster 2 and didj handheld learning systems, a strong library of content for our platforms and the LeapFrog Learning Path, all of which are described in "Item 1-Business" in this report. Critical Accounting Policies, Judgments...

  • Page 40
    ... for Doubtful Accounts, Product Returns, Defective Products, Discounts and Promotions We principally derive revenue from sales of our technology-based learning products and related proprietary content for education of infant through grade school children at home and in schools. We evaluate the...

  • Page 41
    ...31, 2007, and 2006, respectively. Our estimate of the write-down for slow-moving, excess and obsolete inventories is based on our management's review of on-hand inventories compared to their estimated future usage, our product demand forecast, anticipated product selling prices, the expected product...

  • Page 42
    ... stock price volatility used in the model require the exercise of judgment. The expected life of the options represent the period of time the options are expected to be outstanding and is currently based on the guidance provided in the SEC Staff Accounting Bulletin No. 107 on Share-Based Payment...

  • Page 43
    ... periods indicated: Year Ended December 31, 2007 2006 2005 Net sales ...Cost of sales ...Gross profit ...Operating expenses: Selling, general and administrative ...Research and development ...Advertising ...Depreciation and amortization ...Total operating expenses ...Income (loss) from operations...

  • Page 44
    ... $(60.0) (12)%100% 100% (1) In millions (2) Includes sales of platform hardware, software and accessories for the Leapster, Leapster TV and Leapster L-MAX product lines Based on management's current projections of the sales of new products, sales are expected to grow significantly in 2008. Segment...

  • Page 45
    ... sales of Leapster products. Higher sales in Mexico in 2007 compared to 2006, due primarily to the launch of ClickStart products and the full year impact of sales of Leapster products, which entered the Mexico market in 2006. Our LeapPad and Leapster products were our only products that accounted...

  • Page 46
    ... our School segment designed to return it to positive operating income by focusing our sales efforts on profitable regions. Four products each accounted for 10% or more of our net sales in the School segment in 2007 or 2006. Net Sales Year Ended December 31, Change 2007(1) 2006(1) $(1) % % of Total...

  • Page 47
    ... or 2.6 percentage points of gross margin, related to required asset write-offs bringing unamortized FLY Fusion Pentop Computer assets to levels consistent with sales trends. • • International The gross margin for 2007 improved by 10.6 percentage points compared to the same period in 2006. The...

  • Page 48
    ... related to the concept design, production and testing stages of our software and books. For more information regarding content development expense, see Note 2 to the Consolidated Financial Statements-Summary of Significant Accounting Policies-Content Capitalization and Amortization in this report...

  • Page 49
    ... 2007 compared to 2006, due to costs associated with extensive new product introductions in 2008 and 2009. Research and development expenses are expected to decline in 2008. Advertising Expense The advertising expense in dollars for each segment and the related percentage of the segment's net sales...

  • Page 50
    ...credit ratings of AAA to AA-. We are uncertain as to when the liquidity issues relating to these investments will improve. The carrying value of our investments in ARS as of December 31, 2007 represents our best estimate of the fair value of these investments based on currently available information...

  • Page 51
    ...2006. Specifically, we reported 68% lower sales for our FLY Pentop Computer business compared to 2005, reflecting promotional and other activities to reduce existing FLY Pentop inventories in its last selling season. We replaced the FLY Pentop Computer with the FLY Fusion Pentop Computer in 2007. 43

  • Page 52
    ...our School segment to return it to positive earnings contribution, and more closely align it with our consumer strategy. Gross Profit and Gross Margin The gross profit for each segment and the related gross profit percentage of segment net sales, or gross margin, were as follows: Segment Performance...

  • Page 53
    ...new product development strategies formalized in the third quarter of 2006. This increase unfavorably impacted gross margin by approximately 3.0 percentage points. Closeout and promotional arrangements caused by weaker demand for our LeapPad line of products and our planned replacement of FLY Pentop...

  • Page 54
    ... employee performance as well as our company performance. In 2005, the bonus plan paid out was based solely on our company business performance goals, whereas in 2006 employees were able to achieve a portion of the bonus opportunity based on achievement of individual goals that support our company...

  • Page 55
    ... for 2006 compared to 2005. In 2006, we decided to consolidate our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California, to better align our research and development, product and marketing activities. In...

  • Page 56
    ...and 2006, we purchased software products and support services from Oracle Corporation in an arms length agreement totaling $0.5 million and $0.4 million, respectively. Lawrence J. Ellison, the Chief Executive Office of Oracle Corporation, may be deemed to have or share the power to direct the voting...

  • Page 57
    ... voting shares. The parties are awaiting the results of a California state tax audit of Mounte LLC before proceeding with discussions. Seasonality and Quarterly Results of Operations Our business is highly seasonal, with our retail customers making a large percentage of all purchases in preparation...

  • Page 58
    ...) per common share: Basic ...Diluted ...Market price range common stock High ...Low ...2006 Net sales ...Cost of sales ...Gross profit ...Operating expenses: Selling, general and administrative ...Research and development ...Advertising ...Depreciation and amortization ...Total operating expenses...

  • Page 59
    ...for content for our existing and new products. Cash, cash equivalents, and short-term investments LeapFrog's primary source of cash during 2007 was cash received from the collection of accounts receivable balances generated from sales in the second half of 2007 and the sale of marketable securities...

  • Page 60
    ... to meet the holiday season demand. The following table shows certain quarterly cash flows from operating activities data that illustrate the seasonality of our business: Cash Flow From Operating Activities 2007(1) 2006(1) 2005(1) 1st Quarter ...2nd Quarter ...3rd Quarter ...4th Quarter ...Total...

  • Page 61
    ... through design manufacturability, and elimination of the larger portion of inventory relating to discontinued, or soon to be discontinued, products. Inventories consisted of the following: December 31, 2007 2006 In thousands Raw materials ...Work in process ...Finished goods ...Inventories...

  • Page 62
    ... the write down of prepaid royalties related to our FLY technology. Accounts payable Accounts payable was $46.9 million at December 31, 2007 and $46.7 million at December 31, 2006. Investing activities Net cash provided by investing activities was $41.0 million in 2007, compared to net cash used by...

  • Page 63
    ... a company to disclose its accounting policy (i.e. gross vs. net basis) relating to the presentation of taxes within the scope of EITF 06-03. Furthermore, for taxes reported on a gross basis, an enterprise should disclose the amounts of those taxes in interim and annual financial statements for...

  • Page 64
    ... financial statements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk We develop products in the United States and market our products primarily in North America and, to a lesser extent, in Europe and the rest of the world. We are billed by and pay our third-party manufacturers...

  • Page 65
    ...and Chief Financial Officer, or CFO. Disclosure controls are controls and procedures designed to reasonably assure that information required to be disclosed or submitted in our reports filed under the Exchange Act, such as this report, are recorded, processed, summarized and reported within the time...

  • Page 66
    ...Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Management's assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies...

  • Page 67
    ... our employees and directors, including our Chief Executive Officer, Chief Financial Officer, who is our principal financial officer, and our Vice President, Corporate Controller, who is our principal accounting officer. In August 2006, our Board adopted a number of versions of our Code of Business...

  • Page 68
    ... Board of Directors" "Board of Directors and Corporate Governance-Committees of the Board" Item 14. Principal Accountant Fees and Service. The information appearing in our 2008 Proxy Statement under the heading "Proposal 3: Ratification of Selection of Independent Registered Public Accounting Firm...

  • Page 69
    ... (2) Financial Statement Schedules: The following financial statement schedule is included as Appendix A of this report: Valuation and Qualifying Accounts and Allowances (3) The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this Annual Report...

  • Page 70
    ... this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signatures Title Date /S/ JEFFREY G. KATZ Jeffrey G. Katz Chief Executive Officer (Principal Executive Officer), President and Director Chief Financial Officer...

  • Page 71
    Signatures Title Date /S/ E. STANTON MCKEE, JR. E. Stanton McKee, Jr. Director March 12, 2008 /S/ DAVID C. NAGEL David C. Nagel Director March 12, 2008 /S/ CADEN WANG Caden Wang Director March 12, 2008 /S/ RALPH R. SMITH Ralph R. Smith Director March 12, 2008 63

  • Page 72
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  • Page 73
    LEAPFROG ENTERPRISES, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS. Page Reports of Independent Registered Public Accounting Firm ...F-2 - F-3 Consolidated Balance Sheets ...Consolidated Statements of Operations ...Consolidated Statements of Stockholders' Equity ...Consolidated Statements of ...

  • Page 74
    ... of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the...

  • Page 75
    REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of LeapFrog Enterprises, Inc. We have audited LeapFrog Enterprises, Inc.'s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated ...

  • Page 76
    LEAPFROG ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except per share data) December 31, 2007 2006 ASSETS Current assets: Cash and cash equivalents ...Short-term investments ...Accounts receivable, net of allowance for doubtful accounts of $97, and $785 at December 31, 2007 and ...

  • Page 77
    LEAPFROG ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) Year Ended December 31, 2007 2006 2005 Net sales ...Cost of sales ...Gross profit ...Operating expenses: Selling, general and administrative ...Research and development ...Advertising ......

  • Page 78
    ... . . Total comprehensive loss ...Balances at December 31, 2005 ...Stock-based compensation ...Class A common stock issued upon exercise of stock option and employee purchase plan (602 shares) ...Issuance of stock options to non-employees ...Tax related to stock-based compensation ...Treasury stock...

  • Page 79
    ...Financing activities: Cash used to collateralize letter of credit ...Proceeds from release of restricted cash ...Purchases of treasury stock ...Proceeds from the exercise of stock options and employee stock purchase plan ...Net cash provided by financing activities ...Effect of exchange rate changes...

  • Page 80
    ... CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share and percent data) 1. Description of Business LeapFrog Enterprises, Inc. (the "Company" or "LeapFrog"), designs, develops and markets innovative, technology-based learning products and related proprietary content for the education of...

  • Page 81
    LEAPFROG ENTERPRISES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share and percent data) Revenue Recognition The Company principally derives revenue from sales of its technology-based learning products and related proprietary content for education of infant through...

  • Page 82
    ...were no plans to sell in the foreseeable future. Amounts written off in 2007 include $1,181 related to the FLY Pentop Fusion products. Software Development Costs Research and development costs, which include software development costs, are expensed as incurred. Costs incurred after the technological...

  • Page 83
    ... Financial Instruments LeapFrog transacts business in various foreign currencies, primarily in the British Pound, Canadian Dollar, Euro and Mexican Peso. In order to protect itself against reductions in the value and volatility of future cash flows caused by changes in currency exchange rates...

  • Page 84
    ... tools quarterly to ensure that the related product line is still in production and that the estimated useful lives of the manufacturing tools are consistent with the Company's depreciation policy. Depreciation expense for manufacturing tools is included in cost of goods sold. During the years 2007...

  • Page 85
    ... financial statements, and temporary gains and losses on investments. Stock-Based Compensation Prior to January 1, 2006, the Company accounted for stock-based compensation under the measurement and recognition provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related...

  • Page 86
    ... stock price volatility used in the model require the exercise of judgment. The expected life of the options represent the period of time the options are expected to be outstanding and is currently based on the guidance provided in the SEC Staff Accounting Bulletin No. 107 on Share-Based Payment...

  • Page 87
    ...are currently evaluating the impact of the adoption of SFAS 159 on our consolidated financial statements. 3. Fair Value of Financial Instruments At December 31, 2007 and 2006, the carrying values of financial instruments, including cash and cash equivalents, short-term investments, foreign exchange...

  • Page 88
    ... the credit markets recover and successful auctions resume, the Company may be able to recover an amount greater than the carrying value of the ARS as of December 31, 2007, which would result in a gain. However, if the issuers are unable to successfully close future auctions and their credit ratings...

  • Page 89
    ...2,358 $ 5,449 Work in process ...4,663 8,093 Finished goods ...45,394 59,478 Inventories ...$52,415 $73,020 During 2007, we recorded net sales of $12,000 on $8,173 of inventory written down in 2006. We also established new write-downs of $12,770, of which approximately $7,147 related to inventory on...

  • Page 90
    ... STATEMENTS (In thousands, except per share and percent data) 6. Property and Equipment Property and equipment consisted of the following: In thousands December 31, 2007 2006 Tooling, cards, dies, and plates ...Computers and software ...Capitalized content development ...Capitalized website...

  • Page 91
    ... and 2006, the Company purchased software products and support services from Oracle Corporation in an arms length agreement totaling $481 and $391, respectively. Lawrence J. Ellison, the Chief Executive Office of Oracle Corporation, may be deemed to have or share the power to direct the voting and...

  • Page 92
    ... FINANCIAL STATEMENTS (In thousands, except per share and percent data) 9. Accrued Liabilities and Deferred Revenue Accrued liabilities and deferred revenue are as follows: In thousands December 31, 2007 2006 Advertising and promotion ...Employee-related costs ...Marketing, consulting and web...

  • Page 93
    ... currency transactions with highly rated financial institutions. LeapFrog manufactures and sells its products primarily to national and regional mass-market retailers in the United States. Credit is extended based on an evaluation of the customers' financial condition, and generally collateral...

  • Page 94
    LEAPFROG ENTERPRISES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share and percent data) Customer Concentration A limited number of customers historically have accounted for a substantial portion of our gross sales. The significant customers and the relative ...

  • Page 95
    ... December 31, 2007 2006 2005 Income tax (benefit) at the statutory rate ...State income taxes ...Foreign operations ...Tax exempt interest ...Interest and penalties ...Nondeductible items ...Research and development credits ...Other ...Valuation allowance ...Income tax provision (benefit) ... $(34...

  • Page 96
    ... FINANCIAL STATEMENTS (In thousands, except per share and percent data) During 2006, the Company recorded a non-cash charge to establish a valuation allowance against its gross domestic deferred tax assets. The amount represents 100% of the domestic deferred tax assets as set out in the table...

  • Page 97
    ... quarter of 2009. The United Kingdom's taxing authority is currently reviewing the 2004 and 2005 tax year, but there is currently no proposed audit adjustment and the completion date is still tentative. The state of California has notified the Company of a pending examination related to its Research...

  • Page 98
    ... Accounting Policies." On May 1, 2007, the stockholders approved an amendment to the Company's stock-based compensation plans to increase the number of shares of Class A common stock reserved for issuance under the plan to 24,000 from 21,000. The following table summarizes the effects of stock-based...

  • Page 99
    ... life of current option grants compared to historical grants. Stock-based compensation related to restricted stock and restricted stock unit awards are calculated based on the market price of LeapFrog's common stock on the date of grant. The market value of restricted stock unit and stock awards as...

  • Page 100
    ... related to stock options granted under equity incentive plans. The unrecognized compensation cost is expected to be recognized over a weighted average period of 1.39 years. Additional information with respect to stock option plan activity is as follows: Number of Shares Weighted Average Exercise...

  • Page 101
    ... total compensation components for key executives. The Company concluded that stock options with a substantial portion of the strike price set "out-of-the-money" would provide adequate incentive to key executives, without the related complexity of the performance share program. The performance plan...

  • Page 102
    ... financial measures. As of March 15, 2007, the Company granted to selected executives options to acquire approximately 70 shares of Class A common stock as a replacement for the terminated performance share awards. These stock options were granted at an exercise price equal to the closing market...

  • Page 103
    LEAPFROG ENTERPRISES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share and percent data) 18. Net Income (Loss) Per Share The Company follows the provisions of Statement of Financial Accounting Standard No. 128, "Earnings Per Share" (SFAS 128), which requires the ...

  • Page 104
    ...to all of its current patents and patent applications, as well as patents related to its business arising from applications filed by Tinkers & Chance or its principals through November 2014. On January 4, 2008, the parties executed a formal agreement that memorialized in writing, the terms agreed to...

  • Page 105
    ... net sales and operating income (loss) before interest and taxes. LeapFrog reports the financial results of the following operating segments: • The U.S. Consumer segment includes the development, design and marketing of electronic educational hardware products and related software, sold primarily...

  • Page 106
    ... STATEMENTS (In thousands, except per share and percent data) • The School segment includes the development, design and marketing of electronic educational hardware products and related software, sold primarily to school systems in the United States. Net Sales Income (Loss) from Operations Total...

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    ..., and accessories for the Leapster, Leapster TV, and Leapster L-MAX product lines (3) Includes sales of classic LeapPad hardware and software Within each segment, LeapFrog has three classes of customers: (1) direct customers who pay cash in advance through check or credit card, (2) distributors, and...

  • Page 108
    ..." in this report. 2007 For Quarter Ended1 Year Ended March 31 June 30 September 30 December 31 December 31 Net sales ...$ 60,924 $ 55,995 Cost of sales ...36,221 35,711 Gross profit ...Operating expenses: Selling, general and administrative ...Research and development ...Advertising ...Depreciation...

  • Page 109
    ... Significant Accounting Policies" and "Note 16: Stock-Based Compensation Note 16 to these financial statements is not "Employee Equity Incentive Plans] in the Notes to Consolidated Financial Statements in this report. LeapFrog's Class A common stock (symbol LF) trades on The New York Stock Exchange...

  • Page 110
    ..., 2007 ...Allowance for defective products Year ended December 31, 2005 ...Year ended December 31, 2006 ...Year ended December 31, 2007 ...Allowance for returns Year ended December 31, 2005 ...Year ended December 31, 2006 ...Year ended December 31, 2007 ...Allowance for chargebacks and price changes...

  • Page 111
    ...Employee Directors' Stock Award Plan, as amended Form of Nonstatutory Stock Option Agreement under the 2002 Non-Employee Directors' Stock Award Plan 2002 Employee Stock Purchase Plan Form of Offering under the 2002 Employee Stock Purchase Plan Compensation Arrangements between LeapFrog and its Board...

  • Page 112
    ... the heading "Compensation of Directors" in LeapFrog's definitive proxy materials filed with the SEC on March 26, 2007 and incorporated herein by reference (n) Filed as an exhibit to LeapFrog's Current Report on Form 8-K filed with the Securities and Exchange Commission on July 10, 2006 (SEC File No...

  • Page 113
    ... as an exhibit to LeapFrog's Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 10, 2005 (SEC File No. 001-31396) and incorporated herein by reference †Compensation plans or arrangements in which directors or executive officers are eligible to participate or...

  • Page 114
    ... 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All...

  • Page 115
    ... 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All...

  • Page 116
    ... 906 of the Public Company Accounting Reform and Investor Protection Act of 2002 (18 U.S.C. § 1350, as adopted, the "Sarbanes-Oxley Act"), Jeffrey G. Katz, the Chief Executive Officer of LeapFrog Enterprises, Inc. (the "Company"), and William B. Chiasson, the Chief Financial Officer of, each hereby...

  • Page 117
    ...one-time stock option exchange program under which eligible LeapFrog employees (including our executive officers) and members of our board of directors would be able to elect to exchange outstanding stock options issued under our equity plans for new lower-priced stock options, including, as part of...

  • Page 118

  • Page 119
    ... for director. Approval of a one-time stock option exchange program under which eligible LeapFrog employees (including our executive officers) and members of our board of directors would be able to elect to exchange outstanding stock options issued under our equity plans for new lower-priced stock...

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    including, as part of the stock option exchange program, approval of the issuance of options to our Chief Executive Officer. 3. Ratification of Ernst & Young LLP as our independent registered public accounting firm for our fiscal year ending December 31, 2008. How do I vote? You may either vote "...

  • Page 121
    ...proxy to LeapFrog's Corporate Secretary at 6401 Hollis Street, Emeryville, California 94608. You may attend the annual meeting and vote in person. Simply attending the meeting will not, by itself, revoke your proxy. Please remember, as mentioned above, if you are a beneficial owner of shares you may...

  • Page 122
    ... 2-Approval of a one-time stock option exchange program, including approval of the issuance of options to our Chief Executive Officer as part of the stock option exchange program. This proposal must receive a "For" vote from the holders of a majority of votes cast either in person or by proxy on the...

  • Page 123
    ... future product or service launches, future product or service features, the scope and success of future launches, potential impact of the Option Exchange Program on our financial results and overhang of outstanding stock options, and our expectations for sales, trends, margins, profitability...

  • Page 124
    ... estate development company, as a member of the board of Spring Group plc, a publicly held information technology services company in the United Kingdom whose shares are traded on the London Stock Exchange, as a director of Nobel Learning Communities, Inc., a publicly held non-sectarian, for-profit...

  • Page 125
    ...publicly held company that produces and markets personal care products, as a director of Heron International, a privately held European real estate development company, and also serves as an officer and director of privately held companies affiliated with Knowledge Learning Corporation, a for-profit...

  • Page 126
    ...philanthropy dedicated to helping build better futures for disadvantaged children in the United States. Since 2004, Mr. Smith has served on the board of directors of Nobel Learning Communities, Inc., a publicly held non-sectarian, for-profit provider of education and educational services for the pre...

  • Page 127
    ...employees, including executive officers, and members of our board of directors would be able to elect to exchange outstanding eligible options to purchase shares of our Class A common stock for new stock options with a lower exercise price but covering fewer shares (the "New Options"). Stock options...

  • Page 128
    ... them to work toward our success and rewarding their contributions by allowing them to benefit from increases in the value of our shares. In addition, since late 2006, we have been implementing a multi-year turnaround plan with a new business strategy that was designed to return LeapFrog to growth...

  • Page 129
    ... in order to keep total employee compensation packages competitive with those of our peer companies from year to year. In addition to this year's annual equity grants, we considered granting employees special supplemental stock option grants at current market prices in order to restore the value of...

  • Page 130
    ... for future grants under the Plans and would also result in decreased reported earnings, which could negatively impact our stock price. Participation by Our Executive Officers and Our Board of Directors. The members of our board of directors and our executive officers work closely as a team and...

  • Page 131
    ... by our independent compensation consultant using the Black-Scholes option valuation model and based upon our stock price at the closing of the Offer to Exchange. The following table shows (a) the number of shares underlying outstanding Eligible Options in each exercise price range as of April...

  • Page 132
    ... cases, our employees, including our executive officers, were granted stock options that had tiered exercise pricing, meaning that a portion of the stock options were granted with exercise prices set at premiums approximately 33% and 66% higher than the fair market value at the time of grant. With...

  • Page 133
    ... our 2002 Equity Incentive Plan. The shares of Class A common stock for which the New Options may be exercised are currently registered on a registration statement filed with the SEC. Return of Eligible Options Surrendered. Consistent with the terms of the Plans, the pool of shares available for the...

  • Page 134
    ... predict how many Eligible Options will be exchanged, assuming full participation in the Option Exchange Program, market price of our Class A common stock of $7.00 per share, an exercise price of the New Options of $7.50 per share and exchange ratios that result in the fair value of the New Options...

  • Page 135
    ...: (1) each director and executive officer decides to exchange all of his or her Eligible Options, (2) the market price of our Class A common stock is $7.00 per share and (3) the exercise price of the New Options is $7.50 per share. Hypothetical Number of Shares Underlying New Options that Weighted...

  • Page 136
    ... 384,000 shares. Equity Compensation Plan Information The following table shows certain information concerning our Class A common stock to be issued in connection with our 2002 Equity Incentive Plan and our 2002 Non-Employee Directors' Stock Award Plan as of December 31, 2007: Number of securities...

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    ... has been approved. Independent Registered Public Accounting Firm Fee Information In connection with the audit of the 2007 financial statements, we entered into an engagement agreement with Ernst & Young LLP that set forth the terms by which Ernst & Young LLP will perform audit services for us. That...

  • Page 138
    ... statement filing with the SEC and SAB99 consultation work. Tax Fees There were no aggregate fees billed by Ernst & Young LLP for tax services in 2007, and in 2006, the aggregate fees billed by Ernst & Young LLP for tax services, consisting of tax compliance, tax advice and tax planning, totaled...

  • Page 139
    ... the election of all members of our board of directors and all other matters submitted to a vote of our stockholders. Mr. Ellison is Chief Executive Officer of Oracle Corporation. Beneficial Ownership of Our Common Stock The following table sets forth certain information regarding the ownership of...

  • Page 140
    ...* (1) Based on 35,910,519 shares of Class A common stock and 27,614,176 shares of Class B common stock outstanding as of April 8, 2008. Unless otherwise indicated in the footnotes to this table, the applicable address for each of our directors and executive officers is c/o LeapFrog Enterprises, Inc...

  • Page 141
    ... Technologies LLC or Renaissance. The address for Renaissance is 800 Third Avenue, New York, New York 10022. (10) Based solely on information provided in a Schedule 13G filed on January 29, 2008 by Wells Fargo & Company or Wells Fargo. Wells Fargo has sole voting power over 1,874,400 shares, shared...

  • Page 142
    ...Mr. McKee's term on LeapFrog's board of directors; (21) Represents 40,069 shares of Class A common stock issuable upon the exercise of options that are exercisable within 60 days after April 8, 2008 and 8,333 shares of Class A common stock issuable upon restricted stock unit awards vesting within 60...

  • Page 143
    ...that are exercisable within 60 days after April 8, 2008 and 10,725 shares of Class A common stock that are scheduled to be released within 60 days after April 8, 2008 upon the vesting of restricted stock unit awards held by executive officers who are not named in the Summary Compensation Table below...

  • Page 144
    ... of our voting shares. In 2007 we purchased software products and support services from Oracle Corporation totaling $481,104. As of December 31, 2007, Lawrence J. Ellison, the Chief Executive Office of Oracle Corporation, may be deemed to have or share the power to direct the voting and disposition...

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    BOARD OF DIRECTORS AND CORPORATE GOVERNANCE BOARD OF DIRECTORS Independence of the Board of Directors As required under the New York Stock Exchange, or NYSE, listing standards, a majority of the members of a listed company's board of directors must qualify as "independent," as affirmatively ...

  • Page 146
    ... table exclude the impact of estimated forfeitures related to service-based vesting conditions. (3) In March 2007, each of our independent directors was granted a restricted stock unit award with the following full grant date fair value, as calculated under FAS 123R for financial statement reporting...

  • Page 147
    ... December 31, 2007, the total cash compensation paid to non-employee directors was $427,917. The members of our board of directors are also eligible for reimbursement of their expenses incurred in attending board meetings. Our 2002 Non-Employee Directors' Stock Award Plan, or Director Plan, provides...

  • Page 148
    ...the board has the authority to determine the number of shares subject to such stock awards. No other stock awards may be granted at any time under the Director Plan. With respect to stock option awards, the exercise price of options granted under the Director Plan is 100% of the fair market value of...

  • Page 149
    ...our board of directors was established by our board in accordance with Section (3)(a)(58)(A) of the Securities Exchange Act of 1934 and oversees our corporate accounting and financial reporting process and the audits of our financial statements. For this purpose, the audit committee performs several...

  • Page 150
    ... public accounting firm the results of the annual audit and the results of LeapFrog's quarterly financial statements. The audit committee is currently composed of three directors: Messrs. McKee (Chair), Maron and Wang. The audit committee met 11 times during our 2007 fiscal year. The board...

  • Page 151
    ... Integrity of Financial Statements The audit committee is responsible for reviewing LeapFrog's quarterly and annual financial statements and discussing the financial statements with management and Ernst & Young LLP, the company's independent registered public accounting firm. At each of its meetings...

  • Page 152
    ... the board of directors that the financial statements be included in LeapFrog's 2007 Annual Report on Form 10-K filed with the SEC. Oversight of Independent Registered Public Accounting Firm The audit committee appoints the independent registered public accounting firm and reviews their performance...

  • Page 153
    ... and the total number of shares that may be granted in any given year. Our policy is that we will not time or select the grant dates for any stock options or stock-based awards in coordination with the release by us of material non-public information, nor will we have any program, plan or practice...

  • Page 154
    ... of the board, assessing the performance of management and the board, reviewing the compensation paid to non-employee directors for their service on our board and its committees, and developing a set of corporate governance principles for LeapFrog. Our governance committee is currently composed of...

  • Page 155
    ... made to our management, business direction and operations in 2006 and 2007, the board dissolved the strategy committee in July 2007. CORPORATE GOVERNANCE Corporate Governance Guidelines In April 2004, our board of directors documented the governance practices followed by LeapFrog by adopting...

  • Page 156
    ... and corporate governance committee by writing to our Corporate Secretary at 6401 Hollis Street, Emeryville, California 94608. CODE OF ETHICS We have adopted the LeapFrog Code of Business Conduct and Ethics that applies to all of our officers, directors and employees. Our Code of Business Conduct...

  • Page 157
    ...to all of our named executive officers. Executive Compensation Program Philosophy Our compensation philosophy is to provide total compensation packages that reasonably, equitably and responsibly meet the following objectives Motivate and reward outstanding company performance and to a lesser extent...

  • Page 158
    ...for our executive officers. In determining which companies should be included in our compensation peer group for 2007, Towers Perrin reviewed a cross section of competitors and related industries with a focus on toy, gaming and educational products and identified 18 companies from the toy, education...

  • Page 159
    ...benefits, be used in order to provide total compensation packages for our named executive officers and others that meet our objectives as outlined above. The elements of our executive compensation are Base salary Performance-based annual bonus awards Equity incentive awards, including stock options...

  • Page 160
    ... overall performance of the company in 2006 and the comparative position of our executives' salaries relative to the external market, the compensation committee determined that no base salary increases were warranted for our named executive officers in 2007. Two of our named executive officers were...

  • Page 161
    ...would reverse recent sales decline trends. The sales projections from the 2007 momentum index have been incorporated into our board-approved 2008 operating plan. Further, as part of our 2008 bonus program, the compensation committee required that our actual 2008 net sales of new products achieve the...

  • Page 162
    ... 2007 achievements taken into account by our board and compensation committee in the bonus decision-making process include the following: • Development of new products for 2008: We far exceeded product development goals by driving from concept to manufacturing several new innovative products that...

  • Page 163
    ... award granting policy (described below), the grants of those stock awards became effective and were priced in mid-September 2007. Guidelines for the size of equity awards granted to each level of employee are reviewed annually and benchmarked against our peer compensation group companies by Towers...

  • Page 164
    ... directed towards employee incentive programs-all at no expected additional compensation expense to the company for accounting purposes. Many of our senior executives, including all of our named executive officers, were granted "tiered" options to purchase shares of our stock at then-fair market...

  • Page 165
    ... responsibilities and with the rest of the executive management team. The compensation committee approved the stock option award to Mr. Katz by reviewing his overall performance in achieving corporate and individual goals during the first portion of 2007 and his total direct compensation compared...

  • Page 166
    ... reviewing his overall performance in achieving corporate and individual goals during the first portion of 2007 and his total direct compensation compared to CEOs in our compensation peer group. Severance Benefits. In July 2007, the compensation committee approved the Executive Management Severance...

  • Page 167
    ... performance share program. In addition, grants of stock options under our 2002 Equity Incentive Plan are also designed to qualify as "performance-based," provided the grants have exercise prices of no less than 100% of fair market value on the date of grant and do not exceed a calendar year total...

  • Page 168
    ...related to service-based vesting conditions. See the Grants of Plan-Based Awards Table below for more information regarding option awards granted in 2007. The assumptions made in the valuation of the option awards are discussed in Note 16, "Stock-Based Compensation," of Notes to Financial Statements...

  • Page 169
    ... a non-employee member of our board of directors, as well as a member of our audit, nominating and corporate governance and strategy committees. (8) Bonus awarded to Mr. Chiasson in February 2008 under our 2007 bonus plan and based on the achievement of corporate and individual performance goals and...

  • Page 170
    ... of stock options and stock-based awards under which the grant date of all awards to named executive officers will the 15th day of the month subsequent to the month in which the award is approved by the board or compensation committee (or the next succeeding business day that the NYSE is open). If...

  • Page 171
    ..., the board of directors, based upon their review of corporate and individual performance goals and achievements for 2007, were paid in February 2008 and are shown in the "Non-Equity Incentive Plan Compensation" column of the Summary Compensation Table above. (3) Restricted stock units are granted...

  • Page 172
    ... year of continuous employment service and 1/48 th of the shares vesting for each month of continuous service thereafter. Each option granted under the Plan is subject to all terms and conditions set forth in the Plan and in a stock option grant notice and stock option agreement substantially in the...

  • Page 173
    ... Market Value of Number of Shares Shares or or Units Number of Units of of Stock Securities Stock That Underlying Option That Have Have Unexercised Exercise Option Not Not Options (#) Price Expiration Vested Vested Unexercisable ($) Date (#)(2) ($)(3) Jeffrey G. Katz ...Chief Executive Officer...

  • Page 174
    ... multiplying the closing market price of our Class A common stock as reported by the NYSE for December 31, 2007, $6.73, by the number of shares of restricted stock units that have not vested as of December 31, 2007. (4) Our performance share program was discontinued by the compensation committee in...

  • Page 175
    ...Fiscal 2007 Option Awards Number of Shares Value Acquired on Realized on Exercise Exercise (#) ($) Stock Awards Number of Shares Value Acquired Realized on on Vesting Vesting (#) ($) Name Jeffrey G. Katz ...Chief Executive Officer and President William B. Chiasson ...Chief Financial Officer Martin...

  • Page 176
    ...73, which was the price of our Class A common stock reported by the NYSE at the close of market on December 31, 2007. With respect to the estimated or potential value of options that are accelerated and/or have extended exercise periods in connection with a named executive officer's termination or...

  • Page 177
    ... would have been no value related to the additional vesting because the exercise price of the Options exceeded $6.73, the closing price of our Class A common stock as reported by the NYSE for December 31, 2007. We would also pay to Mr. Katz the Katz Severance Benefits, as applicable. For purposes of...

  • Page 178
    ...the event, then the employee would not have good reason. If a covered termination (which includes a resignation for good reason) is triggered and does not occur in relation to a change in control of LeapFrog, the Severance Plan provides for the following severance benefits: Base Severance (Months of...

  • Page 179
    ... of the options exceeded $6.73, the closing price of our Class A common stock as reported by the NYSE for December 31, 2007, there would be no value related to the equity acceleration, assuming exercise on December 31, 2007. Messrs. Chiasson, Pidel and Dodd and Ms. MacIntyre are required to execute...

  • Page 180
    ... our directors and executive officers, and persons who own more than ten percent of a registered class of our equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other equity securities of LeapFrog. Officers, directors and...

  • Page 181
    ... that is a controlling stockholder of LeapFrog. The director is an employee, officer or director of a foundation, university or other non-profit organization to which LeapFrog gives directly, or indirectly through the provision of property or services, in the current fiscal year, donations that do...

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    ... A COMMON STOCK Continental Stock Transfer & Trust New York, New York (212) 509-4000 x206 ANNUAL MEETING The 2008 Annual Meeting of Stockholders will take place at 9:00 a.m. Pacific time on Thursday, June 5, 2008 at the company's headquarters in Emeryville, California. INVESTOR RELATIONS LeapFrog...

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