UNITED STATES

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 September 30, 2000

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 0-28977

VARSITY GROUP INC.

Registrant’s telephone number, including area code: (202) 667-3400

(Former Name, Former Address and Former Fiscal Year, if

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

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS

      Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15 (d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes  [  ]  No  [  ]

      As of November 7, 2000, the registrant had 15,795,485 shares of common stock outstanding.

VARSITY GROUP INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

INDEX

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PART I.

Item 1:  Financial Statements

VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

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VARSITY GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Description of Operations

      Varsity Group Inc. (formerly VarsityBooks.com Inc., the “Company”), a college marketing services provider and a leading online retailer of new college textbooks, was incorporated on December 16, 1997 and launched its Website in August 1998, at which time the Company began generating revenues. In August 1999, the Company established two wholly-owned subsidiaries, CollegeImpact.com, Inc. and VarsityBooks.com, LLC (formerly CollegeOps.com LLC), to assist in the overall management of its marketing and retailing activities, respectively.

      In February 2000, we issued 4,000,000 shares of Common Stock at an initial public offering price of $10.00 per share. In March 2000, we sold an additional 35,000 shares pursuant to the exercise of the underwriters’ over-allotment option at $10.00 per share. Total net proceeds were approximately $35.9 million. On February 22, 2000, approximately $2.5 million of this amount was used to pay all amounts due under the credit facility with Imperial Bank (“Imperial”) (see discussion below). As of September 30, 2000, approximately $16.7 million had been used for working capital purposes. The balance of approximately $16.7 million was invested in cash and cash equivalents at September 30, 2000.

Note 2: Basis of Presentation

      The condensed consolidated financial statements of Varsity Group Inc. and subsidiaries included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim period in conformity with generally accepted accounting principles.

      Certain information and footnote disclosure normally included in the financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999. Operating results for the interim periods are not necessarily indicative of results for an entire year.

      Certain reclassifications of prior year amounts have been made to conform with the current year presentation.

Note 3: Revolving Credit Facility

      On January 19, 2000, the Company executed an agreement with Imperial to provide the Company with a revolving credit facility in the aggregate amount of $7.5 million with sub-limits of $3.0 million for purchases of property, equipment and software and $750,000 for letters of credit. The maturity date for advances of working capital is December 31, 2000 and for property, equipment and software advances, the maturity date is October 18, 2002. Interest on outstanding balances accrued at Imperial’s prime rate (9.5% at September 30, 2000) plus 1% until the closing of the Company’s initial public offering, and afterwards at Imperial’s prime rate. All amounts outstanding, which could be up to $7.5 million, are collateralized by a pledge of all of the Company’s assets. Under the terms of the credit facility, as amended, the Company must maintain a tangible net worth of $15.0 million and a ratio of its current assets to its current liabilities of 1.5 to 1. The Company also issued warrants to Imperial to purchase 37,500 shares of its common stock at an exercise price of $10 per share. The Company borrowed $2.5 million under the revolving credit facility during February 2000 and repaid such borrowings on February 22, 2000 with a portion of the net proceeds of its initial public offering. No amounts were outstanding under the agreement at September 30, 2000 with the exception of a letter of credit in the amount of $0.3 million.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Note 4: Marketing Services and Product Promotion Agreements

      On February 3, 2000, the Company entered into a marketing services agreement and a product promotion agreement with Sallie Mae, Inc. Pursuant to the marketing services agreement, Sallie Mae will pay the Company $2.0 million over a two year period. In exchange, the Company will develop and execute a marketing plan for Sallie Mae to reach the college market.

      Pursuant to the product promotion agreement, the Company will pay Sallie Mae referral fees based on a percentage of any revenue generated by Sallie Mae customers during the term of the arrangement. Sallie Mae will promote the Company’s products to Sallie Mae customers. Sallie Mae will also actively promote eduPartners, the Company’s partnership program, to the schools to which it sells and promotes Sallie Mae products. In addition, the Company will be the exclusive textbook retailer on the Sallie Mae Web site. In exchange, the Company granted Sallie Mae a warrant to purchase up to 616,863 shares of common stock, which represented 3.5% of its aggregate common stock outstanding and reserved for issuance immediately prior to the completion of the Company’s initial public offering, at a price equal to the initial public offering of price of $10 per share. Of these shares, 352,493 vested on February 3, 2000 and the remaining 264,370 shares will vest over the two year term of the agreement depending on the number of customer transactions and eduPartner™ school referrals Sallie Mae delivers during that period. Prior to the quarter ending September 30, 2000, the Company assumed that Sallie Mae would be able to meet the criteria needed to allow it to exercise the performance-based warrants. As a result, the Company recorded an expense for the performance-based warrants from the date of issuance to June 30, 2000. For the quarter ending September 30, 2000, the Company believes that Sallie Mae will not be able to meet the criteria needed to allow it to exercise the performance-based warrants and therefore has not recorded warrant expense for the quarter ending September 30, 2000.

      In the accompanying condensed consolidated financial statements for the quarter ended September 30, 2000, the Company has combined the two agreements for accounting purposes and recorded a receivable of $2.0 million and a deferred charge of $0.6 million. The total of the receivable and deferred charge of $2.6 million equaled the fair value of the vested portion of the warrant on the date of the grant. The fair value of the warrant was estimated using the Black-Scholes option pricing model with the following assumptions: dividend yield of 0.0%; volatility of 74%; risk free interest rate of 6.0%; and expected term of 7 years. The receivable will be relieved as payments are made under the marketing services agreement and the deferred charge will be amortized on a straight-line basis over the two-year life of the agreement. Expense of approximately $200,000 was recorded as of September 30, 2000. The receivable and deferred charge are recorded as warrant subscription receivable and other, an offset to stockholders’ equity, in the accompanying condensed consolidated balance sheet as of September 30, 2000.

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Forward Looking Statements

      This document contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “except,” “plan,” “anticipate,” “expect,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.

      Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

      Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included herein and under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” included in the Company’s Annual Report on Form 10-K for the year ended December 31, 1999 and other reports and filings made with the Securities and Exchange Commission.

Overview

      We are a leading college marketing services provider and online retailer of new college textbooks. We were incorporated in December 1997 and began offering books for sale on our Web site on August 10, 1998. For the period from inception through August 9, 1998, our primary activities consisted of:

	•	Developing our business model;
	•	Establishing, negotiating and consummating a relationship with our supplier, Baker & Taylor;
	•	Initial planning and development of our Web site;
	•	Developing our information systems infrastructure;
	•	Developing our information systems infrastructure;
	•	Developing our marketing plans; and
	•	Establishing finance and administrative functions.

      Since the launch of our Web site, we have continued these activities and have also focused on increasing sales, expanding our product and service offerings, improving the efficiency of our order and fulfillment process, recruiting and training employees, recruiting and training our student representatives, enhancing finance and administrative functions, and increasing customer services operations and the depth of our management team to help implement our growth strategy.

      To date, our revenues have consisted primarily of sales of new textbooks. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are shipped to customers. We have also generated revenues through the sales of general interest books, banner advertisements and marketing service agreements, as well as co-marketing programs, pursuant to which we have arrangements to sell textbooks through other Web sites. Revenues from the sales of Internet advertisements are recognized net of commissions paid. Revenues from our marketing services are recognized ratably over the period in which the services are delivered, provided that no significant performance obligations remain and the collection of the related receivable is probable.

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      During the fourth quarter of fiscal 1999, we began generating revenues from marketing programs. In May 2000, we announced our intent to accelerate the migration of our business more towards this marketing services business. We have pursued that strategy, and have since signed marketing services agreements with a number of public and private companies, including AT&T Wireless Services, Inc., Palm, Incorporated, Papa John’s International, Inc., Ben & Jerry’s Homemade, Inc.

      In addition, we have successfully lowered the overall operating expenses and increased the margins of our retail book business through various means, including the imposition of increased retail pricing. Although our margins are improving, our ability to become profitable given our planned expenses and liquidity depends on our ability to generate and sustain higher net revenues. If we do achieve profitability, we cannot be certain that we can sustain or increase profitability on a quarterly or annual basis in the future. We do not expect to achieve positive cash flow from operations until the third quarter of 2001. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have little experience forecasting our revenues. Therefore, we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely upon them as an indication of our future performance. If we cannot achieve and sustain operating profitability or positive cash flows from operations, we may be unable to meet our working capital requirements or to obtain additional financing, which would adversely affect our business and may cause us to discontinue operations.

      We have incurred substantial losses and negative cash flows from operations in every fiscal period since our inception. For the year ended December 31, 1999, we incurred a loss from operations of $31.9 million and negative cash flows from operations of $29.4 million. For the nine month period ended September 30, 2000, we incurred a loss from operations of $33.7 million and negative cash flows from operations of $26.5 million. As of December 31, 1999 and September 30, 2000, we have accumulated deficits of $34.2 million and $67.1 million respectively. We expect operating losses and negative cash flows to continue into the second half of 2001, and expect to achieve positive cash flow in the third quarter of 2001.

Results of Operations

      The following table and discussion provides information which management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the condensed consolidated financial statements and accompanying notes thereto included elsewhere herein.

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Three Months Ended September 30, 2000

  Net Sales

      Net sales increased to $11.7 million for the three months ended September 30, 2000 from $7.2 million for the three months ended September 30, 1999, as a result of the significant growth in orders primarily from eduPartners™, our program in which we contract on an exclusive basis with educational institutions, including private secondary schools, to become the textbook supplier to their student populations. In addition, marketing services sales totaled $1.0 million for the three months ended September 30, 2000, a significant increase from the less than $0.1 million recognized in the same period in 1999. This reflects the continuing migration of our business towards this business.

  Operating Expenses

      Cost of Books — Related Party (Baker & Taylor). Cost of books — related party consists of the cost of books sold to customers. Cost of books — related party increased to $8.2 million for the three months ended September 30, 2000 from $6.2 million for the three months ended September 30, 1999. This increase was primarily attributable to our increased sales volume between years.

      Cost of Shipping — Related Party (Baker & Taylor). Cost of shipping — related party consists of outbound shipping. Cost of shipping increased to $0.7 million for the three months ended September 30, 2000 from $0.6 million for the three months ended September 30, 1999. This increase was primarily attributable to

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      Cost of Marketing Services. Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. Cost of marketing services totaled $0.2 million for the three months ended September 30, 2000. There was no cost of marketing services for the three months ended September 30, 1999.

      Marketing and Sales. Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses such as the amortization of deferred compensation for personnel engaged in marketing and the expenses associated with the continued development of our nationwide network of student representatives. Marketing and sales expense decreased to $7.2 million for the three months ended September 30, 2000 from $10.0 million for the three months ended September 30, 1999. This decrease was primarily attributable to decreased marketing with respect to the national retail book business and decreased personnel and related expenses. Included in marketing and sales is $1.0 million and $0.4 million of non-cash charges for the three months ended September 30, 2000 and 1999, respectively. Non-cash charges consist of the amortization of deferred compensation and charges related to warrants issued under the Sallie Mae and AOL/ ICQ, Inc. agreements. Non-cash charges increased primarily as a result of the termination of our interactive marketing agreement with AOL/ ICQ on September 21, 2000.

      Product Development. Product development expense consists of payroll and related expenses such as the amortization of deferred compensation for development and systems personnel and consultants. Product development expense decreased to $0.4 million for the three months ended September 30, 2000 from $1.7 million for the three months ended September 30, 1999. This decrease was primarily attributable to decreased web development, consulting and personnel costs between years.

      General and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel such as the amortization of deferred compensation, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense decreased to $2.1 million for the three months ended September 30, 2000 from $2.5 million for the three months ended September 30, 1999. This decrease was primarily attributable to decreased personnel and professional services expenses between years. Included in general and administrative expenses is less than $0.1 million and $0.5 million of non-cash charges for the three months ended September 30, 2000 and 1999, respectively. Non-cash charges decreased primarily as a result of a reduction in the number of employees.

  Other income (expense), net.

      Other income (expense), net consists primarily of interest income on our cash and cash equivalents and investments, and interest expense attributable to our credit facility with Imperial Bank at September 30, 2000. Other income was $0.2 million for the three months ended September 30, 2000 compared to less than $0.1 million for the three months ended September 30, 1999. This increase is primarily attributable to interest income on higher average cash, cash equivalent and short-term investment balances during the three months ended September 30, 2000, offset by interest expense of $0.1 million related to a warrant issued to Imperial Bank in connection with the Company’s credit facility (see discussion below).

  Income Taxes.

      As of September 30, 2000, we had net operating loss carryforwards for federal income tax purposes of $57.0 million, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability.

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Nine Months Ended September 30, 2000

      Net Sales. Net sales increased to $26.1 million for the nine months ended September 30, 2000 from $8.9 million for the nine months ended September 30, 1999, as a result of the significant growth in orders as well as the commencement and growth of our eduPartners™ program. Marketing services sales increased to $1.4 million for the nine months ended September 30, 2000 from $0.1 million in marketing services sales during the nine months ended September 30, 1999, reflecting the continuing migration of our revenues towards the marketing services business.

  Operating Expenses

      Cost of Books — Related Party (Baker & Taylor). Cost of books — related party consists of the cost of books sold to customers. Cost of books-related party increased to $20.4 million for the nine months ended September 30, 2000 from $7.7 million for the nine months ended September 30, 1999. This increase was primarily attributable to our increased sales volume between years.

      Cost of Shipping — Related Party (Baker & Taylor). Cost of shipping — related party consists of outbound shipping. Cost of shipping increased to $2.1 million for the nine months ended September 30, 2000 from $0.7 million for the nine months ended September 30, 1999. This increase was primarily attributable to our increased sales volume between years. Also for the nine months ended September 30, 2000, cost of shipping — related party exceeded shipping revenue by $0.5 million, or 28.0%. For the nine months ended September 30, 1999, cost of shipping — related party exceeded shipping revenue by approximately $0.2 million, or 34%. This decrease was primarily attributable to the increase in the shipping rates charged to our customers that was implemented in July 2000.

      Equity Transactions — Related Party (Baker & Taylor). Equity transactions-related party consists of the fair value of warrants issued to Baker & Taylor. During 1999, we issued warrants to purchase up to 5,950 and 62,500 shares of our common stock at an exercise price of $2.33 and $0.22 per share, respectively, to Baker & Taylor. We estimated the fair value of the warrants on the date of grant using an established option pricing model. In connection with the Baker & Taylor equity transactions, we recorded an aggregate expense of $169,000 for the nine months ended September 30, 1999.

      Cost of Marketing Services. Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. Cost of marketing services totaled $0.2 million for the nine months ended September 30, 2000. There was no cost of marketing services for the nine months ended September 30, 1999.

      Marketing and Sales. Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses such as the amortization of deferred compensation for personnel engaged in marketing and the expenses associated with the continued development of our nationwide network of student representatives. Marketing and sales expense increased to $24.9 million for the nine months ended September 30, 2000 from $13.4 million for the nine months ended September 30, 1999. This increase was primarily attributable to expansion of our online and offline advertising, continued growth of eduPartners™, expenses associated with the Company’s agreement with AOL/ICQ and scholarship programs, and marketing fees assessed by Baker & Taylor. Included in marketing and sales is $2.0 million and $0.5 million of non-cash charges for the nine months ended September 30, 2000 and 1999, respectively. Non-cash charges consist of the amortization of deferred compensation and charges related to warrants issued under the Sallie Mae and AOL/ICQ, Inc. agreements. Non-cash charges increased primarily as a result of additional option grants and the impact of warrants issued in connection with the AOL/ICQ, Inc. and Sallie Mae agreements.

      Product Development. Product development expense consists of payroll and related expenses such as the amortization of deferred compensation for development and systems personnel and consultants. Product development expense increased to $3.8 million for the nine months ended September 30, 2000 from

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      General and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel such as the amortization of deferred compensation, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense increased to $8.4 million for the nine months ended September 30, 2000 from $3.7 million for the nine months ended September 30, 1999. This increase was primarily attributable to the hiring of additional personnel and increased professional services expenses between years. Included in general and administrative expenses is $2.2 million and $0.9 million of non-cash charges for the nine months ended September 30, 2000 and 1999, respectively. Non-cash charges increased primarily as a result of additional options grants and the accelerated vesting of shares owned by our former Executive Vice President of Development in March 2000.

  Other Income (expense), net

      Other income (expense), net consists primarily of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable at September 30, 1999 and credit facility with Imperial Bank at September 30, 2000. Other income was $0.8 million for the nine months ended September 30, 2000 compared to $0.2 million for the nine months ended September 30, 1999. This increase is primarily attributable to interest income on higher average cash, cash equivalent and short-term investment balances during the nine months ended September 30, 2000, offset by interest expense of $0.2 million related to a warrant issued to Imperial Bank in connection with the Company’s credit facility (see discussion below) and a less than $0.1 million loss from the disposition of excess computer equipment.

  Income Taxes

      As of September 30, 2000, we had net operating loss carryforwards for federal income tax purposes of $57.0 million, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability.

Liquidity and Capital Resources

      From inception until our initial public offering, we financed our operations primarily through private sales of our convertible preferred stock. On August 6, 1998 and December 3, 1998, we issued an aggregate of 2,071,420 shares of Series A preferred stock at a purchase price of $.70 per share, resulting in gross proceeds of approximately $1.5 million. On February 25, 1999, we issued 6,933,806 shares of Series B preferred stock at a purchase price of $1.44 per share, resulting in gross proceeds of approximately $10.0 million. On August 27, 1999 and September 21, 1999, we issued an aggregate of 8,928,571 shares of Series C preferred stock at a purchase price of $3.36 per share, resulting in gross proceeds of approximately $30.0 million. Upon the closing of our initial public offering, shares of our Series A, B and C preferred stock were converted into 8,966,879 shares of our common stock.

      In April 1999, we entered into an agreement with Campus Pipeline, Inc. under which a warrant to purchase 25,000 shares of our common stock with an exercise price of $6.00 per share was issued and will be exercisable upon the achievement of contractual revenues of $30.0 million on or before December 31, 2000, with an additional warrant for 50,000 shares with an exercise price of $6.00 per share which will be exercisable if contractual revenues equal or exceed $80.0 million on or before July 31, 2001. Since the exercisability of these warrants is based on the achievement of uncertain future revenue targets, we have not recorded any expense for these warrants.

      In December 1999, we granted AOL a warrant to purchase 493,246 shares of our common stock, which does not include the additional warrant to purchase 1,125 shares which we granted to AOL when we entered into definitive agreements with Imperial Bank and the additional warrant to purchase 34,367 shares which we granted to AOL when we entered into the product promotion agreement with Sallie Mae, with an exercise price of $10 per share. Of the aggregate of 528,738 shares subject to purchase under these warrants, 176,245 shares were

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      In February 2000, we granted Sallie Mae, Inc. warrants to purchase up to 616,863 shares of our common stock, with an exercise price of $10 per share. Of these shares, warrants to purchase 352,493 are immediately exercisable and the warrants to purchase the remaining 264,370 shares may vest over the two year period following the grant date based on Sallie Mae’s performance under our product promotion agreement.

      In February 2000, we issued 4,000,000 shares of Common Stock at an initial public offering price of $10.00 per share. In March 2000, we sold an additional 35,000 shares pursuant to the exercise of the underwriters’ over-allotment option at $10.00 per share. Total net proceeds (after deducting discounts, commissions and other expenses of the offering) were approximately $35.9 million. On February 22, 2000, approximately $2.5 million of this amount was used to pay all amounts outstanding under the credit facility with Imperial Bank (see discussion below). As of September 30, 2000, approximately $16.7 million had been used for working capital purposes. The balance of approximately $16.7 million was invested in cash and cash equivalents at September 30, 2000.

      As of September 30, 2000, prepaid marketing expenses were $0.2 million compared to $4.6 million at December 31, 1999. The decrease is a result of costs incurred in conjunction with our January/ February selling period.

      As of December 31, 1999, we deferred expenses of approximately $1.0 million related to our initial public offering. These costs were offset against additional-paid-in-capital upon the completion of our offering in February 2000. Such costs are reflected as a deferred charge in the accompanying December 31, 1999 consolidated balance sheet.

      Net cash used in operating activities was $26.5 million for the nine months ended September 30, 2000, compared to $10.2 million for the nine months ended September 30, 1999, consisting primarily of net losses adjusted for changes in accounts receivable, accounts payable and accrued expenses.

      Net cash used in investing activities was $1.1 million for the nine months ended September 30, 2000, and $1.2 million for the nine months ended September 30, 1999, consisting primarily of purchases of computer equipment and fixtures and furniture totaling $0.6 million and $1.2 million at September 30, 2000 and 1999, respectively. Also, for the nine months ended September 30, 2000, the Company capitalized $0.6 million of development costs primarily related to its Web site. Such costs will be amortized over an 18-month period.

      Net cash provided by financing activities was $36.4 million for the nine months ended September 30, 2000 and $38.5 million for the nine months ended September 30, 1999 consisting primarily of the net proceeds from the Company’s initial public offering and the issuance of preferred stock, respectively.

      On January 19, 2000 we entered into a revolving credit agreement with Imperial Bank in an aggregate amount of $7.5 million with sub-limits of $3.0 million for purchases of property, equipment and software and $750,000 for letters of credit. The maturity date for working capital advances is December 31, 2000 and the maturity date for property, equipment and software advances is October 18, 2002. Interest on outstanding balances accrued at Imperial Bank’s prime rate (9.5% at September 30, 2000) plus 1.0% until the closing of our initial public offering, and afterwards at Imperial Bank’s prime rate. All amounts outstanding, which could be up to $7.5 million, are collateralized by a pledge of all of our assets. Under the terms of the credit facility, as amended, we must maintain a tangible net worth of $15 million and a ratio of our current assets to our current liabilities of 1.5 to 1. We also issued a warrant to Imperial Bank to purchase 37,500 shares of our common stock at an exercise price of $10 per share. We borrowed $2.5 million under the revolving credit facility during February 2000 and repaid such borrowings on February 22, 2000 with a portion of the proceeds of our initial public offering. No amounts were outstanding under the agreement at September 30, 2000 with the exception of a letter of credit in the amount of $0.3 million.

      We expect that operating losses and negative cash flows will continue until at least the second half of 2001. As part of the increased emphasis on our higher margin marketing services business, we anticipate that costs and expenses related to brand development, marketing and other promotional activities associated with

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      We currently expect that cash, cash equivalent and short term investment balances will be sufficient to meet our anticipated needs for working capital and capital expenditures into the third quarter of 2001. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed our current expectations. Any required additional financing may be unavailable on terms favorable to us, or at all.

Factors That May Affect Future Operating Results

      This quarterly report on Form 10-Q contains forward looking statements which involve risks and uncertainties. Our actual results could differ materially from those anticipated by such forward looking statements as a result of such factors, including those set forth below.

      We require substantial working capital to fund our business in the near and longer term. If we do not achieve cash flow profitability in the third quarter of 2001, we may have to raise additional funds to finance our operations beyond the third quarter of 2001. We may elect to seek these additional funds at any time, but there can be no assurance that any future fund raising efforts will be successful. If we raise additional funds by selling our common stock or securities convertible into common stock, the relative ownership of our existing investors could be significantly diluted or the new investors could obtain terms more favorable than those of our existing investors. Furthermore, the actual amount and timing of our longer-term future capital requirements may differ materially from our current estimates because our revenues and costs depend upon certain factors that we cannot control. We may experience significant changes and fluctuations in our revenues, operating costs and development expenses due to changes in technology and regulations, increased competition and factors such as seasonality and performance by third parties in connection with our operations. These variations may significantly affect our future need for capital. If we cannot obtain appropriate levels of financing when needed and on terms acceptable to us or at all, we may be forced to curtail our operations.

      Since the company’s inception, our business has focused primarily on the online sale of new textbooks. Only since May 2000 have we begun to focus on a new business model that aggressively grows our eduPartners™ program, in which we contract with educational institutions to become their exclusive textbook supplier, and which also accelerates the migration of our business towards our marketing services business. We must deploy and execute upon our marketing services business model successfully and generate adequate revenue and gross margin in order for us to achieve positive cash flow. Because we have limited experience in operating our marketing services business, we cannot give any assurances that we will be able to successfully build this business and our historical financial information is of limited value to you in projecting our future results.

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      Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder, Chief Executive Officer, President and Chairman of the Board. We have entered into an agreement with Mr. Kuhn which provides, among other things, that he be compensated in the event he is terminated without cause. We have not entered into similar agreements with any other personnel. Nonetheless, the loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team. In addition, a number of members of our management team have joined us within the last year. These individuals have not previously worked together and are becoming integrated into our management team. They may not be able to work together effectively or successfully manage our growth, resulting in adverse consequences to our business.

  Our business and growth will suffer if we are unable to successfully hire and retain key personnel.

      Our future success depends on our ability to attract, train, motivate and retain highly skilled employees and student representatives. We may be unable to retain our key employees and student representatives or attract, assimilate or retain other highly qualified employees or student representatives in the future. The failure to attract and retain the necessary managerial, marketing, merchandising, operational, customer service, technical, financial or administrative personnel could harm our business. In addition, as we grow and add additional product and service offerings, we anticipate a need to further develop and expand our Web site. Competition for highly skilled and qualified Web site and software developers is intense. We cannot be certain we will be able to attract and retain a sufficient number of qualified software developers or outside consultants for our Web site and transaction-processing systems.

  We expect to continue to incur significant losses and experience negative cash flow.

      We expect significant operating losses and net negative cash flows from operations to continue until the third quarter of 2001, and possibly longer. Because we have planned expenses and relatively low gross margins in our retail textbook business, our ability to become profitable depends on our ability to generate and sustain higher net revenues and gross margins through our marketing services business and eduPartners™ program. If we do achieve profitability, we cannot be certain that we can sustain or increase profitability on a quarterly or annual basis in the future. We base our current and future expense levels on our operating plans and estimates of future revenues. If we cannot achieve and sustain operating profitability or positive cash flow from operations, we may be unable to meet our working capital requirements, which would adversely affect our business and may cause us to discontinue operations.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

      The Company is subject to interest rate risk on its cash and cash equivalents, short-term investments and credit facility. If market rates were to increase immediately and uniformly by 10% from the level at September 30, 2000, the change to the Company’s interest sensitive assets and liabilities would have an immaterial effect on the Company’s financial position, results of operations and cash flows over the next fiscal year.

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PART II.

Item 1:  Legal Proceedings

      Not Applicable

Item 2:  Changes in Securities

      Not Applicable

Item 3:  Defaults Upon Senior Securities

      Not Applicable

Item 4:  Submission of Matters to a Vote of Security Holders

      Not Applicable.

Item 5:  Other Information

      Our common stock currently trades on the Nasdaq National Market. Under the rules of the Nasdaq National Market, in order for our common stock to be designated as a National Market security, we must be in compliance with certain standards which include, among other things, (i) a minimum closing bid price for the common stock of at least $1.00 per share, and (ii) a market value for our publicly held shares (i.e., which does not include shares held by executive officers, directors or 10% shareholders) of at least $5,000,000. On October 27, 2000, Nasdaq notified us that our common stock had failed to maintain a minimum bid price of $1.00 for the previous 30 consecutive trading days. Under the Nasdaq rules, we have until January 25, 2001 to comply with the above mentioned listing requirements. One way that we can regain such compliance is if the bid price of our common stock is at least $1.00 for a minimum of 10 consecutive trading days prior to such date. If we are not able to demonstrate compliance with this requirement on or before January 25, 2001, our common stock will be delisted at the open of business on January 29, 2001, unless we request a hearing on our delisting before Nasdaq. We are considering possible responses to our failure to comply with the Nasdaq minimum closing bid price requirements, which include various actions designed to raise the bid price for our common stock, but which could include a decision to take no such action. We cannot assure you that we will regain compliance with this listing requirement or that we will not fail to satisfy this or other requirements in the future. For example, based on the recent minimum bid price of our common stock, we may in the future fail to comply with the $5,000,000 market value requirement referred to above. In such case, our common stock would no longer be listed on the Nasdaq National Market. In such event, stockholders may be forced to trade our stock in the over the counter market on an electronic bulletin board established for securities that do not meet the listing requirements, or what is commonly referred to as the “pink sheets.” The result of such delisting would be a reduction in the liquidity of any investment in our common stock. Delisting would also reduce the ability of holders of our common stock to purchase or sell shares as quickly and as inexpensively as they have done historically. This lack of liquidity may also make it more difficult for us to raise capital in the future.

Item 6:  Exhibits and Reports on Form 8-K

      (a)  Exhibits

	(b)	Reports on Form 8-K None

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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.

	VARSITY GROUP INC.

	By:	/s/ ERIC J. KUHN

	Eric J. Kuhn
	Chairman, Chief Executive
	Officer and President

Date:  November   , 2000

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