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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2002 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
TRANSITION PERIOD FROM ________ TO ________
Commission file number 0-22019
HEALTH GRADES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 62-1623449
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
44 UNION BOULEVARD, SUITE 600
LAKEWOOD, COLORADO 80228
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (303) 716-0041
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
None
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $.001 PER SHARE
(Title of class)
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy statement incorporated
by reference in Part III of this annual report on Form 10-K or any amendment to
this annual report on Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
As of June 28, 2002, the aggregate market value of the Common Stock held by
non-affiliates of the registrant was $724,305. Such aggregate market value was
computed by reference to the closing sale price of the Common Stock as reported
on the OTC Bulletin Board on such date. For purposes of making this calculation
only, the registrant has defined "affiliates" as including all directors and
beneficial owners of more than five percent of the Common Stock of the Company.
As of March 31, 2003 there were 36,406,649 shares of the registrant's Common
Stock outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
None
TABLE OF CONTENTS
PART I
Item 1. Business........................................................... 2
Item 2. Properties......................................................... 20
Item 3. Legal Proceedings.................................................. 21
Item 4. Submission of Matters to a Vote of Security Holders................ 21
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters........................................... 22
Item 6. Selected Financial Data............................................ 23
Item 7. Management's Discussion and Analysis of Financial Condition And
Results of Operations.......................................... 23
Item 7A. Quantitative and Qualitative Disclosures About Market Risk......... 28
Item 8. Financial Statements and Supplementary Data........................ 28
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................... 28
PART III
Item 10. Directors and Executive Officers of the Registrant................. 29
Item 11. Executive Compensation............................................. 29
Item 12. Security Ownership of Certain Beneficial Owners and Management..... 29
Item 13. Certain Relationships and Related Transactions..................... 29
Item 14. Controls and Procedures............................................ 30
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K... 31
This Report contains forward-looking statements that address, among other
things, the availability of healthcare data, the generation of increased
revenues, potential equity and/or debt financing. These statements may be found
under "Item 1-Business," "Item 1-Risk Factors," and "Item 7-Management's
Discussion and Analysis of Financial Condition and Results of Operations" as
well as in this Report generally. We generally identify forward-looking
statements in this report using words like "believe," "intend," "expect," "may,"
"will," "should," "plan," "project," "contemplate," "anticipate" or similar
statements. Actual events or results may differ materially from those discussed
in forward-looking statements as a result of various factors, including: the
failure of the Company to generate increased revenues or the inability of the
Company to raise additional financing. In addition, other factors that could
cause actual events or results to differ materially from those discussed in the
forward looking statements are addressed in "Item 1-Risk Factors" and matters
set forth in the Report generally. We undertake no obligation to update publicly
any forward-looking statements for any reason, even if new information becomes
available or other events occur in the future.
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PART I
Item 1. Business.
BUSINESS
OVERVIEW
Health Grades, Inc. ("HealthGrades") provides healthcare ratings, advisory
services and other healthcare information. We grade, or provide the means to
assess and compare the quality or qualifications of, various types of healthcare
providers. Our customers include healthcare providers, employees, health plans,
insurance companies and consumers.
We provide ratings or profile information relating to the following
healthcare providers:
- 5,000 hospitals according to specialty (cardiac surgery,
cardiology, orthopedic surgery, neurosciences, pulmonary,
vascular surgery and obstetrics);
- 620,000 physicians in over 70 specialties;
- 17,000 nursing homes;
- 7,800 home health agencies;
- 3,000 hospice programs; and
- 300 fertility clinics that provide assisted reproductive
technology (ART) services.
We offer services to hospitals that are either attempting to build a
reputation based upon quality of care or are working to identify areas to
improve quality. For hospitals that have received high ratings, we offer the
opportunity to license our ratings and trademarks and provide assistance in
their marketing programs. For hospitals that have not received high ratings, we
offer quality improvement services.
We also provide basic and expanded profile information on a variety of
providers and facilities. We make this information available to consumers,
employers and health plans to assist them in selecting healthcare providers. The
basic profile information is available free of charge on our website,
www.healthgrades.com. For a fee, we offer healthcare quality reports with
respect to certain healthcare providers. These reports provide more detailed
information than is available free of charge on our website. Report pricing and
content varies based upon the type of provider and whether the user is a
consumer or a healthcare professional (for example, medical professional
underwriter).
We provide online integrated healthcare quality services for employers,
health plans and other organizations that license access to our database of
healthcare providers.
We have also entered into strategic arrangements with other service
providers, including GeoAccess and J.D. Power & Associates, in an effort to
increase our name recognition and market presence, as well as enhance our
service offerings.
HEALTHCARE INFORMATION; HEALTHGRADES.COM
We compile comprehensive information regarding various healthcare providers
and distill the information to meet the requirements of consumers, employers,
health plans and other customers. We provide certain information for no charge
on our healthgrades.com Internet site. Our revenues are generated, in part,
through the provision of healthcare information derived from our database in a
manner that can be useful to employers, health plans and others.
Healthgrades.com is a comprehensive healthcare information website that
provides rating and other profile information regarding a variety of providers
and facilities. Our goal is to provide comprehensive, objective healthcare
ratings and profiles to assist consumers in making the most informed decisions
regarding their health and that of their families.
We distinguish the healthgrades.com website from most other healthcare
information websites based on the nature of the information we provide. Most
other healthcare information websites provide general information regarding
specific diseases, conditions or procedures. Healthgrades.com, in contrast,
provides information to assist the user in finding quality care or a quality
provider, using our rating and profile information. However, we do not endorse
any particular provider or facility. We strive to provide unbiased ratings
regarding the quality of providers and facilities by developing proprietary
algorithms or other methodologies and applying them to a number of databases
used on our ratings website.
We provide information on our healthgrades.com website through the sections
described below. As noted above, the data used to compile information for our
website also provides the more comprehensive information and reports we make
available for a fee.
Hospital Report Cards(TM) - This page provides a list of hospitals and
ratings for the hospitals with respect to different medical procedures or
diagnoses chosen by the user. Information with regard to procedures and
diagnoses is provided in the following areas:
- cardiac;
- orthopaedics;
- neurosciences;
- neurosurgery;
- pulmonary/respiratory;
- obstetrics; and
- vascular surgery.
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For each particular diagnosis or procedure chosen by the user, other than
those relating to obstetrics, we provide a rating system of five stars, three
stars or one star (five stars is the highest rating; one star is the lowest)
with regard to the performance of the majority of hospitals in the United
States. We base all of our ratings, except ratings on obstetrics, on three years
of MEDPAR (Medicare Provider Analysis and Review) data that we purchase from the
Centers for Medicare and Medicaid Services (formerly Health Care Financing
Administration), known as CMS. The MEDPAR database contains the inpatient
records of all Medicare patients. We apply proprietary algorithms to the MEDPAR
data to account for variations in risk in order to make the data comparable from
hospital to hospital. Generally, approximately 70% to 80% of hospitals studied
are classified as three stars. The three star rating is applied when there is
very little difference, statistically speaking, between a hospital's predicted
and actual performance. Approximately 10% to 15% of hospitals are rated five
stars, which means that their performance is better than expected on a
statistically significant basis. Approximately 10% to 15% of hospitals are rated
one star, meaning that their performance was worse than expected on a
statistically significant basis.
For our obstetrics ratings, which also are subject to the five star rating
system, we use state all-payor files from 18 individual states derived from the
inpatient records of persons who utilize hospitals in those states. The 18
states represented on the site are: Arizona, California, Florida, Iowa,
Illinois, Maryland, Massachusetts, Nevada, New Jersey, New York, North Carolina,
Pennsylvania, Texas, Utah, Vermont, Virginia, Washington, and Wisconsin. We
believe that these 18 states are the only states with sufficient data for use on
our website. This data represents all discharges for the 18 states over a
three-year period set from 1998-2000, with the exception of Iowa (2000 only),
Illinois (1999 and 2000 only), North Carolina (1999 and 2000 only) and Texas
(1999 and 2000 only). We analyzed the following factors for each hospital within
the 18 all-payor states:
- Actual complication rates from vaginal and cesarean section single
birth deliveries;
- Volume of vaginal and cesarean single birth deliveries; and
- Presence of neonatal intensive care unit (NICU).
Hospitals are assigned a score in respect of each of the factors. Volume
for vaginal and cesarean single birth deliveries was ordered into tenth
percentile groups by state with the highest volume percentile group in each
state receiving a value of 10 and the lowest volume percentile group in each
state receiving a value of 1. Complication rates were placed into tenth
percentile groups by state. The highest complication rate percentile group in
each state received a value of 1 while the lowest complication rate percentile
group in each state received a value of 10. The presence of a NICU was assigned
a value of 10 while no NICU was assigned a value of 1. We then developed a
system that assigned a weight to each factor based on its importance to the
quality of obstetric care in the hospital. These weightings were developed by
interviewing a group of obstetricians who had an average of 17 years of practice
experience. Each factor's score was multiplied by its percentage weight and then
summed to create an overall score. The top 30% of hospitals (in the 18 states)
receive five stars, the middle 40% receive three stars and the bottom 30%
receive one star.
Nursing Home Report Cards(TM) - This page provides rankings of the performance
of nursing homes across the United States that were Medicare or Medicaid
certified and active in these programs. In preparing the ratings, we analyzed
licensing survey data from CMS's Online Survey Certification and Reporting
(OSCAR) database and complaint data from CMS's Skilled Nursing Facility (SNF)
Complaint database. Licensing surveys are inspections that assess compliance
with standards of patient care such as staffing, quality of care and
cleanliness. Complaint surveys are investigations of complaints and serious
problems. Nursing homes whose most recent survey date was more than 20 months
prior to the date the data was received by HealthGrades were not included in the
analysis. Stand-alone Medicare and/or Medicaid nursing homes were analyzed apart
from Medicare, hospital-based nursing homes. We did not rate Medicare,
hospital-based nursing homes because these facilities are designed for
short-term patient care. In addition, nursing homes with only one licensing
survey were not included in our analysis. The ratings were assigned on a state
by state basis, rather than nationally, because the surveys from which
information is derived are conducted by state agencies, and there may be
variations in the states' survey process and results.
In conjunction with a group of nursing home professionals (which included
nursing home administrators, a physician, long-term care ombudsmen, a nurse
consultant and others), we developed a proprietary scoring system that
translated the scope and severity of each deficiency into a numerical value. A
low numerical value indicated a deficiency that was not severe (no actual harm
to the resident) and isolated (involved very few residents) in scope. A high
numerical value indicated a deficiency that was very severe (actual harm to the
resident) and was widespread throughout the nursing home. Each nursing home
received several scores from the analysis of licensing surveys and complaint
surveys. We then performed a statistical analysis of these scores that produced
a weight for each area. The weighted scores were summed to produce an overall
score for each nursing home. Based upon the overall score, the best 30% of
nursing homes received five stars, and the middle 40% of nursing homes received
three stars.
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Home Health Report Cards(TM) - This page provides rankings of the performance of
Medicare certified home health agencies across the United States. Home health
agencies provide health and social services to persons at their homes. These
persons are recovering from an illness or injury or require assistance with
daily needs such as eating, dressing and bathing. We rate home health agencies
based upon data provided by CMS. Information is derived from complaint surveys
and licensing surveys. Complaint surveys are conducted by a state survey team in
response to one or more complaints about a home health agency. Licensing surveys
are surveys completed for Medicare certification. The licensing survey
information is derived from individual state agencies, which enter the
information into the OSCAR database. These surveys generally occur every 36
months, but may occur more frequently based on the results of the previous
survey. Home Health Report Cards(TM) is updated annually, and currently reflects
May 2002 OSCAR data (the next data update will occur mid-2003). In preparing the
ratings, we reviewed survey information from the most recent licensing surveys
and a maximum of four complaint surveys of home health agencies. Only home
health agencies that were active in the Medicare program during this time period
were included in the analysis. Specifically, we utilized the following elements
to capture the quality of care and operational stability of each home health
agency:
- Complaint surveys (two elements):
- Number of complaint surveys within the last four years
- Number of complaint surveys dated within six months of each
other;
- Condition level deficiencies (very serious deficiencies that may give
cause for penalties or de-certification by Medicare) (four elements) -
Number of condition level deficiencies on each of the past four
surveys;
- Standard level deficiencies (non-serious deficiencies that require a
plan for correction) (four elements) - Number of standard level
deficiencies on each of the last four surveys;
- Condition level deficiencies reported on both the most recent and
prior survey;
- Standard level deficiencies reported on both the most recent and prior
survey;
- Surveyor's summary score on the quality of care during the most recent
survey;
- Years in operation; and
- Ownership changes as compared to years in operation.
Working with a group of healthcare professionals whose area of expertise is
home healthcare; we developed a proprietary weighting system that translates the
elements detailed above into numeric scores. Home health agencies were sorted by
state based upon the overall score. The top 30% of home health agencies in each
state received five stars, the middle 60% received three stars and the bottom
10% received one star. As is the case with nursing homes, the ratings were
assigned on a state-by-state basis, rather than nationally, because the surveys
from which information is derived on the OSCAR database are conducted by state
agencies, and there may be variations in the states' survey process and results.
In addition, our site provides specific information with regard to particular
deficiencies found in the surveys.
Hospice Report Cards(TM) - This page differs from some of our other report card
pages in that it does not provide ratings. Instead, it provides users with the
means to assess hospice programs across the United States that participate in
Medicare. The data on our Hospice Report Card site is purchased from CMS, and is
derived from their Provider of Service ("POS") file. The POS file contains data
on every hospice program that participates in Medicare. Hospice services are
categorized as "provided by staff" and "provided under arrangement." "Provided
by staff" refers to a hospice service that is performed by an employee or staff
member of the hospice, whereas "provided under arrangement" refers to a service
that is delegated to a healthcare provider other than a hospice employee or
staff member. For example, if a hospice program does not employ a physical
therapist, but a patient requires physical therapy, the organization might
contract with an independent physical therapist to provide this service. In
addition, hospice services are categorized as "core services" or "non-core
services." Core services, as defined in the POS file, are important, basic
elements of hospice care that are crucial to virtually every hospice patient and
their family. These services include the following:
- nursing care provided by or under the supervision of a registered
nurse;
- medical social services provided under the direction of a physician;
- physician services; and
- counseling.
Non-core services are also important to high-quality hospice care, but each
non-core service may be inappropriate or unnecessary for every hospice patient.
Non-core hospice services, as defined in the POS file, include:
- physical therapy;
- occupational therapy;
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- speech pathology;
- home health aide;
- homemaker services;
- medical supplies; and
- short-term inpatient care.
Hospice report cards provide users with a list of hospices from which they
can refine their search based upon the following criteria:
- whether the program provides nursing care directly by hospice
employees;
- whether the program provides medical social services directly by
hospice employees;
- whether the program provides physician services directly by hospice
employees;
- whether the program provides counseling directly by hospice employees;
and
- whether the program provides all non-core hospice services.
Fertility Clinic Report Cards(TM) - Like our Hospice Report Card pages,
this page differs from our other report card pages in that it does not provide
ratings. Instead, it provides users with the means to assess fertility clinics
across the United States. Information on healthgrades.com presently represents
one year of assisted reproductive technology ("ART") data. ART is defined as any
clinical treatment or procedure that involves the handling of human eggs and
sperm to help a woman become pregnant. Types of ART include IVF (in vitro
fertilization), GIFT (gamete intrafallopian transfer), ZIFT (zygote
intrafallopian transfer), egg or embryo donation and surrogate birth.
The ART data on the healthgrades.com website is acquired from an annual
report published by the National Center for Chronic Disease Prevention and
Health Promotion of the Centers for Disease Control and Prevention ("CDC"), the
American Society of Reproductive Medicine, the Society for Assisted Reproductive
Technology ("SART") and RESOLVE, a national consumer group for men and women
facing infertility. Fertility clinics in the United States are required to
provide ART data to SART, and information for over 300 fertility clinics are
represented in the CDC/SART report.
Each fertility clinic profile consists of the following five elements:
- General information (contact information for each facility);
- Program characteristics, including whether the clinic accepts single
women and gestational carriers (women who carry children for other
women), whether the clinic utilizes a donor egg program and whether
the clinic is a member of SART;
- Percentage of facilities nationwide that have designated program
characteristics;
- Type of ART (each fertility clinic's ART procedures (e.g., % of
procedures using IVF) compared to the national average);
- Patient diagnosis (individual clinic patient diagnoses compared to the
national average); and
- Pregnancy success rates (individual clinic pregnancy success rates in
four age categories compared to the national average). For each age
category, success rates are provided for three types of ART cycles:
cycles that utilize fresh embryos from non-donor eggs, cycles that
utilize frozen embryos from non-donor eggs, and cycles that utilize
donor eggs.
Provider Profiles - In addition to the report card sections, we provide
profiles containing information with regard to the following providers or
facilities:
- Physicians - The physician data provides a list of physicians by
specialty based on geographic criteria selected by the user. Physician
information provided by HealthGrades includes primary and secondary
specialty areas, medical school attended, years since medical school,
address, telephone number, and maps. For a fee, we also provide board
certification, hospital affiliation and federal or state medical board
sanction information. The directory contains detailed profiles for
more than 620,000 physicians.
- Hospitals -- The hospital profile database includes a directory of
almost every hospital in the U.S. The directory contains detailed
profiles and maps for more than 5,000 hospitals;
- Children's Hospitals -- The children's hospital profile database is an
online directory of every Medicare-licensed children's hospital in the
U.S. The directory contains detailed profiles and maps for more than
70 children's hospitals;
- Chiropractors - HealthGrades Chiropractor Profiles is an online
directory that contains detailed profiles and maps for more than
60,000 chiropractors in the United States;
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- Assisted living residences - HealthGrades Assisted Living Profiles is
on online directory that contains detailed profiles (including
accreditation information) and maps for more than 21,000 residences in
the United States;
- Mammography facilities - HealthGrades Mammography Facility Profiles is
an online directory that contains detailed profiles and maps for more
than 10,000 facilities in the United States;
- Acupuncturists - HealthGrades Acupuncturist Profiles is an online
directory that contains detailed profiles and maps for more than 800
acupuncturists in the United States;
- Naturopathic physicians - HealthGrades Naturopathic Physician Profiles
is an online directory that contains detailed profiles and maps for
more than 700 naturopathic physicians in the United States;
- Birth centers - HealthGrades Birth Center Profiles is on online
directory that contains detailed profiles (including accreditation
information) and maps for more than 70 facilities in the United
States;
- Emergency Centers -HealthGrades Emergency Services Profiles includes
detailed profiles of over 10,000 hospital emergency rooms, rural
health clinics and federally-qualified community health centers;
- Cancer Centers - HealthGrades Cancer Center Profiles is an online
directory of cancer facilities designated by the National Cancer
Institute as comprehensive or clinical cancer centers. The directory
contains detailed profiles that include contact information, disease
specializations, clinical trials, patient support programs, screenings
and prevention programs and maps for over 50 cancer centers.
INFORMATION AND RELATED SERVICES FOR HOSPITALS, EMPLOYERS, HEALTH PLANS,
PROFESSIONALS AND CONSUMERS
The information provided on our healthgrades.com website, and the database
from which this information is derived, forms the basis of our marketing
efforts. While certain information is provided free of charge on our website, we
seek to generate revenues from hospitals and other providers, as well as
employers, health plans and consumers as described below:
SERVICES FOR HOSPITALS - We offer a Strategic Quality Initiative(TM) (SQI)
program, a Quality Assessment and Improvement(TM) (QAI) program and a Ratings
Quality Analysis Program(TM) (RQA) for hospitals. As our programs are targeted
toward specific areas (for example, Cardiac, Neurosciences, etc.) some of our
hospital customers choose to work with us utilizing our SQI programs for their
higher rated areas and utilizing our QAI and RQA programs for their lower rated
areas. As of March 22, 2003, over 130 hospitals have joined our SQI program, QAI
program or RQA program.
SQI Program. We offer the SQI program to highly rated providers only after
our ratings are completed; we do not adjust our ratings based on whether a
provider is willing to license with us.
Marketing. The SQI program provides business development tools to hospitals
that are highly rated on our website. Under our SQI program, we license the
commercial use of the HealthGrades corporate mark, applicable data and multiple
marketing messages that may be used by hospitals to demonstrate third party
validation of excellence, including:
- HealthGrades' name, logo, stars and current ratings data including
performance score o National designation (i.e., Top 5% in the Nation,
Top 10% in the Nation) as applicable;
- State rank (i.e., Best in State, Best in Region) as applicable;
- Marketing messages developed and approved by HealthGrades; and
- Ratings comparisons developed and approved by HealthGrades.
The license may be in a single service line (for example, Cardiac) or multiple
service lines (for example, Cardiac, Neuroscience and Orthopaedics). In
addition, the SQI program provides ongoing access to HealthGrades' marketing
service and resources, tailored to the hospital's specific needs, and includes:
- Assistance in the creation and distribution of marketing/public
relations communications;
- Communication tools, such as press releases, that are customized as
needed;
- A comprehensive reference guide with sample client marketing material,
template letters, electronic artwork and detailed descriptions of our
ratings methodology;
- "Award" certificates and posters recognizing the client as a Five Star
provider of services; and
- Customized web site ("Quality Net") for access to HealthGrades'
library, which includes case studies regarding HealthGrades' clients;
sample marketing materials, including print, television and radio ad
samples; and direct access to HealthGrades logos which can be
downloaded for immediate use and Ratings Quality Analysis for the
licensed service line(s), described below.
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RQA Programs. We also assist hospitals in measuring the success of their
quality efforts utilizing our team of in-house healthcare consultants. Either
purchased as a stand-alone product, or as part of the SQI program, HealthGrades
provides an on-site presentation to administrative, physician and quality
improvement staff regarding an annual comprehensive quality analysis of the
hospital's identified weaknesses and potential areas for improvement within the
service line(s) licensed by the hospital. This analysis includes:
- National and Five Star performer benchmarks;
- Analysis of the hospital's annual actual and predicted outcome data;
- Risk adjusted analysis and comparison of hospital's documented and
coded risk factors;
- Risk adjusted analysis and comparison of hospital's documented and
coded complications;
- Summary analysis presenting key observations and recommendations for
overall improvement; and
- An annual regional performance comparison to assist hospitals in
identifying competitive trends.
QAI Program. Our QAI program is principally designed to help a hospital
measure and improve the quality of its care in particular areas where it has
lower ratings. Using our database and focusing on a particular hospital's
information and ratings we can help identify areas to improve quality and
measure how well the hospital performs relative to national and regional best
practices. Detailed quality comparisons are also available at the hospital,
physician group and individual physician level. Our consultants work on-site
with the hospital staff and physicians to present the data and assist in the
quality analysis. Under our QAI program, hospitals will receive the following
services with respect to the service line(s) licensed from us:
- - detailed analysis of the last two years of the hospital's Medicare and all
payer-data, including risk adjusted analysis and comparison of the
hospital's:
- annual actual and predicted mortality data for various hospital
procedures;
- documented and coded risk factors for various hospital
procedures; and
- documented and coded complications for various hospital
procedures;
- - comparison of all data by physician and physician group when appropriate;
- - provision of updated data on a quarterly basis;
- - consultation with key administrative and hospital staff, key physicians and
quality improvement team and implementation groups during every on-site
visit
SERVICES FOR EMPLOYERS, HEALTH PLANS AND OTHERS - We license access to, and
customize our database for employers, health plans and others. Depending on the
client's needs, we can customize our content for the intended users (for
example, health plan members who are affiliated with the health plan). Some of
the healthcare quality information available to our customers and their web
users includes:
Physicians
Profiles of over 620,000 practicing physicians in the nation that include:
- Sanction database for every state except HI, SD, DC;
- Board certification status by specialty;
- Hospital affiliations; and
- Medical school.
Hospitals
Profiles of every hospital in the nation that include:
- Ratings based on outcomes for the most current three-year data set;
and
- Ratings by procedure or diagnosis in the six areas addressed by our
Hospital Report Cards.
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Nursing Homes
Profiles of every Medicare/Medicaid - licensed nursing home in the nation
that include:
- Ratings based on health and complaint surveys over the last four years
- Benchmark data to help evaluate risk; and
- Detailed deficiency information.
HEALTHCARE QUALITY REPORTS FOR PROFESSIONALS - We offer comprehensive quality
information to organizations in need of current and historical quality
information on nursing homes and hospitals. In addition, we offer reports on
physicians that contain detailed information with respect to education,
professional licensing history and other items.
Nursing Home Quality Reports for Professionals(TM) - Our primary customers
for our Nursing Home Quality Reports for professionals are medical professional
liability underwriters and other organizations. We currently offer three
categories of reports on nursing homes. Our Nursing Home Quality Report for
Professionals contains detailed information on ownership, certification history,
staffing and patient demographics as well as performance and ranking data from
health, complaint and life safety surveys. Our Executive Summary is a three-page
report, which summarizes this information. Our Risk Assessment is a two to three
page textual analysis of the Nursing Home Quality Report that highlights
potential problem areas within a facility that require risk management.
Hospital Reports for Professionals(TM) - Our Hospital Reports contain
detailed information on ownership, services provided and clinical performance
outcomes. Some of the features of our reports include:
- Risk and severity-adjusted performance measures for cardiac,
neuroscience, vascular, orthopaedics, pulmonary and obstetrics
procedures and diagnoses;
- Comparative statistics and state/national benchmarks;
- Infections, complication and mortality rates; and
- "Cases At Risk" analysis, which projects how many cases are likely to
have adverse outcomes based upon our proprietary mortality or
complication rate analysis.
In addition to the information contained in our Hospital Reports, we offer
access to a selection of public record reports to further assess risk, such as:
- Business information, including bankruptcies, liens, judgments, credit
reports, corporate records and federal employer identification
numbers;
- Background checks on administrators and officers and directors; and
- Media searches.
Physician Reports for Professionals(TM) - Our Physician Reports contain
detailed information on a physician's demographics, which include:
- Education history;
- Professional licensing history;
- Board certifications;
- State medical board and Medicare sanction history;
- Hospital and health plan affiliations;
- Our quality ratings for each hospital with which the physician is
affiliated; and
- Bankruptcies, liens and judgments.
We also offer credit reports and civil and criminal records checks in
separate reports.
HEALTHCARE QUALITY REPORTS FOR CONSUMERS - We offer comprehensive quality
information to consumers that provides current and historical quality
information on hospitals and nursing homes in more detail than is available on
our website. In addition, we offer reports on physicians that contain detailed
information with respect to education, professional licensing history and other
items.
Hospital Quality Reports for Consumers(TM) - Our Hospital Quality Reports
for Consumers include:
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- All procedures and diagnoses rated by HealthGrades for the hospital;
- Survey data prepared in connection with The Leapfrog Group (described
below); and
- HealthGrades' methodology and helpful hints for choosing a hospital.
Nursing Home Quality Reports for Consumers(TM) - Our Nursing Home Quality
Reports for Consumers include:
- Our rating for the particular nursing home;
- Health survey history with descriptions and severity of the
deficiencies for the last four licensing surveys;
- Instances of repeated deficiencies;
- How the nursing home compares to others in the state; and
- Our methodology and helpful hints for choosing a nursing home.
Physician Quality Reports for Consumers(TM) - Our Physician Quality Reports
for Consumers include:
- Board certification information;
- State and federal sanction information within the last 5 years (if
any);
- Name and address of hospital affiliation(s);
- Name of health plan affiliation(s);
- National comparative statistics in board certification and sanction
activity about physicians in the same specialty field; and
- Information on how to choose a physician with a checklist and guide.
ARRANGEMENTS WITH OTHER SERVICE PROVIDERS
We have also entered into arrangements with other service providers in an
effort to increase name recognition and market presence, as well as enhance our
service offerings. The following is a summary of our current arrangements for
the provision of joint product offerings.
Distinguished Hospital Program(TM) with J.D. Power and Associates. In
August 2002, we entered into an agreement with J.D. Power and Associates to
offer a Distinguished Hospital Program, which is designed to validate and
recognize hospitals that perform at notably high levels utilizing J.D. Power and
Associates' customer satisfaction data and HealthGrades' clinical quality data.
Under this program, hospitals may be concurrently or separately recognized and
awarded for exceptional clinical performance and for the provision of
"outstanding patient experience." The first component of this program, clinical
excellence recognition, is provided by HealthGrades and developed thorough
detailed, risk-adjusted analysis of up to three years of actual and predicted
hospital mortality data and documented coded risk factors, in addition to
documented and coded complications in specialty areas, based on our Hospital
Report Cards methodology. The second component of the program, service
excellence recognition, is provided by J.D. Power and Associates and is obtained
by surveying a random sample of patients who have recently experienced a
hospital stay and comparing the results with those from a nationally
representative patient experience study. The Distinguished Hospital Performance
Program offers hospitals that receive recognition the ability to enter into a
license agreement to reference the awards in future advertising and marketing
efforts. To enhance the visibility, understanding and appreciation of the
available awards, HealthGrades and J.D. Power and Associates provide the
following support:
- onsite strategic marketing and communication consulting;
- advertising and press release samples;
- electronic artwork;
- links to both the J.D. Power and Associates and HealthGrades web
sites; and recognition of the award posted on both the J.D. Power and
Associates and HealthGrades web sites.
GeoAccess/HealthGrades Quality Rating Suite. We have developed a suite of
web-based decision support tools for consumers referred to as our Quality
Ratings Suite. Included in this product offering are our Hospital, Physician and
Nursing Home Quality Reports for Professionals, which provide online
applications designed to help users select the best healthcare provider to suit
their needs. We have entered into an arrangement with GeoAccess, Inc., a company
affiliated with Ingenix, Inc., to market our Quality Ratings Suite to managed
care organizations, health plans, employers and benefit management companies
through GeoAccess' sales and marketing teams. GeoAccess provides much of the
physician data included in our Quality Ratings Suite, which combines access to
HealthGrades quality ratings and The LeapFrog Group Patient Safety Survey
information. (The Leapfrog Group, a consortium of
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more than 90 Fortune 500 companies and other large private and public healthcare
purchasers, began a national effort in November 2000 to reward hospitals for
advances in patient safety and to educate employees, retirees, and families
about the importance of hospitals' efforts in this area. The Leapfrog Group's
Survey assesses the extent to which urban, acute care hospitals in selected
regions of the U.S. currently meet or are striving to implement three patient
safety practices: Computer Physician Order Entry, Evidence-Based Hospital
Referral and ICU Physician Staffing.) In addition, under the
GeoAccess/HealthGrades Quality Rating Suite, customers are offered project
management, information technology, user support and communications services
(for example, materials to inform users of the GeoAccess/HealthGrades Quality
Rating Suite and how to access the information). The Quality Rating Suite also
includes the following applications:
- integrated search within online physician and hospital directory;
- risk severity adjusted mortality/complication rates by
procedures/diagnoses;
- hospital comparison tools;
- search by geography, procedure/diagnoses and consumer preference;
- downloadable hospital quality reports;
- nursing home ratings;
- leading physician ratings; and
- additional customization (user interface or additional data, such as
state and local data).
COMPANY HISTORY
We were incorporated in Delaware in December 1995 under the name Specialty
Care Network, Inc. Upon commencement of operations in 1996, we were principally
engaged in the management of physician practices engaged in musculoskeletal
care, which is the treatment of conditions relating to bones, joints, muscles
and connective tissues. Through March 31, 1998, we entered into comprehensive
affiliation arrangements with 21 practices including 164 physicians. Due to
difficulties in the physician practice management industry in general, and with
respect to our affiliated physician practices in particular, we terminated or
restructured our arrangements with various physician practices. As a result, the
scope of our physician practice management business became increasingly limited
in subsequent years, particularly after a restructuring of our arrangements with
nine practices in June 1999, and ceased entirely in September 2002.
During 1998, we began to focus on the provision of healthcare information
through the establishment of our healthcare provider quality ratings and profile
information, which we first introduced on our website. Since that time, we have
expanded the scope of our healthcare information services to encompass the
additional services described above.
In January 2000, we changed our name to Healthgrades.com, Inc. In November
2000, we changed our name to Health Grades, Inc.
COMPETITION
With respect to our quality services for hospitals, we face competition
from data providers, such as Solucient and healthcare consulting companies such
as GE Medical Systems and Premier that offer certain consulting services to
hospitals. We believe that the ability to demonstrate the value of marketing and
consulting programs, name brand recognition and cost are the principal factors
that affect competition.
We face competition with respect to our service offerings to employers,
health plans, consumers and others from companies that provide online
information and decision support tools regarding healthcare providers and
physicians. There are several companies that currently offer online healthcare
information and support tools such as Subimo, SelectQualityCare and Doctor
Quality. We believe that the ability to provide accurate and comprehensive
healthcare information in a manner that is cost-effective to the client is the
principal factor that affects competition in this area.
We face competition on our nursing home quality reports with companies such
as CareScout, which provide ratings of nursing homes and charge professionals
and consumers for this information.
GOVERNMENT REGULATION
The delivery of healthcare services has become one of the most highly
regulated of professional and business endeavors in the United States. Both the
federal government and the individual state governments are responsible for
overseeing the activities of
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individuals and businesses engaged in the delivery of healthcare services. The
focus of Federal regulation of healthcare businesses and professionals is based
primarily upon their participation in the Medicare and Medicaid programs. Each
of these programs is financed, at least in part, with Federal funds. State
jurisdiction is based upon its financing of healthcare as well the states'
authority to regulate and protect the health and welfare of its citizens.
A provision of the federal Social Security Act, commonly known as the
Medicare/Medicaid Anti-kickback Law, prohibits kickbacks, rebates and bribes in
return for referrals. This law provides an extremely broad base for finding
violations. Indeed, any remuneration, direct or indirect, offered, paid,
solicited, or received, in return for referrals of patients or business for
which payment may be made in whole or in part under Medicare, or a state
healthcare program (Medicaid) could be considered a violation of law. The
language of the Anti-Kickback Law also prohibits payments made to anyone to
induce them to "recommend purchasing, leasing, or ordering any good, facility,
service, or item for which payment may be made in whole or in part" by Medicare.
Similar laws exist in most states.
To provide more direct guidance on the interpretation of the anti-fraud and
abuse provisions, the Office of the Inspector General, or OIG, of the Centers
for Medicare and Medicaid Services ("CMS", formerly HCFA) has developed
regulations regarding what types of business arrangements are not to be
considered violative of the law and to develop criteria to be applied to any new
arrangement to determine whether it is acceptable under the law. The regulations
feature certain "Safe Harbors" addressing activities that may be technically
violative of the act, but are not to be considered as illegal when carried on in
conformance with the proposed regulation. The OIG has also set forth specific
procedures by which the Department of Health and Human Services, through the
OIG, in consultation with the Department of Justice (DOJ), will issue advisory
opinions to outside parties regarding the interpretation and applicability of
anti-kickback and certain other statutes relating to Federal and State
healthcare programs.
Whenever an arrangement exists with an entity capable of providing services
reimbursed by Medicare or Medicaid, the arrangement must be analyzed to
determine if the Anti-kickback Law is implicated (i.e., can the arrangement be
characterized as involving remuneration intended to induce referrals or the
provision of covered services). Because our customers will, in some instances,
be healthcare providers, we must be mindful of the anti-kickback laws; that is,
we want to be sure that any payments to us will not be considered a payment for
a referral of patients or business that HealthGrades controls.
The only payments made to us by providers and practitioners will be for
access to information, evaluation and consulting services, not to induce
referrals. Federal courts have interpreted the anti-kickback provisions very
broadly to prohibit even those payments made in return for legitimate services,
if the intent to induce referrals can be inferred from the arrangement. However,
where the payments made under an agreement represent fair market value or
reasonable remuneration for the goods, services or other consideration being
received, there should be no factual support for any inference that payments are
in exchange for referrals. Moreover, HealthGrades does not control patients,
doctors, or others in a position to refer patients or other business covered
under Medicare or Medicaid.
There is a potential that our arrangements could be brought within the
personal services and management agreement safe harbor that is provided by
federal statute. The personal services and management agreement safe harbor
provides that payments under such agreements will not constitute remuneration
under the anti-kickback statute if the payments meet six criteria including that
the payments are set forth is writing and fixed in advance, are consistent with
fair market value and do not take into account the volume or value of any
referrals or business generated between the parties. Outside of a statutory
exception or a safe harbor, the government could attempt to draw an inference
that at least one purpose of the remuneration is to induce referrals.
Nevertheless, we believe that our operations comply with applicable legal
regulatory requirements of the anti-kickback laws. However, some of these laws
have been applied to payments by physicians for marketing and referral services
and could constrain our relationships, including financial and marketing
relationships with customers such as hospitals. It is possible that additional
or changed laws, regulations or guidelines could be adopted in the future that
could affect our business.
In addition to the Anti-Kickback laws, false claims are prohibited pursuant
to federal criminal and civil statutes. Criminal provisions prohibit the knowing
filing of false claims, making false statements or causing false statements to
be made by others. Civil provisions prohibit the filing of claims that the
person filing knew or should have known were false. Criminal penalties include
fines and imprisonment. Civil penalties include fines up to $10,000 per claim,
plus treble damages, for each claim filed.
Although we are not filing claims ourselves, liability under the statutes
can extend to those who "cause claims to be presented." To the extent that
consulting advice provided to our customers could be construed as aiding or
abetting the presentation of false claims by our customers, there could be false
claims liability, although we endeavor to provide advice that cannot be so
construed.
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Many states have laws that prohibit payment of kickbacks or other payment
of remuneration to those in a position to control the referral of patients.
Therefore, it is possible that our activities may be found not to comply with
these laws. Noncompliance with such laws could subject us to penalties and
sanctions. Nonetheless, to our knowledge, we are not in violation of any legal
requirements under such state laws.
Healthcare Reform. In recent years, a variety of legislative proposals designed
to change access to and payment for healthcare services in the United States
have been introduced. Although no major health reform proposals have been passed
by Congress to date, such legislation has been and may be considered by Congress
and state legislatures. We can make no prediction as to whether healthcare
reform legislation or similar legislation will be enacted or, if enacted, the
effect that such legislation will have on us.
Privacy of Information and HIPAA
Consumers sometimes enter private information about themselves or their
family members when using our services. Also, our systems record use patterns
when consumers access our databases that may reveal health related information
or other private information about the user. In addition, information regarding
employee usage of healthcare providers and facilities can also be complied by
our systems in connection with services we offer to employers and other health
plans. Numerous federal and state laws and regulations govern collection,
dissemination, use and confidentiality of patient-identifiable health
information, including:
- state privacy and confidentiality laws;
- state laws regulating healthcare professionals, such as physicians,
pharmacists and nurse practitioners;
- Medicaid laws;
- the U.S. Health Insurance Portability and Accountability Act of 1996,
or HIPAA, as described in detail below, and related rules proposed by
the Health Care Financing Administration; and
- CMS standards for Internet transmission of health data.
Under HIPAA, Congress set national standards for the protection of health
information. Under the law, and regulations known collectively as the Privacy
Rule, covered entities must implement standards to protect and guard against the
misuse of individually identifiable health information by the compliance
deadline date of April 14, 2003. Failure to timely implement these standards
may, under certain circumstances, trigger the imposition of civil or criminal
penalties.
The Rule does not replace federal, state, or other law that grants
individuals even greater privacy protections, and covered entities are free to
retain or adopt more protective policies or practices.
By law, the Privacy Rule applies only to covered entities -- health plans,
healthcare clearinghouses, and certain healthcare providers. However, most
healthcare providers and health plans do not carry out all of their healthcare
activities and functions by themselves. Instead, they often use the services of
a variety of other persons or businesses. The Privacy Rule allows covered
providers and health plans to disclose protected health information to these
"business associates" if the covered entities obtain satisfactory assurances
that the business associate will use the information only for the purposes for
which it was engaged by the covered entity, will safeguard the information from
misuse, and will help the covered entity comply with some of the covered
entity's duties under the Privacy Rule. HealthGrades is not a covered entity,
however, it may be asked to enter into business associate agreements with
covered entities, which may restrict its ability to receive or utilize
information from covered entities.
Covered entities may disclose protected health information to an entity in
its role as a business associate only to help the covered entity carry out its
healthcare functions -- not for the business associate's independent use or
purposes, except as needed for the proper management and administration of the
business associate.
If a covered entity finds out about a material breach or violation of the
privacy related provisions of the contract by the business associate, it must
take reasonable steps to cure the breach or end the violation, and, if
unsuccessful, terminate the contract with the business associate. If termination
is not feasible (e.g., where there are no other viable business alternatives for
the covered entity), the covered entity must report the problem to the
Department of Health and Human Services Office for Civil Rights.
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GOVERNMENT REGULATION OF THE INTERNET
Any new or revised law or regulation pertaining to the Internet, or the
application or interpretation of existing laws and regulations, could decrease
demand for our services, increase our cost of doing business, decrease the
availability of the data we obtain and use from third parties, increase the
costs of online marketing, or otherwise cause our business to suffer.
Laws and regulations have been adopted in the United States and throughout
the world, and additional laws and regulations may be adopted in the future,
that address Internet-related issues, including online content, privacy, online
marketing, pricing and quality of products and services. This legislation could
increase our cost of doing business and negatively affect our business.
Moreover, it likely will take many years to determine the extent to which older
laws and regulations governing issues like property ownership, libel, negligence
taxes, and personal privacy are applicable to the Internet.
Currently, U.S. privacy law consists of numerous disparate state and
federal statutes regulating specific industries that collect personal data, or
particular types or uses of personal data. For example, large portions of the
statutory provisions and regulations under HIPAA, which protects the disclosure,
use, and transfer of personal health information in digital form by providers
and others, are currently taking effect in stages during 2003 and 2004. Several
other privacy laws and regulations predate and therefore do not specifically
address online activities. In addition, a number of comprehensive legislative
and regulatory privacy proposals have taken effect or are now under
consideration by federal, state and local governments in the United States. All
such privacy laws may decrease access to the raw data that we use, and may
increase our costs of compliance with such laws and regulations in the conduct
of our business.
INTELLECTUAL PROPERTY
We regard the protection of our intellectual property rights to be
important. We rely on a combination of copyright, trademark and trade secret
restrictions and contractual provisions to protect our intellectual property
rights. We require selected employees to enter into confidentiality and
invention assignment agreements as well as non-competition agreements. The
contractual provisions and other steps we have taken to protect our intellectual
property may not prevent misappropriation of our technology or deter third
parties from developing similar or competing technologies.
We own federal trademark registrations for the marks HEALTHGRADES and THE
HEALTHCARE QUALITY EXPERTS.
There is also significant uncertainty regarding the applicability to the
Internet of existing laws regarding matters such as property ownership and other
intellectual property rights. The vast majority of these laws were adopted prior
to the advent of the Internet and, as a result, do not contemplate or address
the unique issues of the Internet and related technologies. In addition, new
laws that regulate activities on the Internet have been passed and may be
passed, which may have unanticipated effects.
For further information, see "Risk Factors - Our propriety rights may not
be fully protected, and we may be subject to intellectual property infringement
claims by others."
EMPLOYEES
As of March 22, 2003, we had 48 employees, most of whom were located at our
corporate offices.
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RISK FACTORS
Risks Related to Our Business
OUR HEALTHCARE INFORMATION BUSINESS HAS NOT BEEN PROFITABLE AND MAY NEVER BECOME
PROFITABLE.
We began developing our healthcare information business in 1998. For the
year ended December 31, 2002, substantially all of our operations related to
this business. Our loss before income taxes and cumulative effect of a change in
accounting principle for the year ended December 31, 2002, was approximately
$1.6 million. Despite our efforts in 2001 and 2002 to reduce expenditures, we
may continue to incur operating losses as we fund operating and capital
expenditures to expand our healthcare information database and website, market
our healthcare information, upgrade our technology and continue efforts to
increase recognition of our brand name. Our business model assumes that
consumers will be attracted to and use the healthcare ratings and profile
information and related content available on our website, which will, in turn,
enable us to license access to the information on our website to hospitals and
other providers. In addition, our business model assumes that employers, health
plans, insurance plans, consumers and other potential customers will seek our
healthcare information to help increase the quality and reduce the cost of
healthcare. Our business model is not yet proven, and we cannot assure you that
we will ever achieve or sustain profitability or that our operating losses will
not increase in the future.
WE MAY NEED ADDITIONAL CAPITAL TO CONTINUE OUR BUSINESS IF WE DO NOT GENERATE
SUFFICIENT REVENUES OVER THE NEXT TWELVE MONTHS.
We believe that we have sufficient resources to meet our requirements for at
least the next 12 months. However, if our revenues fall short of our
expectations or our expenses exceed our expectations, we may need to raise
additional capital through public or private debt or equity financing. We may
not be able to secure sufficient funds on terms acceptable to us. If equity
securities are issued to raise funds, our stockholders' equity may be diluted.
If additional funds are raised through debt financing, we may be subject to
significant restrictions.
OUR BUSINESS WILL SUFFER IF WE ARE NOT ABLE TO OBTAIN RELIABLE DATA AS A BASIS
FOR OUR HEALTHCARE INFORMATION.
To provide our healthcare information, we must be able to receive
comprehensive, reliable data. We currently obtain this data from a number of
public and private sources. Our business could suffer if some of these sources
were to begin charging for use or access to this data, or cease to make such
information available, and suitable alternative sources are not identified on a
timely basis. Moreover, our ability to attract and retain customers is dependent
on the reliability of the information that we use and purchase. If our
information is inaccurate or otherwise erroneous, our reputation and customer
following could be damaged. In the past, we have had disputes with two providers
of information who sought to terminate our arrangements based on allegations,
which we denied, that our use of the information violated the terms of our
agreements with the providers. We have located alternate sources of information
or modified the scope of information provided in response to these disputes.
Nevertheless, our failure to obtain suitable information, if needed to use in
place of information provided by a source that determines to stop providing
information, or which charges substantially more for such data, could hurt our
business.
OUR PLAN FOR REVENUE GENERATION MAY NOT BE VIABLE.
Our business plan contemplates that we will generate revenues from our
healthcare information business principally by:
- - licensing our data, healthgrades.com name and marks to highly-rated
hospitals and other healthcare providers for use in connection with their
marketing programs;
- - advising lower rated hospitals on improving their quality of care;
- - providing employers, health plans and others with information for use by
employees or members in selecting providers and facilities available to
employees or members;
- - providing insurance underwriters, consumers and others with provider
quality reports;
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However, we do not yet know whether we will be able to generate sufficient
revenues from these activities to be profitable. Specifically, we have not yet
generated substantial revenues from employers or health plans, or our quality
reports. In addition, we do not know whether employers or health plans will view
our rating and profile information as useful in connection with their operations
or whether our quality reports will be accepted by their target markets. In
addition, while we have entered into licensing agreements with a number of
hospitals, the use of Internet information in conjunction with hospital and
other provider marketing campaigns is a new, unproven concept. We may not be
able to expand or retain acceptance by hospitals and other providers.
WE MAY BE SUED FOR INFORMATION WE OBTAIN OR INFORMATION RETRIEVED FROM OUR
WEBSITES OR OTHERWISE PROVIDED TO EMPLOYERS AND OTHERS.
We may be subjected to claims for defamation, negligence, copyright or
trademark or patent infringement, personal injury or other legal theories
relating to the information we publish on our websites or otherwise provide to
customers. These types of claims have been brought, sometimes successfully,
against online services as well as print publications in the past. We have
received threats from some providers that they will assert defamation and other
claims in connection with the information posted on our healthgrades.com
website. One provider has brought a claim in Washington state alleging that our
use of our rating system constitutes a business practice that violates state
consumer protection and defamation laws and may also be a basis for product
disparagement, negligent misrepresentation and other claims. That case was
dismissed for lack of personal jurisdiction, but the dismissal was reversed on
appeal. We have filed a petition seeking review of the jurisdictional issue
before the United States Supreme Court.
Patients who file lawsuits against providers often name as defendants all
persons or companies with any nexus to the providers. As a result, patients may
file lawsuits against us based on treatment provided by hospitals or other
facilities that are highly rated by us, or doctors who are identified on our
website or through other information that we provide. In addition, a court or
government agency may take the position that our delivery of health information
directly, or information delivered by a third-party website that a consumer
accesses through our website, exposes us to malpractice or other personal injury
liability for wrongful delivery of healthcare services or erroneous health
information. The amount of insurance we maintain with insurance carriers may not
be sufficient to cover all of the losses we might incur from these claims and
legal actions. In addition, insurance for some risks is difficult, impossible or
too costly to obtain, and as a result, we may not be able to purchase insurance
for some types of risks.
We could be adversely affected if the provider were to prevail in this
litigation.
IF WE DO NOT STRENGTHEN RECOGNITION OF OUR BRAND NAME, OUR ABILITY TO EXPAND OUR
BUSINESS WILL BE IMPAIRED.
To expand our audience of online users and increase our online traffic and
increase interest in our other healthcare information services, we must
strengthen recognition of our brand name. To be successful in this effort,
consumers must perceive us as a trusted source of healthcare information;
hospitals and other providers must perceive us as an effective marketing and
sales channel for their services and products; and employees, health plans,
insurers, consumers and others must perceive us as a source of valuable
information that can be used to enhance the quality and cost-effectiveness of
healthcare. We may be required to increase substantially our marketing budget in
our efforts to strengthen brand name recognition. Our business will suffer if
our efforts are not productive.
OUR BUSINESS WILL SUFFER IF WE ARE UNABLE TO ATTRACT, RETAIN AND MOTIVATE HIGHLY
SKILLED EMPLOYEES.
During 2001, we reduced the size of our employee base in order to lower
expenses. Nevertheless, our ability to execute our business plan and be
successful depends upon our ability to attract, retain and motivate highly
skilled employees when needed. We rely on the continued services of our senior
management and other personnel. If we are able to expand our business, we will
need to hire additional personnel to support our operations. We may be unable to
retain our key employees or attract or retain other highly qualified employees
in the future. If we do not succeed in attracting new personnel as needed and
retaining and motivating our current personnel, our business will suffer.
WE MAY EXPERIENCE SYSTEM FAILURES THAT COULD INTERRUPT OUR SERVICES.
The success of our healthgrades.com website and activities related to the
website will depend on the capacity, reliability and security of our network
infrastructure. We rely on telephone communication providers to provide the
external telecommunications infrastructure necessary for Internet
communications. We will also depend on providers of online content and services
for some of the content and applications that we make available through
healthgrades.com. Any significant interruptions in our services or an increase
in response time could result in the loss of potential or existing users or
customers. Although we maintain insurance for our business,
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we cannot guarantee that our insurance will be adequate to compensate us for
losses that may occur or to provide for costs associated with business
interruptions.
We must be able to operate our website 24 hours a day, 7 days a week,
without material interruption. To operate without interruption, we and our
content providers must guard against:
- - damage from fire, power loss and other natural disasters;
- - communications failures;
- - software and hardware errors, failures or crashes;
- - security breaches, computer viruses and similar disruptive problems; and
- - other potential interruptions.
Our website may be required to accommodate a high volume of traffic and
deliver frequently updated information. Our website users may experience slower
response times or system failures due to increased traffic on our website or for
a variety of other reasons. We could experience disruptions or interruptions in
service due to the failure or delay in the transmission or receipt of this
information. Any significant interruption of our operations could damage our
business.
OUR PROPRIETARY RIGHTS MAY NOT BE FULLY PROTECTED, AND WE MAY BE SUBJECT TO
INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS BY OTHERS.
Our failure to adequately protect our intellectual property rights could
harm our business by making it easier for our competitors to duplicate our
services. We have three trademarks that have been registered with the U.S.
Patent and Trademark Office. In addition, we require some of our employees to
enter into confidentiality and invention assignment agreements and, in more
limited cases, non-competition agreements. Nevertheless, our efforts to
establish and protect our proprietary rights may be inadequate to prevent
imitation of our services or branding by others or may be subject to challenge
by others. Furthermore, our ability to protect some of our proprietary rights is
uncertain since legal standards relating to the validity, enforceability and
scope of intellectual property rights in Internet related industries are
uncertain and are still evolving.
In addition to the risk of failing to adequately protect our proprietary
rights, there is a risk that we may become subject to a claim that we infringe
upon the proprietary rights of others. Although we do not believe that we are
infringing upon the rights of others, third parties may claim that we are doing
so. The possibility of inadvertently infringing upon the proprietary rights of
another is increased for businesses such as ours because there is significant
uncertainty regarding the applicability to the Internet of existing laws
regarding matters such as, copyrights and other intellectual property rights. A
claim of intellectual property infringement may cause us to incur significant
expenses in defending against the claim. If we are not successful in defending
against an infringement claim, we could be liable for substantial damages or may
be prevented from offering some aspects of our services. We may be required to
make royalty payments, which could be substantial, to a party claiming that we
have infringed their rights. These events could damage our business.
WE MAY LOSE BUSINESS IF WE ARE UNABLE TO KEEP UP WITH RAPID TECHNOLOGICAL OR
OTHER CHANGES.
If we are unable to keep up with changing technology and other factors
related to our market, we may be unable to attract and retain users or
customers, which would reduce or limit our revenues. The markets in which we
compete are characterized by rapidly changing technology, evolving technological
standards in the industry, frequent new service and product announcements and
changing consumer demand. Our future success will depend on our ability to adapt
to these changes, and to continuously improve the content, features and
reliability of our services in response to competitive service and product
offerings and the evolving demands of the marketplace. In addition, the
widespread adoption of new Internet networking or telecommunications
technologies or other technological changes could require us to incur
substantial expenditures to modify or adapt our website or infrastructure, which
might negatively affect our ability to become or remain profitable.
OUR BUSINESS WILL SUFFER IF WE ARE NOT ABLE TO COMPETE SUCCESSFULLY.
The market for healthcare information is new, rapidly evolving and
competitive. We expect competition to increase significantly,
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and our business will be adversely affected if we are unable to compete
successfully. We currently compete, or potentially compete, with many providers
of healthcare information services and products, both online and through
traditional means. We compete, directly and indirectly, for users and customers
principally with:
- - data providers that provide detailed utilization and outcomes information to
hospitals;
- - healthcare consulting companies;
- - companies or organizations providing or maintaining online healthcare
information;
- - vendors of healthcare information, products and services distributed through
other means, including direct sales, mail and fax messaging;
- - companies and organizations providing or maintaining general purpose
consumer online services that provide access to healthcare content and
services;
- - companies and organizations providing or maintaining public sector and
non-profit websites that provide healthcare information and services without
advertising or commercial sponsorships;
- - companies and organizations providing or maintaining web search and
retrieval services and other high-traffic websites; and
- - publishers and distributors of traditional media, some of which have
established or may establish websites.
Some of these competitors are larger, have greater resources and have more
experience in providing healthcare information than us.
RISKS RELATED TO HEALTHCARE INFORMATION AND THE INTERNET
HEALTHCARE REFORMS AND THE COST OF REGULATORY COMPLIANCE COULD NEGATIVELY AFFECT
OUR BUSINESS.
The healthcare industry is heavily regulated. In the ordinary course of
business, healthcare entities and companies that do business with them are
subject to state and federal regulatory scrutiny, supervision, oversight and
control. These various laws, regulations and guidelines affect, among other
matters, the provision, licensing, labeling, marketing, promotion and
reimbursement of healthcare services and products. Our failure or the failure of
our customers to comply with any applicable legal or regulatory requirements, or
any investigation or audit of our or our customers' practices could:
- - result in limitation or prohibition of business activities;
- - subject us or our customers to legal fees and expenses and adverse
publicity; or
- - increase the costs of regulatory compliance and, if found by a court of
competent jurisdiction to have engaged in improper practices, subject us or
our customers to criminal or civil monetary fines or other penalties.
A federal law commonly known as the Medicare/Medicaid Anti-kickback Law,
prohibits kickbacks, rebates and bribes in return for referrals. This law
provides an extremely broad base for finding violations. Indeed, any
remuneration, direct or indirect, offered, paid, solicited or received in return
for referrals of patients or business for which payment may be made in whole or
in part under Medicare or Medicaid could be considered a violation of law. The
statute also prohibits payments made to anyone to induce them to "recommend
purchasing, leasing or ordering any good, facility, service or item for which
payment may be made in whole or in part" by Medicare. Similar laws exist in some
states.
We believe that our operations comply with applicable legal regulatory
requirements of the anti-kickback laws. Nevertheless, some of these laws have
been applied to payments by physicians for marketing and referral services and
could constrain our relationships, including financial and marketing
relationships with customers such as hospitals. It is possible that additional
or changed laws, regulations or guidelines could be adopted in the future.
18
Criminal provisions prohibit the knowing filing of false claims or making
false statements or causing false statements to be made by others, and civil
provisions prohibit the filing of claims that one knows or should have known
were false. Criminal penalties include fines and imprisonment. Civil penalties
include fines of up to $10,000 per claim plus treble damages, for each filed
claim. Although we are not filing claims ourself, liability under the statutes
can extend to those who "cause claims to be presented." To the extent that
consulting advice provided to our customers could be construed as aiding or
abetting the presentation of false claims by its customers, there could be false
claims liability.
THE INTERNET IS SUBJECT TO MANY LEGAL UNCERTAINTIES AND POTENTIAL GOVERNMENT
REGULATIONS THAT MAY DECREASE USAGE OF OUR WEBSITE, INCREASE OUR COST OF DOING
BUSINESS OR OTHERWISE HAVE A DAMAGING EFFECT ON OUR BUSINESS.
Any new law or regulation pertaining to the Internet, or the application or
interpretation of existing laws, could decrease usage for our website, increase
our cost of doing business or otherwise cause our business to suffer.
Laws and regulations may be adopted in the future that address
Internet-related issues, including online content, user privacy, pricing and
quality of products and services. This legislation could increase our cost of
doing business and negatively affect our business. Moreover, it may take years
to determine the extent to which existing laws governing issues like property
ownership, libel, negligence and personal privacy are applicable to the
Internet. Currently, U.S. privacy law consists of disparate state and federal
statutes regulating specific industries that collect personal data. Most of them
predate and therefore do not specifically address online activities. In
addition, a number of comprehensive legislative and regulatory privacy proposals
are now under consideration by federal, state and local governments in the
United States.
OUR BUSINESS COULD BE IMPAIRED BY STATE AND FEDERAL LAWS DESIGNED TO PROTECT
INDIVIDUAL HEALTH INFORMATION.
If we fail to comply with current or future laws or regulations governing
the collection, dissemination, use and confidentiality of patient health
information, our business could suffer.
Consumers sometimes enter private information about themselves or their
family members when using our services. Also, our systems record use patterns
when consumers access our databases that may reveal health-related information
or other private information about the user. In addition, information regarding
employee usage of healthcare providers and facilities can also be compiled by
our systems in connection with services we offer to employers and other health
plans. Numerous federal and state laws and regulations govern collection,
dissemination, use and confidentiality of patient-identifiable health
information, including:
- - state privacy and confidentiality laws;
- - state laws regulating healthcare professionals, such as physicians,
pharmacists and nurse practitioners;
- - Medicaid laws;
- - the Health Insurance Portability and Accountability Act of 1996 and related
rules proposed by the Health Care Financing Administration; and
- - CMS standards for Internet transmission of health data.
Congress has been considering proposed legislation that would establish a
new federal standard for protection and use of health information. While we are
not gathering patient health information at this time, other third-party
websites that consumers access through our website and employees, health plans
and other customers may not maintain systems to safeguard any health information
they may be collecting. In some cases, we may place our content on computers
that are under the physical control of others, which may increase the risk of an
inappropriate disclosure of information. For example, we contract out the
hosting of our website to a third party. In addition, future laws or changes in
current laws may necessitate costly adaptations to our systems.
19
ONLINE SECURITY BREACHES COULD HARM OUR BUSINESS.
Our security measures may not prevent security breaches. Substantial or
ongoing security breaches on our system or other Internet-based systems could
reduce user confidence in our website, causing reduced usage that adversely
affects our business. The secure transmission of confidential information over
the Internet is essential to maintain confidence in our websites. We believe
that consumers generally are concerned with security and privacy on the
Internet, and any publicized security problems could inhibit the growth of the
Internet and, therefore, our provision of healthcare information on the
Internet.
We will need to incur significant expense to protect and remedy against
security breaches when we identify a significant business risk. Currently, we do
not store sensitive information, such as patient information or credit card
information, on our websites. If we launch services that require us to gather
sensitive information, our security expenditures will increase significantly.
A party that is able to circumvent our security systems could steal
proprietary information or cause interruptions in our operations. Security
breaches could also damage our reputation and expose us to a risk of loss or
litigation and possible liability. Our insurance policies may not be adequate to
reimburse us for losses caused by security breaches. We also face risks
associated with security breaches affecting third parties conducting business
over the Internet or customers and others who license our data.
OTHER RISKS
OUR OFFICERS AND DIRECTORS MAINTAIN SIGNIFICANT CONTROL OF HEALTH GRADES, INC.
Our current officers and directors and entities with which they are
affiliated beneficially own approximately 31.6% of our outstanding common stock.
In addition, Essex Woodlands Health Ventures Fund IV, L.P. holds approximately
38.5% of our outstanding common stock. If our officers, directors and Essex
Woodlands act together, they will be able to control the management and affairs
of Health Grades, Inc. and will have the ability to control all matters
requiring stockholder approval, including the election of directors and approval
of significant corporate transactions. This concentration of ownership may have
the effect of delaying, deferring or preventing an acquisition of us and may
adversely affect the market price for our common stock.
OUR CERTIFICATE OF INCORPORATION AND BYLAWS INCLUDE ANTI-TAKEOVER PROVISIONS
THAT MAY DETER OR PREVENT A TAKEOVER ATTEMPT.
Some provisions of our certificate of incorporation and bylaws and
provisions of Delaware law may deter or prevent a takeover attempt, including an
attempt that might result in a premium over the market price for our common
stock. Our certificate of incorporation requires the vote of 66 2/3% of the
outstanding voting securities in order to effect certain actions, including a
sale of substantially all of our assets, certain mergers and consolidations and
our dissolution or liquidation, unless these actions have been approved by a
majority of the directors. Our certificate of incorporation also authorizes our
Board of Directors to issue up to 2,000,000 shares of preferred stock having
such rights as may be designated by our Board of Directors, without stockholder
approval. Our bylaws provide that stockholders must follow an advance
notification procedure for certain nominations of candidates for the Board of
Directors and for certain other stockholder business to be conducted at a
stockholders meeting. The General Corporation Law of Delaware restricts certain
business combinations with interested stockholders upon their acquisition of 15%
or more of our common stock.
All of these provisions could make it more difficult for a third party to
acquire, or could discourage a third party from attempting to acquire, control
of us.
WE HAVE NO INTENTION TO PAY DIVIDENDS ON OUR COMMON STOCK.
We have never declared or paid any cash dividends on our common stock. We
currently intend to retain all future earnings to finance the expansion of our
business.
Item 2. Properties
We have a lease for our approximately 12,200-sq. foot headquarters facility
in Lakewood, Colorado, which expires on February 15, 2005. Our annual lease
payments for this facility are approximately $215,000.
20
Item 3. Legal Proceedings
On or about October 10, 2002, Strategic Performance Fund -- II ("SPF-II")
commenced an action in the Circuit Court of the 17th Judicial Circuit in and for
Broward County, Florida against us, alleging breach of two leases. These leases
relate to two buildings in which one of our former affiliated practices,
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
leased office space. Park Place ceased the payment of its rental obligations
with respect to the two leases in May 2000, and subsequently filed a petition
for bankruptcy, under Chapter 11 of the Bankruptcy Code, in the United States
Bankruptcy Court, Southern District of Florida, Ft. Lauderdale Division. SPF-II
is seeking damages against HealthGrades in the amount of approximately $4.7
million.
The basis of the allegation against HealthGrades is that while under the
corporate name of Specialty Care Network, Inc., we entered into an Assignment,
Assumption and Release Agreement dated July 8, 1997, under which we assumed the
obligations of Orthopaedic Management Services, Inc., as lessee, under its Lease
Agreement with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The
agreement was executed in connection with our acquisition of most of the
non-medical assets of the Park Place practice. On October 1, 1997, the owner of
the leased property sold its interests in the leasehold estates to SPF-II, Inc.
On June 10, 1999, we sold the assets of the Park Place practice, including the
leasehold interests, back to Park Place and entered into an Absolute Assignment
and Assumption Agreement with Park Place, under which Park Place agreed to
indemnify us in connection with the leasehold obligations. In addition, we
entered into an Indemnification Agreement with Park Place and its individual
physician owners, under which the individual physician owners (severally up to
their ownership interest in the practice) agreed to indemnify us in connection
with the leasehold obligations. SPF-II alleges that, notwithstanding the
assignment of our leasehold interests to Park Place, HealthGrades remains liable
for all lessee obligations under the leases.
We have filed a response to the initial complaint instituted by SPF-II,
denying all liability with respect to the subject leases. In addition, we have
filed a third-party complaint against the individual physician owners seeking
indemnification from each of these individuals under the terms of the
Indemnification Agreement. The physician owners have filed a response to our
complaint denying their liability under the Indemnification Agreement, and
asserting several affirmative defenses, including, among others, our failure to
mitigate damages, lack of consideration, our assertion of a premature claim as
liability and damages have not been established by SPF-II, rejection of the
leases by the bankruptcy court, and, in the case of one physician owner, a claim
that an "agent" of ours (who was, in fact, an employee of Park Place both before
and after our affiliation with the practice) fraudulently induced the purchase
of the Park Place practice's assets from us. The physician owners have also
filed a motion to enjoin further prosecution of the action instituted against
them by HealthGrades and Bank of America, the lender in connection with their
repurchase of the assets of the Park Place practice, pending resolution of the
bankruptcy proceeding.
The parties are currently engaged in a mediation process in an attempt to
resolve this matter. If the mediation is not successful, we intend to contest
our obligations under the Assignment, Assumption and Release Agreement, fully
explore SPF-II's obligations to mitigate damages and vigorously pursue our
rights against Park Place and the individual physician owners.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Executive Officers of the Registrant
The following table sets forth certain information concerning the executive
officers of the Company:
NAME AGE POSITION
Kerry R. Hicks.......................... 43 President, Chief Executive Officer
David G. Hicks.......................... 45 Executive Vice President-Information Technology
G. Allen Dodge.......................... 35 Senior Vice President-Finance, CFO & Treasurer
Peter A. Fatianow....................... 39 Senior Vice President-Corporate Services
Sarah Loughran.......................... 38 Senior Vice President-Provider Services
Michael D. Phillips..................... 45 Senior Vice President-Provider Sales
John R. Morrow.......................... 43 Senior Vice President-Strategic Development
KERRY R. HICKS, one of our founders, has served as our Chief Executive Officer
since our inception in 1995. He also served as our President from our inception
until November 1999 and since March 2002.
21
DAVID G. HICKS has served as our Executive Vice President -- Information
Technology since November 1999. He was Senior Vice President of Information
Technology from May 1999 to November 1999 and Vice President of Management
Information Systems from March 1996 until May 1999.
G. ALLEN DODGE, has served as Senior Vice President -- Finance and Chief
Financial Officer since May 2001. He was Vice President -- Finance/Controller
from March 2000 to May 2001 and Corporate Controller from September 1997 to
March 2000. Mr. Dodge is a Certified Public Accountant.
PETER A. FATIANOW has served as our Senior Vice President -- Business
Development since March 2000. He has served in several capacities for our
subsidiary, HG.com and its successor Healthcare Ratings, Inc. since July 1998,
most recently as Senior Vice President -- Operations. He was previously our Vice
President of Business Development from our inception until July 1998. From July
1998 until February 1999, he was a partner of Consolidation Capital Partners
LLC, which provided consulting services to us in connection with our
restructuring transaction with our former affiliated practices.
SARAH LOUGHRAN has served as our Senior Vice President -- Provider Services
since December 2001 and as Senior Vice President -- Content of our subsidiary,
HG.com and its successor, Healthcare Ratings, Inc. since 1998. She was our
Senior Vice President -- Content from March 2000 to December 2001.
MICHAEL D. PHILLIPS has served as Senior Vice President -- Provider Sales since
December 2001. He was previously Vice President of Provider Sales since April
2000. Prior to joining HealthGrades, Mr. Phillips was Vice President of Sales at
HCIA-Sachs and LBA Healthcare Management as well as National Sales Manager for
HPI Health Care Services.
JOHN R. MORROW has served as Senior Vice President -- Strategic Development
since February 2003. From June 2000 to January 2003, he was a self-employed
consultant. From November 1999 to May 2000, Mr. Morrow served as Senior Vice
President and Publisher for HCIASachs LLC (later named Solucient LLC). From
August 1998 to November 1999 Mr. Morrow served as Senior Vice President and
Publisher for HCIA, Inc. During his term with HCIA and Solucient, Mr. Morrow was
responsible for the Syndicated Products business units and 100 Top Hospitals
Programs and Corporate Channel Relationships.
Kerry R. Hicks and David G. Hicks are brothers.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The following table sets forth the high and low sales prices for our Common
Stock for the quarters indicated as reported on the Nasdaq Small Cap Market
through the first quarter of 2001. Subsequent to the first quarter of 2001, the
high and low sales prices for our Common Stock for the quarters indicated are as
reported by the OTC Bulletin Board (OTCBB).
HIGH LOW
Year Ended December 31, 2001
First Quarter.................................... $ .81 $ .22
Second Quarter .................................. .31 .10
Third Quarter.................................... .22 .08
Fourth Quarter................................... .10 .04
Year Ended December 31, 2002
First Quarter.................................... $ .17 $ .05
Second Quarter .................................. .10 .04
Third Quarter.................................... .09 .05
Fourth Quarter................................... .10 .02
We have never paid or declared any cash dividends and do not anticipate paying
any cash dividends in the foreseeable future. We currently intend to retain any
future earnings for use in our business.
22
Item 6. Selected Financial Data
Statement of Operations Data
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
2002 2001 2000 1999 1998
------------ ------------ ------------ ------------ ------------
Ratings and advisory revenue 5,091,891 3,088,451 1,578,979 407,577 --
Physician practice service fees 195,492 551,925 4,249,658 28,948,397 76,649,778
Loss from operations (1,770,555) (7,620,773) (7,355,737) (2,599,167) (91,938,916)
(Loss) income before cumulative effect of a
change in accounting principle (562,482) (7,367,243) (7,544,746) 964,930 (61,786,086)
Net (loss) income $ (1,650,793) $ (7,367,243) $ (7,544,746) $ 964,930 $(61,786,086)
============ ============ ============ ============ ============
Net (loss) income per common share (basic) $ (0.05) $ (0.30) $ (0.39) $ 0.07 $ (3.39)
============ ============ ============ ============ ============
Weighted average number of common shares
used in computation (basic) 36,189,748 24,399,699 19,535,841 14,202,748 18,237,827
============ ============ ============ ============ ============
Net (loss) income per common share (diluted) $ (0.05) $ (0.30) $ (0.39) $ 0.07 $ (3.39)
============ ============ ============ ============ ============
Weighted average number of common
shares and common share equivalents
used in computation (diluted) 36,189,748 24,399,699 19,535,841 14,817,732 18,237,827
============ ============ ============ ============ ============
Balance Sheet Data
DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000 DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- ----------------- ----------------- ----------------- -----------------
Working capital (deficit) $ 44,207 $ 161,324 $ 4,292,698 $ 1,383,945 $(21,457,105)
Total assets 7,117,551 7,747,904 14,371,174 20,392,868 70,179,278
Total long-term debt -- -- -- 8,803,283 680,152
Total short-term debt -- -- 1,559,213 7,702,005 53,514,615
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
In evaluating our financial results and financial condition, management has
focused principally on the following:
- - Revenue growth -- We believe this is the key factor affecting both our
results of operations and our liquidity. In 2002, our increased
revenues reflected our success in adding new hospital customers to our
Strategic Quality Initiative (SQI) and Quality Assessment and
Improvement (QAI) programs and obtaining renewals from hospitals
already enrolled in these programs. Furthermore, because we typically
receive payment in advance for the annual terms of these agreements,
the addition of new customers could significantly affect our liquidity.
Management is focused on increasing revenues in other areas of our
business as well. We believe the principal risk we confront in this
regard is that we may be unable to effect market penetration and growth
in these other areas.
- - Cost control -- We have been successful in substantially reducing
expenses, due largely to personnel reductions in 2001. We do not
anticipate that further expense reductions are feasible or advisable,
particularly because we want to be positioned to accommodate increased
business if our efforts to increase revenues are successful. Moreover,
we believe it is important to provide incentives to our remaining
employees, who have been willing to accommodate our expense control
initiatives as we have attempted to preserve our resources during the
past two years. Specifically, we believe it is important to provide
appropriate compensation and incentives to those employees who
contribute to the further growth of our company. Management recognizes,
however, that any increases in expenses to accommodate such growth must
be applied in a disciplined fashion so as to enable us to obtain
meaningful benefits from the standpoint of our operations and cash
flows.
23
- - Liquidity -- We believe that current economic conditions and our
depressed market price provides a very challenging environment for
external financing, although we have a maximum of $1,000,000
availability under line of credit with a bank. Therefore, we believe
that our focus must be devoted to generating cash flow from operations.
During 2002, we benefited from significantly reduced losses from
operations, as well as a $1,000,000 tax refund resulting from tax
legislation enacted last year. We believe our cash resources are
sufficient to support ongoing operations for the next twelve months,
but we confront the risk that our inability to generate revenues as
expected could compel us to seek additional financing. Moreover, as
noted elsewhere in this report, we are engaged in litigation relating
to property leased by a former affiliated practice. While we do not
currently anticipate an outcome that would fundamentally affect our
liquidity, an unanticipated result could be materially harmful to our
financial position.
- - Subsequent Events - Effective March 11, 2003, we executed an amendment
to our agreement with a bank noted above. The terms of the amendment
provide for an extension of the maturity date of the $1,000,000 line of
credit arrangement to February 20, 2004. To date, we have not borrowed
any funds under the line of credit. In addition, the amendment provides
for a term loan of $500,000. The term loan accrues interest at 5.94%
and requires us to pay twenty-four equal installments of principal and
interest over the term, beginning on April 1, 2003. We have the
ability, at our option, to prepay all, but not less than all, of the
term loan without penalty after August 21, 2003, provided we give the
bank at least thirty days written notice prior to such repayment. In
addition, we entered into a Stock and Warrant Repurchase Agreement,
dated March 11, 2003, with Chancellor V, L.P. ("Chancellor"). Under the
terms of the Stock and Warrant Repurchase Agreement, we repurchased
from Chancellor 12,004,333 shares of our common stock and warrants to
purchase 1,971,820 shares of our common stock for a total purchase
price of $500,000. Chancellor initially acquired the common stock and
warrants from us in two private transactions in 2000 and 2001.
Immediately prior to the repurchase, Chancellor's ownership of
HealthGrades common stock represented 33% of our outstanding common
stock, and Chancellor's ownership of HealthGrades common stock and
warrants represented 36% of the our total outstanding common stock
(assuming full exercise of the warrants held by Chancellor, but
assuming no exercise of any other warrants or options).
CRITICAL ACCOUNTING POLICIES
In preparing our financial statements, management is required to make
estimates and assumptions that, among other things, affect the reported amounts
of assets, revenues and expenses. These estimates are most significant in
connection with our critical accounting policies, namely those of our accounting
policies that are most important to the presentation of financial condition and
results of operations and that require the most difficult, subjective, complex
judgments. These judgments often result from the need to make estimates about
the effects of matters that are inherently uncertain. For the 2002 year, we have
identified evaluation of goodwill impairment and revenue recognition as our
critical accounting policies.
Goodwill Impairment
As a result of the adoption of Statement of Financial Accounting Standards
No. 142 (SFAS 142), we discontinued the amortization of goodwill effective
January 1, 2002. Statement 142 also requires companies to perform a transitional
test of goodwill for impairment, and we completed this test during the second
quarter of 2002. Based upon the results of the test, we recorded a charge of
approximately $1.1 million in our consolidated statement of operations for the
quarter ended June 30, 2002, as a cumulative effect of a change in accounting
principle. Goodwill, net in the accompanying consolidated balance sheet is shown
net of the impairment charge described above as of December 31, 2002. As of
December 31, 2001, accumulated amortization was approximately $1.7 million.
SFAS 142 describes various potential methodologies for determining fair
value, including market capitalization (if a public company has one reporting
unit), discounted cash flow analysis (present value technique) and techniques
based on multiples of earnings, revenue, EBITDA, and/or other financial
measures. SFAS 142 also states that if a valuation technique is used that
considers multiple sources of information, such as an average of the quoted
market prices of the reporting unit over a specific time period and the results
of a present value technique, the company should apply that technique
consistently period to period (i.e. in the required annual impairment analysis
in subsequent years).
As HealthGrades consists of only one reporting unit, and is publicly traded,
management began its fair value analysis with an evaluation of our market
capitalization. We applied a market capitalization approach by multiplying the
number of actual shares outstanding by an average market price. We applied an
additional premium of 30% to this valuation to give effect to management's best
estimate of a "control premium". As the majority of our outstanding shares were
owned by management and two venture
24
capitalist investors (we subsequently repurchased the shares owned by one of the
venture capital investors), we believe a premium of 30% was reasonable to give
effect to additional benefits a purchaser would derive from control of Health
Grades, Inc.
As our shares are very thinly traded, management believes that any analysis
of HealthGrades' fair value should include valuation techniques in addition to
the overall market capitalization. We contemplated utilizing cost, market or
income approaches. However, utilization of cost or market approaches was not
feasible, particularly given the fact that HealthGrades does not fall into an
easily identifiable "peer group" of companies from which to compare valuations
in the form of P/E ratios, sales of similar companies, etc. Therefore management
determined to utilize an approach using the present value of expected future
cash flows as an additional valuation technique. Due to the inherent uncertainty
involved in projecting cash flows, in particular for a growth company,
management developed a range of possible cash flows and derived a
probability-weighted average of the range of possible amounts to determine the
expected cash flow.
We utilized a five-year period for examination of cash flows and expect to
utilize this time period in our subsequent annual impairment valuations absent
evidence to the contrary. Based upon the inherent uncertainty in future cash
flows in particular for a growth company, we feel the utilization of a longer
time period would not be appropriate. As we utilized the expected future cash
flow approach for our present value measurements, the appropriate discount rate
to utilize for application to future cash flow estimates is the risk-free rate
of interest over the time period of the expected cash flows (or five years in
our case). This is due to the fact that in our expected cash flows, we have
already built in our assumptions concerning the uncertainty of cash flows.
Therefore, these assumptions should not be taken into account again in our
discount rate. As the 5-year treasury maturity rate as of December 31, 2002, was
3.03%, this is the rate we utilized.
After deriving the market capitalization and expected cash flow valuations as
described above, we then applied an equal weighting to each model to derive an
overall fair value estimate of HealthGrades. Subsequent to this valuation, we
compared the implied fair value of goodwill to the carrying amount of goodwill
to arrive at the final impairment loss calculation of approximately $1.1
million.
Although management believes its approach of applying equal weighting to both
the market capitalization and expected cash flow valuations was reasonable,
applying different weightings to the valuations could have resulted in a range
of no impairment charge recorded to an impairment charge of approximately $2.2
million.
As required under SFAS 142, we performed our annual test for impairment of
our goodwill during the fourth quarter of 2002. This test resulted in no
additional impairment to our goodwill balance. We will perform the annual
impairment test in the fourth quarter of subsequent years or sooner if
indicators of impairment arise at an interim date. Any impairment identified
during the annual impairment tests will be recorded as an operating expense in
our consolidated statement of operations. We expect to continue to utilize the
combined market capitalization and expected cash flow approach described above
to perform our annual impairment analysis and interim tests if necessary.
Revenue Recognition -- Ratings and Advisory Revenue
We currently derive our ratings and advisory revenue principally from annual
fees from hospitals that participate in our Strategic Quality Initiative (SQI)
program. The SQI program provides business development tools to hospitals that
are highly rated on our website. Under our SQI program, we license the
HealthGrades name and our "report card" ratings to hospitals. The license may be
in a single area (for example, Cardiac) or multiple areas (for example, Cardiac,
Neurosciences and Orthopaedics.) We also assist hospitals in promoting their
ratings and measuring the success of their efforts utilizing our team of
in-house healthcare consultants. Another key feature of this program is a
detailed comparison of the data underlying a hospital's rating to local and
national benchmarks.
We recognize revenue related to these arrangements in a straight-line manner
over the term of the agreement (typically one-year). We follow this method
because the primary deliverable under the agreement is the license to utilize
our rating over the contract term. In addition, consulting services are
performed as requested by the client as needed over the term of the agreement.
As we typically receive a non-refundable payment for the contract term upon
execution of the agreement, we record the cash payment as deferred revenue that
is then amortized to revenue over the contract term.
At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF)
reached a final consensus regarding EITF 00-21, Revenue Arrangements with
Multiple Deliverables. The consensus provides that revenue arrangements with
multiple deliverables should be divided into separate units of accounting if
certain criteria are met. The consideration for the arrangement should be
allocated to the separate units of accounting based on their relative fair
values, with different provisions if the fair value of all deliverables are not
known or if the fair value is contingent on delivery of specified items or
performance conditions. Applicable
25
revenue recognition criteria should be considered separately for each separate
unit of accounting. EITF 00-21 is effective for revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. Entities may elect to
report the change as a cumulative effect adjustment in accordance with APB
Opinion 20, Accounting Changes. We have not determined the effect of adoption of
EITF 00-21 on our financial statements or the method of adoption that we will
use.
CONSOLIDATED STATEMENT OF OPERATIONS PRESENTATION
During 2002, we revised the presentation of our statement of operations by
making certain modifications to the classification of expenses. These
reclassifications have been made to all periods presented in this report. The
primary changes made were to add line items for cost of ratings and advisory
revenue, cost of physician practice management revenue and to make certain
reclassifications from general and administrative expenses to both sales and
marketing and product development.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
REVENUE:
Ratings and advisory revenue
Ratings and advisory revenue was approximately $5.1 million for the year
ended December 31, 2002; an increase of approximately $2.0 million or 65% from
the year ended December 31, 2001. This increase reflects our continued addition
of new customers while maintaining a high renewal rate with respect to current
customers. In 2002, approximately 82% of our ratings and advisory revenue was
derived from our strategic quality initiative (SQI) services. Approximately 9%
of our ratings and advisory revenue was derived from our quality assessment and
improvement (QAI) services.
Physician practice service fees
Physician practice service fees include services fees and other revenue
derived from our physician practice management business. Our last contract to
provide management services expired in September 2002. We will no longer provide
physician practice management services.
Cost of ratings and advisory revenue
Cost of ratings and advisory revenue consists primarily of the costs
associated with the delivery of services related to our SQI and QAI programs, as
well as the costs incurred to acquire the data utilized in connection with these
and other services. The cost of delivery of services relates primarily to the
client consultants and support staff that delivers our services.
Cost of physician practice management revenue
In 2002, cost of physician practice management revenue primarily consisted of
consulting costs related to the delivery of limited services to physician
practices under agreements that expired at various times through September 2002.
In 2001, these costs primarily consisted of costs related to litigation with
certain former affiliated practices, as well as certain consulting costs.
Sales and marketing
Sales and marketing costs include salaries, wages and commission expenses
related to our sales efforts, as well as other direct sales and marketing costs.
For our SQI and QAI agreements, we pay our sales personnel commissions as we
receive payment from our hospital clients. Although we typically record revenue
earned from our SQI and QAI agreements over the term of the agreement (typically
one year), we record the commission expense in the period it is earned, which is
typically upon contract execution. We record the commission expense in this
manner, because once a contract is signed, the salesperson has no remaining
obligations to perform in order to earn the commission.
26
Sales and marketing costs decreased from approximately $3.2 million for the
year ended December 31, 2001, to approximately $2.1 million for the same period
of 2002. This decrease is primarily the result of personnel reductions that
occurred during the latter part of 2001.
General and administrative
For the year ended December 31, 2002, general and administrative expenses
were approximately $2.1 million, compared to approximately $3.7 million for the
same period of 2001. Contributing to this decrease was a significant reduction
in salaries and wages expenses in 2001, due to certain voluntary and involuntary
employee reductions during 2001. Professional fees also decreased substantially
as a result of cost reductions in areas such as consulting, legal and investor
relations. During the second quarter of 2001, we also incurred a non-recurring
financing fee of approximately $162,000. Finally, we decreased costs in several
additional areas as a result of a cost reduction effort initiated during 2001.
Income tax benefit
On March 9, 2002, President Bush signed into law the Job Creation and Worker
Assistance Act of 2002 ("JCWA Act"). One of the provisions of the JCWA Act
extends the net operating loss carryback provisions of the Internal Revenue Code
from two years to five years for losses incurred in 2001 and 2002. Prior to the
passage of the JCWA Act we did not have the ability to utilize our 2001 tax loss
to reduce prior year taxable income because we had no taxable income in 2000 or
1999. However, with the passage of the JCWA Act, we were able to carryback our
2001 tax loss to reduce taxable income in 1997. In April 2002, we filed an
Application for Tentative Refund for the 1997 tax year. We received the tax
refund, which amounted to approximately $1.0 million, in May 2002.
Cumulative effect of change in accounting principle
Based upon the results of the transitional impairment test performed on our
goodwill as required by SFAS 142, we recorded a charge of approximately $1.1
million in our consolidated statement of operations for the quarter ended June
30, 2002, as a cumulative effect of change in accounting principle. See Note 5
to our consolidated financial statements included in this Form 10-K for further
discussion of the application of SFAS 142.
YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000
REVENUE:
Ratings and advisory revenue
Ratings and advisory revenue was approximately $3.1 million for the year
ended December 31, 2001; an increase of approximately $1.5 million or 96% from
the year ended December 31, 2000. During 2001, approximately 73% of our ratings
and advisory revenue was derived from our SQI services, reflecting an increase
in the number of customers for our SQI programs. Approximately 17% of our
ratings and advisory revenue was derived from licensing access to our database
of healthcare information.
Physician practice service fees
Physician practice service fees include services fees and other revenue
derived from our physician practice management business. For the year ended
December 31, 2001, physician practice service fees decreased to approximately
$550,000 from $4.2 million for the year ended December 31, 2000. This decrease
reflects the substantial reduction in our physician practice management
operations. By September 2002, all of these agreements had expired or were
terminated.
COSTS AND EXPENSES:
Cost of ratings and advisory revenue
Cost of ratings and advisory revenue was approximately $1.3 million for the
year ended December 31, 2001; an increase of approximately $770,000 from the
year ended December 31, 2000. This increase is due to the fact that we hired
additional personnel to support our ratings and advisory products during 2001.
In addition, in the latter part of 2000, we signed an agreement with GeoAccess
to license certain physician data.
27
Cost of physician practice management revenue
Cost of physician practice management revenue decreased to approximately
$760,000 for the year ended December 31, 2001; a decrease of approximately
$680,000 from the year ended December 31, 2000. This decrease is primarily due
to the reduction in the number of management agreements under which we were
providing services.
General and administrative
General and administrative expenses decreased to approximately $3.6 million
for the year ended December 31, 2001, compared to $5.9 million for the year
ended December 31, 2000. Contributing to this decrease was a significant
reduction in salaries and wages expenses in 2001, due to certain voluntary and
involuntary employee reductions. Professional fees also decreased substantially
as a result of cost reductions made to areas such as consulting, legal and
investor relations. Finally, we decreased costs in several additional areas as a
result of a cost reduction effort initiated during 2001.
Gain (loss) on sale of assets and other
During the year ended December 31, 2001, we incurred a gain on sale of assets
and other of approximately $192,000. This gain was the result of the settlement
of a lawsuit related to a note payable by us to a former vendor. Under the terms
of the settlement, the note payable was canceled. The cancellation of the note
as well as the reversal of accrued interest on the note was recorded as a gain.
During the year ended December 31, 2000, we incurred a loss on sale of assets
and other of approximately $699,000. This amount consisted primarily of a loss
of $352,000 on the settlement of a dispute with one of our former affiliated
practices, a loss of $275,000 on the sale of two MRI units, a gain of
approximately $142,000 primarily related to a litigation settlement with one of
our former affiliated practices, and a loss of approximately $214,000 related to
the writedown of certain assets.
Interest expense
We incurred interest expense of approximately $90,000 for the year ended
December 31, 2001, compared to interest expense of approximately $512,000 for
the year ended December 31, 2000. This decrease reflects the fact that we repaid
the entire balance of our debt payable to a bank syndicate in March 2001. We
currently have no outstanding debt.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2002, we had working capital of approximately $44,000, a
decrease of approximately $117,000 from working capital of $161,000 as of
December 31, 2001. For the year ended December 31, 2002, cash flow provided by
operations was approximately $443,000, compared to $3.6 million used in
operations for the same period of 2001. This increase in cash flow from
operations is principally the result of the reduction in our net loss from 2001
to 2002. In addition, included in cash flow from operations in 2002, is an
income tax refund received of approximately $1.0 million, discussed above under
"Results of Operations - Year Ended December 31, 2002 compared to Year Ended
December 31, 2001."
Although we anticipate that we have sufficient funds available to support
ongoing operations for at least the next twelve months, if our revenues fall
short of our expectations or our expenses exceed our expectations, we may need
to raise additional capital through public or private debt or equity financing.
We may not be able to secure sufficient funds on terms acceptable to us. If
equity securities are issued to raise funds, our stockholders' equity may be
diluted. If additional funds are raised through debt financing, we may be
subject to significant restrictions. Furthermore, upon execution of our
strategic quality initiative and quality assessment and improvement agreements,
we typically receive a non-refundable payment for the contract term. This
payment is recorded as deferred revenue, which is reflected as a current
liability in our consolidated balance sheet. Revenues related to these
agreements are recorded ratably over the term of the agreement. As a result, our
operating cash flow is substantially dependent upon our ability to continue to
sign new agreements. Our current operating plan includes growth in new sales
from our strategic quality initiative and quality assessment and improvement
agreements. For the reasons described above, failure to achieve our new sales
plan would have a material negative impact on our financial position and cash
flow. Moreover, as noted elsewhere in this report, we are engaged in litigation
relating to property leased by a former affiliated practice. While we do not
currently anticipate an outcome that would fundamentally affect our liquidity,
an unanticipated result could be materially harmful to our financial position.
Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003,
between Chancellor and us, we repurchased from Chancellor 12,004,333 shares of
our common stock and warrants to purchase 1,971,820 shares of our common stock
for a total purchase price of $500,000. Chancellor initially acquired the common
stock and warrants from us in two private transactions in 2000 and 2001.
Immediately prior to our repurchase, Chancellor's ownership of HealthGrades
common stock represented 33% of our outstanding common stock, and Chancellor's
ownership of HealthGrades common stock and warrants represented 36% of the our
total outstanding common stock (assuming full exercise of the warrants held by
Chancellor, but assuming no exercise of any other warrants or options). As a
result of the transaction, management believes that Chancellor no longer holds
any equity securities in the HealthGrades.
On May 13, 2002, we completed a line of credit arrangement (the "Agreement" with
Silicon Valley Bank. Under the terms of the Agreement, we may request advances
not to exceed an aggregate amount of $1.0 million over the one-year term of the
Agreement, subject to 75% of Eligible Accounts (as defined in the Agreement)
plus 50% of our cash invested with Silicon Valley Bank. As of December 31, 2002,
the entire $1.0 million is available to us. Advances under the Agreement bear
interest at Silicon Valley Bank's prime rate plus .75% and are secured by
substantially all of our assets. Interest is due monthly on advances outstanding
and the principal balance of any taken by us are due at the end of the Agreement
term. Our ability to request advances under the Agreement is subject to certain
financial and other covenants. As of December 31, 2002, we have no advances
outstanding.
Effective March 11, 2003, we executed an amendment to our line of credit
arrangement with Silicon Valley Bank. The terms of the amendment provide for an
extension of the maturity date of the $1,000,000 line of credit arrangement to
February 20, 2004. To date, we have not borrowed any funds under the line of
credit. In addition, the amendment provides for a term loan of $500,000. The
term loan accrues interest at 5.94% and requires us to pay twenty-four equal
installments of principal and interest over the term, beginning on April 1,
2003. We have the ability, at our option, to prepay all, but not less than all,
of the term loan without penalty after August 21, 2003, provided we give Silicon
Valley Bank at least thirty days written notice prior to such repayment.
Item 7a. Quantitative and Qualitative Disclosure about Market Risk
Not applicable.
Item 8. Financial Statements and Supplementary Data
See pages 38-57 of this document.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
As reported in our report on Form 8-K filed on October 2, 2002, and dated
September 29, 2002, our Audit Committee, pursuant to authority delegated by our
Board of Directors, dismissed Ernst & Young LLP ("E&Y") as our independent
public accountants, effective on that date.
In addition, on September 29, 2002, our Audit Committee engaged Grant Thornton
LLP as our new independent accountants to audit our financials statements for
the fiscal year ended December 31, 2002.
E&Y's reports on our consolidated financial statements for either of our two
fiscal years ended December 31, 2002, did not contain an adverse opinion or
disclaimer of opinion, and were not qualified or modified as to uncertainty,
audit scope or accounting principles.
During the two fiscal years ended December 31, 2001 and through the date of
E&Y's dismissal, there were no disagreements with E&Y on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedures which, if not resolved to E&Y's satisfaction, would have
caused it to make reference to the subject matter of the disagreements in
connection with its report on our consolidated financial statements.
28
PART III
Item 10. Directors and Executive Officers of the Registrant
This information (other than the information relating to executive officers
included in Part I) will be included in an amendment to this Form 10-K, which
will be filed within 120 days after the close of our fiscal year covered by this
report.
Item 11. Executive Compensation
This information will be included in an amendment to this Form 10-K, which will
be filed within 120 days after the close of our fiscal year covered by this
report.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Equity Compensation Plan Information
The following table provides information, as of December 31, 2002, regarding
securities issuable under our stock based compensation plans.
Plan category Number of securities Weighted-average Number of securities
to be issued upon exercise price of remaining available
exercise of outstanding options, for future issuance
outstanding options, warrants and rights under equity
warrants and rights compensation plans
(excluding securities
reflected in column
(a))
(a) (b) (c)
Equity compensation
plans approved
by security holders 9,857,426 $0.78 2,855,113
Equity compensation
plans not approved
by security holders 20,000 (1) $2.00 N/A
Total 9,877,426 2,855,113
(1) -- Represents warrants issued to a company with respect to certain financial
advisory services provided to us.
Other information required to be included in this item will be included in an
amendment to this Form 10-K, which will be filed within 120 days after the close
of our fiscal year covered by this report.
Item 13. Certain Relationships and Related Transactions
This information will be included in an amendment to this Form 10-K, which will
be filed within 120 days after the close of our fiscal year covered by this
report.
29
Item 14. Controls and Procedures
An evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures, was carried out by us within 90 days prior to the
filing of this Annual Report on Form 10-K, under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer. Based on that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
are functioning effectively to provide reasonable assurance that the information
required to be disclosed by us in reports filed under the Securities Exchange
Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms. A controls system, no matter how
well designed and operated, cannot provide absolute assurance that the
objectives of the controls system are met, and no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company have been detected. Subsequent to the date of the most
recent evaluation, there were no significant changes in our internal controls or
in other factors that could significantly affect the internal controls,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
30
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements.
The financial statements listed in the accompanying Index to Financial
Statements and Financial Statement Schedule at page F-1 are filed as part of
this Form 10-K.
(a) 2. Financial Statement Schedules.
The following financial statement schedule is filed as part of this Form 10-K:
Schedule II - Valuation and Qualifying Accounts.
All other schedules have been omitted because they are not applicable, or not
required, or the information is shown in the Financial Statements or notes
thereto.
(a) 3. Exhibits.
31
The following is a list of exhibits filed as part of this annual report on Form
10-K. Where so indicated by footnote, exhibits which were previously filed are
incorporated by reference.
EXHIBIT
NUMBER DESCRIPTION
3.1 Certificate of Amendment of
Amended and Restated
Certificate of Incorporation
and Amended and Restated
Certificate of Incorporation
(incorporated by reference
to Exhibit 3.1 to our Annual
Report on Form 10-K for the
year ended December 31,
2001.)
3.2 Amended and Restated Bylaws
(incorporated by reference
to Exhibit 3.2 to our Annual
Report on Form 10-K for the
year ended December 31,
2001.)
10.1* 1996 Equity Compensation Plan, as amended
10.2.1 Loan and Security Agreement by and between
Health Grades, Inc., Healthcare Ratings,
Inc., ProviderWeb.net, Inc., and Silicon
Valley Bank (incorporated by reference to
Exhibit 10.1 to our Quarterly Report on
Form 10-Q for the quarter ended June 30,
2002.)
10.2.2 Loan Modification Agreement by and between
Health Grades, Inc. and Silicon Valley
Bank
10.3 Stock and Warrant Repurchase Agreement
10.4* Employment Agreement dated as of April 1,
1996 by and between Specialty Care
Network, Inc. and Kerry R. Hicks
(incorporated by reference to Exhibit 10.3
to the Company's Registration Statement on
Form S-1 (File No. 333-17627))
10.5.1* Employment Agreement between Specialty
Care Network, Inc. and David Hicks, dated
March 1, 1996 (incorporated by reference
to Exhibit 10.8 to the Company's
Registration Statement of Form S-1 (File
No. 333-17627))
10.5.2* Amendment to Employment Agreement between
Specialty Care Network, Inc. and David
Hicks, dated December 2, 1997.
(incorporated by reference to Exhibit
10.8.1 to the Company's Annual Report on
Form 10-K for the fiscal year ended
December 31, 1997)
23.1 Consent of Grant Thornton LLP
23.2 Consent of Ernst & Young LLP
99.1 Certificate of the Chief Executive Officer
of Health Grades, Inc. pursuant to Title
18, Section 1350 of the United States
Code.
99.2 Certificate of the Chief Financial Officer
of Health Grades, Inc. pursuant to Title
18, Section 1350 of the United States
Code.
* - Constitutes a management contract, compensatory plan or arrangement required
to be filed as an exhibit to this report.
(b) Reports on Form 8-K
During the quarter ended December 31, 2002, we filed a report on Form 8-K. The
report, filed on October 3, 2002, and dated September 29, 2002, provided
information responsive to Items 4 and 7 in connection with a change in our
independent accountants.
32
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
HEALTH GRADES, INC.
Date: April 10, 2003 /s/ KERRY R. HICKS
----------------------------------
Kerry R. Hicks
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
/s/ Kerry R. Hicks Chief Executive Officer April 10, 2003
--------------------------- (Principal Executive Officer)
Kerry R. Hicks
/s/ G. Allen Dodge Senior Vice President -- April 10, 2003
---------------------------- Finance, Chief Financial
G. Allen Dodge Officer and Treasurer
(Principal Financial and
Accounting Officer)
/s/ Peter H. Cheesbrough Director April 10, 2003
----------------------------
Peter H. Cheesbrough
/s/ Leslie S. Matthews, M.D. Director April 10, 2003
----------------------------
Leslie S. Matthews, M.D.
/s/ J.D. Kleinke Director April 11, 2003
----------------------------
J.D. Kleinke
/s/ John Quattrone Director April 9, 2003
----------------------------
John Quattrone
33
CERTIFICATION
I, Kerry R. Hicks, certify that:
1. I have reviewed this annual report on Form 10-K of Health Grades, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: April 11, 2003
/s/Kerry R. Hicks
- -----------------
President and CEO
34
CERTIFICATION
I, G. Allen Dodge, certify that:
1. I have reviewed this annual report on Form 10-K of Health Grades, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: April 11, 2003
/s/ G. Allen Dodge
- ------------------
Senior Vice President -- Finance/CFO
35
SUPPLEMENTAL INFORMATION TO BE FURNISHED
WITH REPORTS FILED PURSUANT TO
SECTION 15(d) OF THE ACT BY
REGISTRANTS WHICH HAVE NOT REGISTERED
SECURITIES PURSUANT TO SECTION 12 OF THE ACT
No annual report covering the Registrant's last fiscal year and no proxy
statement, form of proxy or other soliciting material relating to the
Registrant's 2003 annual meeting of stockholders has been sent to the
Registrant's stockholders. The Registrant intends to send a report to
stockholders for the period covered by this report and a proxy statement and
proxy with respect to the Registrant's next annual meeting of stockholders. The
Registrant will furnish copies of such material when such material is sent to
its stockholders. Such material shall not be deemed to be "filed" with the
Commission or otherwise subject to the liabilities of Section 18 of the
Securities Exchange Act of 1934.
36
INDEX TO FINANCIAL STATEMENTS
HEALTH GRADES, INC. AND SUBSIDIARIES:
Reports of Independent Auditors....................... 38
Consolidated Balance Sheets........................... 40
Consolidated Statements of Operations................. 41
Consolidated Statements of Stockholders' Equity ...... 42
Consolidated Statements of Cash Flows................. 43
Notes to Consolidated Financial Statements............ 44
37
Report of Independent Certified Public Accountants
Board of Directors and Stockholders of Health Grades, Inc.
We have audited the accompanying consolidated balance sheet of Health Grades,
Inc. and subsidiaries as of December 31, 2002, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Health Grades,
Inc. and subsidiaries as of December 31, 2002, and the consolidated results of
their operations and their cash flows for the year then ended, in conformity
with accounting principles generally accepted in the United States of America.
As discussed in Note 5 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" on January 1, 2002.
We have also audited Schedule II for the year ended December 31, 2002. In our
opinion, this schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material
respects, the information therein.
/s/ GRANT THORNTON LLP
----------------------------
Grant Thornton LLP
Denver, Colorado
March 11, 2003
38
Report of Independent Auditors
Board of Directors and Stockholders of Health Grades, Inc.
We have audited the accompanying consolidated balance sheet of Health Grades,
Inc. and subsidiaries (collectively the "Company") as of December 31, 2001, and
the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the two years in the period ended December 31, 2001. Our
audits also included the financial statement schedule listed in the Index at
Item 15(a) for the years ended December 31, 2001 and 2000. These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Health Grades,
Inc. and subsidiaries at December 31, 2001, and the consolidated results of
their operations and their cash flows for each of the two years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
/s/ ERNST & YOUNG LLP
-------------------------------------
Ernst & Young LLP
Denver, Colorado
February 8, 2002
39
Health Grades, Inc. and Subsidiaries
Consolidated Balance Sheets
DECEMBER 31
2002 2001
-------------- -------------
ASSETS
Cash and cash equivalents $ 2,947,047 $ 2,295,557
Accounts receivable, net 675,514 778,370
Prepaid expenses and other 284,898 132,581
Receivable from officer -- 12,726
------------- -------------
Total current assets 3,907,459 3,219,234
Property and equipment, net 103,911 334,178
Goodwill, net 3,106,181 4,194,492
------------- -------------
Total assets $ 7,117,551 $ 7,747,904
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 23,332 $ 149,772
Accrued payroll, incentive compensation and related
expenses 396,774 564,490
Accrued expenses 114,798 130,543
Deferred income 3,251,625 2,136,175
Income taxes payable 76,723 76,930
------------- -------------
Total current liabilities 3,863,252 3,057,910
Long-term liabilities -- --
Total liabilities 3,863,252 3,057,910
Commitments and contingencies -- --
Stockholders' equity:
Preferred stock, $0.001 par value, 2,000,000
shares authorized, no shares issued or outstanding -- --
Common stock, $0.001 par value, 100,000,000 shares
authorized, and 43,965,706 and 42,165,733 shares
issued in 2002 and 2001, respectively 43,966 42,166
Additional paid-in capital 89,762,836 89,549,538
Accumulated deficit (73,284,923) (71,634,130)
Treasury stock, 7,559,057 shares (13,267,580) (13,267,580)
------------- -------------
Total stockholders' equity 3,254,299 4,689,994
------------- -------------
Total liabilities and stockholders' equity $ 7,117,551 $ 7,747,904
============= =============
See accompanying notes to consolidated financial statements.
40
Health Grades, Inc. and Subsidiaries
Consolidated Statements of Operations
Years ended December 31,
2002 2001 2000
------------ ------------ ------------
Revenue:
Ratings and advisory revenue $ 5,091,891 $ 3,088,451 $ 1,578,979
Physician practice service fees 195,492 551,925 4,249,658
Other 20,000 4,490 9,051
------------ ------------ ------------
5,307,383 3,644,866 5,837,688
------------ ------------ ------------
Expenses:
Cost of ratings and advisory revenue 1,468,097 1,307,925 536,787
Cost of physician practice management
revenue 91,051 757,896 1,437,062
------------ ------------ ------------
Gross margin 3,748,235 1,579,045 3,863,839
Operating expenses:
Sales and marketing 2,074,425 3,227,598 2,880,127
Product development 1,321,511 1,478,071 1,599,425
General and administrative 2,122,854 3,655,250 5,923,415
Amortization of goodwill -- 838,899 816,609
------------ ------------ ------------
Loss from operations (1,770,555) (7,620,773) (7,355,737)
Other:
Gain (loss) on sale of assets and other 147,768 191,915 (699,010)
Interest income 14,009 90,409 511,657
Interest expense -- (28,794) (471,553)
------------ ------------ ------------
Loss before income taxes and cumulative
effect of a change in accounting principle (1,608,778) (7,367,243) (8,014,643)
Income tax benefit 1,046,296 -- 469,897
------------ ------------ ------------
Loss before cumulative effect of a change in
accounting principle (562,482) (7,367,243) (7,544,746)
Cumulative effect of a change in accounting
principle (1,088,311) -- --
------------ ------------ ------------
Net loss $ (1,650,793) $ (7,367,243) $ (7,544,746)
============ ============ ============
Net (loss) income per common share (basic and diluted)
Loss before cumulative effect of a change
in accounting principle (0.02) (0.30) (0.39)
------------ ------------ ------------
Cumulative effect of a change in
accounting principle (0.03) -- --
------------ ------------ ------------
Net (loss) income per common share $ (0.05) $ (0.30) $ (0.39)
============ ============ ============
Weighted average number of common shares
used in computation (basic and diluted) 36,189,748 24,399,699 19,535,841
============ ============ ============
See accompanying notes to consolidated financial statements.
41
Health Grades, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
Years ended
December 31, 2002, 2001 and 2000
COMMON STOCK STOCK
$0.001 PAR VALUE ADDITIONAL PURCHASE
---------------- PAID-IN PLAN ACCUMULATED TREASURY
SHARES AMOUNT CAPITAL RECEIVABLE DEFICIT STOCK TOTAL
---------- ------- ----------- ------------- ------------- ------------- -------------
Balances at January 1, 2000 18,738,686 $18,739 $67,509,276 $ -- $(56,722,141) $(11,040,484) $ (234,610)
Non-cash compensation expense
related to employee stock options -- -- 55,718 -- -- -- 55,718
Exercise of employee stock options 113,714 113 62,688 -- -- -- 62,801
888,779 shares acquired as
treasure stock -- -- -- -- -- (2,039,596) (2,039,596)
Equity financing, net 7,565,000 7,565 14,348,635 -- -- -- 14,356,200
Cancellation of officer notes 1,600,000 1,600 3,198,400 -- -- -- 3,200,000
Non-cash compensation expense
related to officer note cancellation -- -- 347,200 -- -- -- 347,200
Acquisition of minority interest 800,000 800 1,849,200 -- -- -- 1,850,000
Retainer warrants -- SmallCaps Online -- -- 10,800 -- -- -- 10,800
Net loss -- -- -- -- (7,544,746) -- (7,544,746)
---------- ------- ----------- ------------ ------------ ------------ ------------
Balance at December 31, 2000 28,817,400 28,817 87,381,917 (64,266,887) (13,080,080) 10,063,767
---------- ------- ----------- ------------ ------------ ------------ ------------
Exercise of employee stock options 15,000 16 8,423 -- -- -- 8,439
250,000 shares acquired as treasury
stock -- -- -- -- -- (187,500) (187,500)
Retainer warrants - SmallCaps Online -- -- 10,800 -- -- -- 10,800
Non-cash financing fee -- -- 161,731 -- -- -- 161,731
Common stock issued 13,333,333 13,333 1,986,667 -- -- -- 2,000,000
Net loss -- -- -- -- (7,367,243) -- (7,367,243)
---------- ------- ----------- ------------ ------------ ------------ ------------
Balance at December 31, 2001 42,165,733 42,166 89,549,538 -- (71,634,130) (13,267,580) 4,689,994
---------- ------- ----------- ------------ ------------ ------------ ------------
Common stock issued 1,799,973 1,800 213,298 (215,098) -- -- --
Payments made under stock purchase
plan -- -- -- 215,098 -- -- 215,098
Net loss -- -- -- -- (1,650,793) -- (1,650,793)
---------- ------- ----------- ------------ ------------ ------------ ------------
Balance at December 31, 2002 43,965,706 $43,966 $89,762,836 $ -- $(73,284,923) $(13,267,580) $ 3,254,299
========== ======= =========== ============ ============ ============ ============
See accompanying notes to consolidated financial statements.
42
Health Grades, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years ended December 31,
2002 2001 2000
----------- ----------- ------------
OPERATING ACTIVITIES
Net loss $(1,650,793) $(7,367,243) $ (7,544,746)
Adjustments to reconcile net loss to net
cash provided by (used in) operating
activities:
Cumulative effective of a change in
accounting principle 1,088,311 -- --
Non-cash compensation expense related to
employee stock options -- -- 55,718
Retainer warrants -- 10,800 10,800
Depreciation expense 249,802 526,111 707,408
Amortization expense -- 838,899 816,609
Bad debt expense 6,500 59,014 324,607
Non-cash compensation expense related to
officer note cancellation -- -- 347,200
Non-cash financing fee -- 161,731 --
(Gain) loss on sale of assets and other 446 (191,915) 699,748
Changes in operating assets and liabilities:
Accounts receivable, net 96,356 (9,690) 1,785,701
Due from affiliated practices in
litigation -- 1,944,919 (243,261)
Prepaid expenses and other assets (152,317) 73,836 (16,019)
Prepaid and recoverable income taxes (207) 1,930 1,913,589
Accounts payable and accrued expenses (142,185) (232,661) (1,105,507)
Accrued payroll, incentive compensation
and related expenses (167,716) (219,819) 320,989
Deferred income 1,115,450 778,145 (433,369)
----------- ----------- ------------
Net cash provided by (used in) operating
activities 443,647 (3,625,943) (2,360,533)
INVESTING ACTIVITIES
Purchases of property and equipment (19,981) (14,746) (418,642)
Proceeds from sale of medical equipment -- -- 125,000
Increase in other assets -- 64,747 4,352
Sale of property, plant and equipment -- -- --
----------- ----------- ------------
Net cash provided by (used in) investing
activities (19,981) 50,001 (289,290)
FINANCING ACTIVITIES
Proceeds from stock purchases 215,098 -- --
Net proceeds from equity financing -- 2,000,000 14,356,200
Issuance of notes receivable -- -- (35,000)
Principal repayments on note payable -- (1,369,767) (10,406,673)
Principal repayments on officer notes -- -- (350,000)
Purchases of treasury stock -- (187,500) --
Exercise of employee stock options -- 8,439 62,801
Repayments of notes receivable 12,726 622,459 3,503,596
----------- ----------- ------------
Net cash provided by financing activities 227,824 1,073,631 7,130,924
----------- ----------- ------------
Net increase (decrease) in cash and
cash equivalents 651,490 (2,502,311) 4,481,101
Cash and cash equivalents at beginning of period 2,295,557 4,797,868 316,767
----------- ----------- ------------
Cash and cash equivalents at end of period $ 2,947,047 $ 2,295,557 $ 4,797,868
=========== =========== ============
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid $ -- $ 38,467 $ 559,700
=========== =========== ============
Income taxes received $(1,046,089) $ (1,930) $ (2,383,485)
=========== =========== ============
See accompanying notes to consolidated financial statements.
43
Health Grades, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2002
1. DESCRIPTION OF BUSINESS
HealthGrades provides healthcare ratings, advisory services and other healthcare
information. We grade, or provide the means to assess and compare the quality or
qualifications of, various types of healthcare providers. Our customers include
healthcare providers, employees, health plans, insurance companies and
consumers.
We offer services to hospitals that are either attempting to build a reputation
based upon quality of care or are working to identify areas to improve quality.
For hospitals that have received high ratings, we offer the opportunity to
license our ratings and trademarks and provide assistance in their marketing
programs. For hospitals that have not received high ratings, we offer quality
improvement services.
We also provide basic and expanded profile information on a variety of providers
and facilities. We make this information available to consumers, employers and
health plans to assist them in selecting healthcare providers. The basic profile
information is available free of charge on our website, www.healthgrades.com.
For a fee, we offer healthcare quality reports with respect to certain
healthcare providers. These reports provide more detailed information than is
available free of charge on our website. Report pricing and content varies based
upon the type of provider and whether the user is a consumer or a healthcare
professional (for example, medical professional underwriter).
We provide online integrated healthcare quality services for employers, health
plans and other organizations that license access to our database of healthcare
providers.
We have also entered into strategic arrangements with other service providers,
including GeoAccess and J.D. Power & Associates, in an effort to increase our
name recognition and market presence, as well as enhance our service offerings.
In addition to the services noted above, which constitute our ratings and
advisory business, we also provided, through September 2002, limited physician
practice management services to musculoskeletal practices under management
services agreements. As of December 31, 2002, all of these agreements had
expired or had been terminated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include Health Grades, Inc. and our
subsidiaries. Effective December 31, 2002, we liquidated our Healthcare Ratings
and Providerweb.net subsidiaries. This liquidation had no impact on our
financial position or operations. All significant intercompany balances and
transactions for the periods presented have been eliminated in consolidation.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and footnotes. These estimates are based on management's current
knowledge of events and actions they may undertake in the future, and actual
results could differ from those estimates.
REVENUE RECOGNITION AND ACCOUNTS RECEIVABLE
Ratings and advisory revenue
Our ratings and advisory revenue is generated principally from annual fees paid
by hospitals that participate in our Strategic Quality Initiative (SQI) and
Quality Assessment and Improvement (QAI) programs. The SQI program provides
business development tools to
44
hospitals that are highly rated on our website. Under the SQI program, we
license the HealthGrades name and our "report card" ratings to hospitals. The
license may be in a single area (for example, Cardiac) or multiple areas (for
example, Cardiac, Neuroscience and Orthopaedics.) We also assist hospitals in
promoting their ratings and measuring the success of their efforts utilizing our
team of in-house healthcare consultants. Another key feature of this program is
a detailed comparison of the data underlying a hospital's rating to local and
national benchmarks.
Our QAI program is principally designed to help hospitals measure and improve
the quality of their care in particular areas where they have lower ratings.
Using our database and focusing on a particular hospital's information and
ratings we can help identify areas to improve quality and measure how well the
hospital performs relative to national and regional best practices. Detailed
quality comparisons are also available from the hospital to the individual
physician level. Our consultants work on-site with the hospital staff and
physicians to present the data and assist in the quality analysis.
We recognize revenue related to these arrangements in a straight-line manner
over the term of the agreement (typically one-year). We follow this method
because the primary deliverable under the agreement is the license for a
hospital to utilize its rating over the contract term. In addition, consulting
services are performed as requested by the client over the term of the
agreement. As we typically receive payment for the entire contract term upon
execution of the agreement, we record the cash payment as deferred revenue,
which is then amortized to revenue over the contract term.
Physician practice service fees
Physician practice service fees include services fees and other revenue derived
from our former physician practice management business.
PRODUCTION, CONTENT AND PRODUCT DEVELOPMENT COSTS
Beginning in 1999, we began incurring production, content and product
development costs related to the development and support of our current (and a
former) website. These costs (which consist primarily of salaries and benefits,
consulting fees and other costs related to software development, application
development and operations expense) are expensed as incurred.
Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased, or Otherwise Marketed," requires
the capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based upon our product development
process, technological feasibility is established upon the completion of a
working model. Costs incurred between completion of a working model and the
launch of our websites were not significant.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents generally consist of cash and overnight investment
accounts that consist of short-term government obligations. These instruments
have original maturity dates not exceeding three months. Such investments are
stated at cost, which approximates fair value and are considered cash
equivalents for purposes of reporting cash flows.
FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, as reported in the accompanying
balance sheets, approximate their fair value primarily due to the short-term
and/or variable-rate nature of such financial instruments.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Costs of repairs and maintenance are
expensed as incurred. Depreciation is computed using the straight-line method
over the estimated useful lives of the underlying assets. Amortization of
leasehold improvements are computed using the straight-line method over the
shorter of the lease term or the estimated useful lives of the underlying
assets. The estimated useful lives used are as follows:
45
Computer equipment and software 3-5 years
Furniture and fixtures 5-7 years
Leasehold improvements 5 years
GOODWILL
Goodwill, which is stated at cost, is evaluated annually for impairment in
accordance with the provisions of SFAS 142. As a result of the adoption of SFAS
142, we discontinued the amortization of goodwill effective January 1, 2002.
SFAS 142 also requires companies to perform a transitional test of goodwill for
impairment as of January 1, 2002, and we completed this test during the second
quarter of 2002. Based upon the results of the test, we recorded a charge of
approximately $1.1 million in our consolidated statement of operations for the
quarter ended June 30, 2002, as a cumulative effect of a change in accounting
principle. See Note 5 for further discussion of our adoption of SFAS 142.
STOCK-BASED COMPENSATION
We account for our stock-based compensation arrangements using the intrinsic
value method under the provisions of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB No. 25), and related
interpretations.
The following table illustrates the effect on net loss and loss per share if we
had applied the fair value recognition provisions of FASB Statement 123,
Accounting for Stock-Based Compensation, using assumptions described in Note 8,
to our stock-based compensation plan
Year ended December 31,
2002 2001 2000
------------ ------------ ------------
Net loss as reported $ (1,650,793) $ (7,367,243) $ (7,544,746)
Add: Stock-based employee compensation expense included in
reported net income under APB No. 25 - - 55,718
Less: Total stock-based employee compensation expense
determined under fair value based method for awards granted,
modified or settled (870,374) (707,091) (895,243)
------------ ------------ ------------
Pro forma net loss $ (2,521,167) $ (8,074,334) $ (8,384,271)
============ ============ ============
Loss per share:
Basic and diluted as reported $(0.05) $(0.30) $(0.39)
======= ======= =======
Basic and diluted pro forma $(0.07) $(0.33) $(0.43)
======= ======= =======
RECLASSIFICATIONS
Certain reclassifications have been made to the 2001 and 2000 financial
statements to conform to the 2002 presentation.
FUTURE EFFECT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Revenue Recognition
At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF) reached a
final consensus regarding EITF 00-21, Revenue Arrangements with Multiple
Deliverables. The consensus provides that revenue arrangements with multiple
deliverables should be divided into separate units of accounting if certain
criteria are met. The consideration for the arrangement should be allocated to
the separate units of accounting based on their relative fair values, with
different provisions if the fair value of all deliverables are not known or if
the fair value is contingent on delivery of specified items or performance
conditions. Applicable revenue recognition criteria should be considered
separately for each separate unit of accounting. EITF 00-21 is effective for
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. Entities may elect to report the change as a cumulative effect adjustment
in accordance with APB Opinion 20, Accounting Changes. We have not determined
the effect of adoption of EITF 00-21 on our financial statements or the method
of adoption that we will use.
Stock-Based Compensation
In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement 148 (SFAS 148), Accounting for Stock-Based
46
Compensation -- Transition and Disclosure: an amendment of FASB Statement 123
(SFAS 123), to provide alternative transition methods for a voluntary change to
the fair value based method of accounting for stock-based employee compensation.
In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require
prominent disclosures in annual financial statements about the method of
accounting for stock-based employee compensation and the pro forma effect on
reported results of applying the fair value based method for entities that use
the intrinsic value method of accounting. The pro forma effect disclosures are
also required to be prominently disclosed in interim period financial
statements. This statement is effective for financial statements for fiscal
years ending after December 15, 2002 and is effective for financial reports
containing condensed financial statements for interim periods beginning after
December 15, 2002, with earlier application permitted. We do not plan a change
to the fair value based method of accounting for stock-based employee
compensation and have included the disclosure requirements of SFAS 148 in the
accompanying consolidated financial statements.
Accounting for Guarantees
In November 2002, FASB Interpretation 45, Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others (FIN 45), was issued. FIN 45 requires a guarantor entity, at the
inception of a guarantee covered by the measurement provisions of the
interpretation, to record a liability for the fair value of the obligation
undertaken in issuing the guarantee. FIN 45 applies prospectively to guarantees
we issue or modify subsequent to December 31, 2002, but has certain disclosure
requirements effective for interim and annual periods ending after December 15,
2002. We have not previously issued guarantees and do not anticipate FIN 45 will
have a material effect on our 2003 financial statements. However, as more fully
described in Note 13, we are currently a defendant in a complaint that alleges
we have continuing liability with respect to certain lease payments under which
the current lessee, a former affiliated practice, has ceased making payments.
This alleged liability could be deemed a guarantee of indebtedness of others in
accordance with FIN 45. Although we deny the allegations made in the complaint,
we have made disclosures in Note 13 with respect to the legal proceedings
initiated by virtue of the complaint.
3. ACCOUNTS RECEIVABLE AND MANAGEMENT FEE REVENUE
Accounts receivable consisted of the following:
DECEMBER 31
2002 2001
--------- ---------
Trade accounts receivable $ 675,514 $ 835,789
Less allowance for doubtful accounts -- 57,419
--------- ---------
$ 675,514 $ 778,370
========= =========
For the years ended December 31, 2002 and 2001, we derived a substantial amount
of our revenue from our ratings and advisory services. Furthermore, our
strategic quality initiative services accounted for 79% and 73% of total ratings
and advisory revenue for the years ending December 31, 2002 and 2001,
respectively.
4. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
DECEMBER 31
2002 2001
----------- -----------
Furniture and fixtures $ 847,147 $ 907,340
Computer equipment and software 1,750,141 1,737,939
Leasehold improvements and other 10,784 10,784
----------- -----------
2,608,072 2,656,063
Accumulated depreciation and amortization (2,504,161) (2,321,885)
----------- -----------
Net property and equipment $ 103,911 $ 334,178
=========== ===========
For the years ended December 31, 2002, 2001 and 2000, depreciation expense was
approximately $250,000, $526,000 and $707,000, respectively.
5. GOODWILL
As a result of the adoption of Statement of Financial Accounting Standards No.
142 (SFAS 142), we discontinued the amortization of goodwill effective January
1, 2002. SFAS 142 also requires companies to perform a transitional test of
goodwill for impairment as of
47
January 1, 2002, and we completed this test during the second quarter of 2002.
Based upon the results of the test, we recorded a charge of approximately $1.1
million in our consolidated statement of operations for the quarter ended June
30, 2002, as a cumulative effect of a change in accounting principle. Goodwill,
net in the accompanying consolidated balance sheet, as of December 31, 2002, is
shown net of the impairment charge described above. As of December 31, 2001,
accumulated amortization was approximately $1.7 million.
SFAS 142 describes various potential methodologies for determining fair value,
including market capitalization (if a public company has one reporting unit),
discounted cash flow analysis (present value technique) and techniques based on
multiples of earnings, revenue, EBITDA, and/or other financial measures. SFAS
142 also states that if a valuation technique is used that considers multiple
sources of information, such as an average of the quoted market prices of the
reporting unit over a specific time period and the results of a present value
technique, the company should apply that technique consistently period to period
(i.e. In the required annual impairment analysis in subsequent years).
As HealthGrades consists of only one reporting unit, and is publicly traded,
management began its fair value analysis with an evaluation of our market
capitalization. We applied a market capitalization approach by multiplying the
number of actual shares outstanding by an average market price. We applied an
additional premium of 30% to this valuation to give effect to management's best
estimate of a "control premium." As the majority of our outstanding shares were
owned by management and two venture capitalist investors, we believe a premium
of 30% is reasonable to give effect to additional benefits a purchaser would
derive from control of HealthGrades.
As our shares are very thinly traded, management believes that any analysis of
HealthGrades' fair value should include valuation techniques in addition to
overall market capitalization. We contemplated utilizing cost, market or income
approaches. However, utilization of cost or market approaches was not feasible,
particularly given the fact that HealthGrades does not fall into an easily
identifiable "peer group" of companies from which to compare valuations in the
form of price/earnings ratios, sales of similar companies, etc. Therefore
management determined to utilize an approach using the present value of expected
future cash flows as an additional valuation technique. Due to the inherent
uncertainty involved in projecting cash flows, in particular for a growth
company, management developed a range of possible cash flows and derived a
probability-weighted average of the range of possible amounts to determine the
expected cash flow.
After deriving the market capitalization and expected cash flow valuations as
described above, we then applied an equal weighting to each model to derive an
overall fair value estimate of HealthGrades. Subsequent to this valuation, we
compared the implied fair value of goodwill to the carrying amount of goodwill
to arrive at the final impairment loss calculation of approximately $1.1
million.
Application of the non-amortization provisions of SFAS 142 resulted in a
reduction of operating expenses of approximately $839,000 ($0.02 per share) for
the year ending December 31, 2002.
Net loss and net loss per share, adjusted to exclude amortization of goodwill,
are as follows:
YEAR ENDED
DECEMBER 31,
---------------------------------------------------
2002 2001 2000
----------- ----------- -----------
Reported net loss........................................... $(1,650,793) $(7,367,243) $(7,544,746)
Add: amortization of goodwill.......................... -- 838,899 816,609
----------- ----------- -----------
Pro forma adjusted net loss ................................ $(1,650,793) $(6,528,344) (6,728,137)
=========== =========== ===========
Basic and diluted loss per share
Reported net loss...................................... $(0.05) $(0.30) $(0.39)
Add back: amortization of goodwill..................... -- .03 .05
----------- ----------- -----------
Pro forma adjusted basic and diluted net loss per share .... $(0.05) $(0.27) $(0.34)
=========== =========== ===========
As required under Statement 142, we performed our annual test for impairment of
our goodwill during the fourth quarter of 2002. This test resulted in no
additional impairment to our goodwill balance. We will perform the annual
impairment test in the fourth quarter of subsequent years, or sooner, if
indicators of impairment arise at an interim date. Any impairment identified
during the annual impairment tests will be recorded as an operating expense in
our consolidated statement of operations. We expect to continue to utilize the
combined market capitalization and expected cash flow approach described above
to perform our annual impairment analysis and interim tests if necessary.
48
6. EQUITY FINANCING
On March 17, 2000, we closed an equity financing transaction (the "Equity
Financing") which raised $18 million. Pursuant to the terms of the Equity
Financing, certain investors paid $14.8 million to us in return for 7,400,000
shares of HealthGrades common stock and five-year warrants to purchase 2,590,000
shares of HealthGrades common stock at an exercise price of $4.00 per share. Net
proceeds of the Equity Financing, after payment of certain legal and other
financing fees, were approximately $14.4 million. In connection with the Equity
Financing, we also issued an aggregate of 165,000 shares to our bank syndicate
as a financing fee. We also issued a five year warrant to purchase 150,000
shares of HealthGrades common stock to a company that served as a financial
advisor to us in connection with the Equity Financing, at an exercise price of
$3.45 per share. In connection with the Equity Financing, certain of our
officers exchanged $3.2 million in notes payable for an aggregate of 1.6 million
shares of our common stock and five-year warrants to purchase 560,000 shares of
HealthGrades common stock at $4.00 per share. In accordance with the provisions
of EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion
Features or Contingently Adjustable Conversion Ratios, upon the exchange of the
notes payable, we recorded an expense of $347,200 based upon the estimated fair
market value of the warrants issued to the officers. This expense is included in
general and administrative expenses in our Consolidated Statement of Operations
for the year ended December 31, 2000.
Effective April 16, 2001, we reached an agreement with Chancellor V., L.P.
("Chancellor") and Essex Woodlands Health Ventures Fund IV, L.P. ("Essex"),
regarding a commitment (the "Commitment") to provide us with up to $2.0 million
of equity financing. Chancellor and Essex were the two principal investors in
the Equity Financing described above. In consideration for the commitment, we
issued Chancellor and Essex warrants (the "Commitment Warrants") to purchase an
aggregate of 500,000 shares of our common stock at an exercise price per share
of $0.26, which was the closing market price per share of our common stock as
reported by Nasdaq on April 16, 2001. The Commitment Warrants expire on April
16, 2007. In addition, we repriced warrants to purchase 100,000 shares of our
common stock that were issued to Chancellor and Essex in March 2000 to the same
$0.26 per share exercise price.
Under the terms of the agreement with Chancellor and Essex, we were granted the
option until December 31, 2001, to sell our common stock to Chancellor and Essex
at an aggregate purchase price of up to $2.0 million. Effective October 9, 2001,
we exercised our option to receive the entire $2.0 million. Under the terms of
the Commitment, in exchange for the $2.0 million, we issued an aggregate of
13,333,333 shares of HealthGrades' common stock to Chancellor and Essex. In
addition, we issued six-year warrants to purchase 350,000 shares of our common
stock at an exercise price per share of $0.15. See also Note 19 for a discussion
of our repurchase of our common stock and warrants from Chancellor in March
2003.
7. BANK LINE OF CREDIT
On May 13, 2002, we completed a line of credit arrangement (the "Agreement")
with Silicon Valley Bank. Under the terms of the Agreement, we may request
advances not to exceed an aggregate amount of $1.0 million over the one-year
term of the Agreement. In addition, advances under the Agreement are limited to
75% of Eligible Accounts (as defined in the Agreement) plus 50% of our cash
invested with Silicon Valley Bank. As of December 31, 2002, the entire $1.0
million is available to us. Advances under the Agreement bear interest at
Silicon Valley Bank's prime rate plus 0.75% and are secured by substantially all
of our assets. Interest is due monthly on advances outstanding and the principal
balance of any advances taken by us are due at the end of the Agreement term.
Our ability to request advances under the Agreement is subject to certain
financial and other covenants. As of December 31, 2002, we had no advances
outstanding. See also Note 19 for an update of this Agreement.
8. COMMON STOCK AND WARRANTS
We record treasury stock at cost with regard to monetary transactions and at
estimated fair value with regard to non-monetary transactions.
As of December 31, 2002, we had the following common shares reserved for future
issuance:
Awards under the 1996 Equity Compensation Plan 9,853,926
Awards under the 1996 Incentive and Non-Qualified Stock Option Plan 3,500
---------
Total shares reserved for future issuance 9,857,426
=========
In June 2000, we issued to SmallCaps Online Group, LLC five-year warrants to
purchase 20,000 shares of HealthGrades common stock at $2.00 per share, in
consideration for certain financial advisory services to be rendered to us.
49
In connection with a severance agreement with a former HealthGrades executive,
effective March 29, 2001, the former executive surrendered 250,000 shares of
HealthGrades' common stock. The cost of these shares is included as treasury
shares purchased in our Consolidated Statements of Stockholders' Equity for the
year ended December 31, 2001.
See also Note 6 for a discussion of warrants issued to certain investors and
certain HealthGrades' officers.
9. STOCK OPTION PLANS
On March 22, 1996, we adopted the 1996 Incentive and Non-Qualified Stock Option
Plan (the "Plan") under which nontransferable options to purchase up to
5,000,000 shares of HealthGrades common stock were available for award to
eligible directors, officers, advisors, consultants and key employees. On
January 10, 1997, the Board of Directors voted to terminate the Plan.
The exercise price for incentive stock options awarded during the year ended
December 31, 1996 was not less than the fair market value of each share at the
date of the grant, and the options granted thereunder had a term of ten years.
Options, which were generally contingent on continued employment with
HealthGrades, could be exercised only in accordance with a vesting schedule
established by our Board of Directors. Of the 553,500 shares underlying options
granted during the year ended December 31, 1996 at an exercise price of $1.00
per share, 3,500 shares underlying the options remain outstanding and
exercisable at December 31, 2002. The other 550,000 shares underlying options
were forfeited or exercised during 1997.
On October 15, 1996, our Board of Directors approved the 1996 Equity
Compensation Plan (the "Equity Plan"), which initially provided for the grant of
options to purchase up to 2,000,000 shares of HealthGrades common stock. The
total number of shares authorized for issuance under the Equity Plan increased
to 6,000,000 in 1998, 7,000,000 in 2000, 8,000,000 in 2001 and 13,000,000 in
2002. Both incentive stock options and non-qualified stock options may be issued
under the provisions of the Equity Plan. Employees of HealthGrades and any
subsidiaries, members of the Board of Directors and certain advisors are
eligible to participate in the Equity Plan, which will terminate no later than
October 14, 2006. Our Board of Directors or a committee of the Board of
Directors authorizes the granting and vesting of options under the Equity Plan.
As of December 31, 2002, there were 2,855,113 remaining shares available for
grant under the Equity Plan.
Pro forma information regarding net income and earnings per share is required by
SFAS No. 123 and has been determined as if we had accounted for our employee
stock options under the fair value method of that accounting pronouncement. The
fair value for options awarded during the years ended December 31, 2002, 2001
and 2000 were estimated at the date of grant using an option pricing model with
the following weighted-average assumptions: risk-free interest rate over the
life of the option of 2.2% to 5.1%; no dividend yield; and expected two to eight
year lives of the options. The Black-Scholes model was utilized to calculate the
value of the options issued. The volatility factors utilized in 2002, 2001, and
2000 were 1.91, 1.60 and 1.46, respectively.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility.
For purposes of pro forma disclosure, the estimated fair value of the options is
amortized to expense over the options' vesting period. Because compensation
expense associated with an award is recognized over the vesting period, the
impact on pro forma net (loss) income as disclosed below may not be
representative of compensation expense in future years.
A summary of HealthGrades' stock option activity and related information for the
years ended December 31 is as follows:
2002 2001 2000
------------------------ ---------------------- -----------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
---------- --------- ---------- --------- ---------- ---------
Outstanding at Beginning of 4,814,278 $ 3.68 6,537,083 $ 4.31 5,536,312 $ 6.10
Year
Granted
Exercise price equal to
fair value of common stock 6,640,759 0.09 775,333 0.39 2,682,489 1.35
Exercised -- -- (15,000) 0.70 (113,714) 0.55
Forfeited (1,597,611) 6.68 (2,483,138) 4.32 (1,568,004) 5.86
---------- ------ ---------- ------ ---------- ------
Outstanding at end of year 9,857,426 0.78 4,814,278 3.68 6,537,083 4.31
========== ========== ==========
Exercisable at end of year 6,601,970 1.07 3,365,928 4.50 3,382,639 5.13
========= ========== ==========
50
2002 2001 2000
------ ------ ------
Weighted-Average Fair Value of Options
Granted During the Year:
Exercise price equal to fair value of
common stock $ 0.08 $ 0.33 $ 1.09
Exercise prices for options outstanding and the weighted-average remaining
contractual lives of those options at December 31, 2002 are as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------------------------- -----------------------------
WEIGHTED
AVERAGE WEIGHTED- WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE
----------------- ------------- ------------- ----------- ------------- ----------
$0.05 -$0.06 658,000 9.38 $0.06 - N/A
0.10 5,737,553 9.10 0.10 3,761,025 $0.10
0.17 - 0.38 367,200 8.51 0.20 123,881 0.20
0.50 - 0.70 1,976,461 6.67 0.58 1,816,461 0.56
0.75 - 0.98 319,397 7.78 0.83 173,135 0.85
1.00 - 1.88 195,550 7.31 1.53 144,203 1.54
2.00 - 4.31 116,668 6.98 3.35 96,668 3.48
6.00 - 6.75 53,400 4.98 6.52 53,400 6.52
8.00 60,000 3.92 8.00 60,000 8.00
9.38 - 9.88 190,194 5.29 9.82 190,194 9.82
10.00 - 12.88 183,003 4.77 12.14 183,003 12.14
----------------- ----------- ---- ------- --------- ------
$ 0.05 - $12.88 9,857,426 8.30 $0.78 6,601,970 $ 1.07
=========== =========
10. SEGMENT DISCLOSURES
For the year ended December 31, 2002, substantially all of our revenue and
operating expenses are derived from our ratings and advisory business.
Therefore, for the year ended December 31, 2002, we had only one reportable
segment.
For the years ended December 31, 2001 and 2000, our reportable segments were
Physician Practice Services ("PPS") and Ratings and Advisory Revenue. PPS
derived its revenue primarily from management services provided to physician
practices. Ratings and Advisory Revenue ("RAR") is derived primarily from
marketing arrangements with hospitals and fees related to the licensing of our
content (including set-up fees).
We used net (loss) income before income taxes for purposes of performance
measurement. The measurement basis for segment assets includes intangible
assets.
For the years ended December 31, 2001 and 2000, segment information for PPS
represents the operating results for Health Grades, Inc. The RAR segment
includes the operating results for Healthcare Ratings, Inc. (HRI), our only
subsidiary with significant operations in 2001 and 2000. Effective December 31,
2002, we liquidated the HRI subsidiary. All operations that were previously
recorded in the HRI subsidiary are now being recorded in Health Grades, Inc. HRI
contained the revenue from our ratings and advisory business. Expenses of HRI
include direct salaries and wages of HRI expenses, disbursements made directly
from HRI, and depreciation recorded on HRI assets. In addition, our goodwill
amortization is included in the RAR segment information. All corporate employees
and operating expenses are included in the PPS segment. We did not perform any
expense allocation other than certain telephone and utilities expense.
51
AS OF AND FOR THE YEAR ENDED
DECEMBER 31, 2002
2001 2000
----------- -----------
PPS
Revenue from external
customers $ 551,925 $ 4,249,658
Interest income 33,588 148,464
Interest expense 28,794 471,553
Depreciation and amortization 292,566 493,811
expense
Segment net (loss) income
before income taxes (4,419,192) (3,710,587)
Segment assets 20,680,689 25,831,100
Segment asset expenditures 11,042 210,680
RAR
Revenue from external
Customers $ 3,088,451 $ 1,578,979
Interest income 56,821 363,193
Depreciation and amortization 1,072,444 1,030,206
expense
Segment net loss before
income taxes (2,948,051) (4,304,056)
Segment assets 5,283,971 6,068,902
Segment asset expenditures 3,704 207,962
REVENUE
Total for reportable segments 3,640,376 5,828,637
Other revenue 4,490 9,051
----------- -----------
Total consolidated revenue $ 3,644,866 $ 5,837,688
=========== ===========
LOSS BEFORE INCOME TAXES
Total net loss before tax for
reportable segments $(7,367,243) $(8,014,643)
Adjustment -- --
----------- -----------
Loss before income
taxes $(7,367,243) $(8,014,643)
=========== ===========
ASSETS
Total assets for reportable
segments $25,964,660 $31,900,002
Elimination of advances to
subsidiaries (10,421,736) (9,733,808)
Elimination of investment in
subsidiaries (7,795,020) (7,795,020)
----------- -----------
Consolidated total assets $ 7,747,904 $14,371,174
=========== ===========
For each of the years presented, our operations and assets were within the
United States of America.
11. LEASES
We are obligated under operating leases for our office space and certain office
equipment.
Future minimum payments under the operating leases with terms in excess of one
year are summarized as follows for the years ending December 31:
2003 $ 225,196
2004 228,832
2005 57,242
2006 21,725
2007 --
---------
Total $ 532,995
=========
Rent expense for the years ended December 31, 2002, 2001 and 2000 under all
operating leases was approximately $278,000, $272,000 and $240,000,
respectively.
52
12. INCOME TAXES
We are a corporation subject to federal and certain state and local income
taxes. The provision for income taxes is made pursuant to the liability method
as prescribed in Statement of Financial Accounting Standards No. 109, Accounting
for Income Taxes. This method requires recognition of deferred income taxes
based on temporary differences between the financial reporting and income tax
bases of assets and liabilities, using currently enacted income tax rates and
regulations.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
our deferred tax assets and liabilities at December 31, 2002 and 2001 are as
follows:
2002 2001
----------- -----------
Deferred tax assets:
Property and equipment, net $ 171,920 $ 191,295
Web development costs 54,578 87,868
Accrued liabilities 10,406 29,679
Deferred start-up expenditures 13,116 26,236
Allowance for doubtful accounts -- 23,541
Net operating loss
carryforwards 7,446,211 7,888,410
----------- -----------
7,696,231 8,247,029
Valuation allowance for deferred
tax assets (7,579,289) (8,195,339)
----------- -----------
Gross deferred tax asset 116,942 51,690
----------- -----------
Deferred tax liabilities:
Prepaid expenses 116,942 51,690
----------- -----------
Gross deferred tax liability 116,942 51,690
----------- -----------
Net deferred tax liability $ -- $ --
=========== ===========
We have established a $7,579,289 valuation allowance as of December 31, 2002.
The valuation allowance results from uncertainty regarding our ability to
produce sufficient taxable income in future periods necessary to realize the
benefits of the related deferred tax assets. During 2002, the valuation
allowance was decreased by $616,050. This reduction was principally due to our
utilization of net operating losses generated in 2001, which we were allowed to
carryback to offset taxable income of prior years pursuant to a 2002 tax law
change.
The income tax (benefit) expense for the years ended December 31, 2002, 2001 and
2000 is summarized as follows:
2002 2001 2000
------------ ---------- ----------
Current:
Federal $ (1,046,296) $ -- $ (472,897)
State -- -- 3,000
------------ ---------- ----------
$ (1,046,296) -- (469,897)
------------- ---------- ----------
Deferred:
Federal -- -- --
State -- -- --
------------ ---------- ----------
-- -- --
------------ ---------- ----------
Total $ (1,046,296) $ -- $ (469,897)
============ ========== ==========
The income tax (benefit) expense differs from amounts currently payable because
certain revenues and expenses are reported in the statement of operations in
periods that differ from those in which they are subject to taxation. The
principal differences relate to different methods of calculating depreciation
for financial statement and income tax purposes, business acquisition and
start-up expenditures that are capitalized for income tax purposes and expensed
for financial statement purposes and currently non-deductible book accruals and
reserves.
During 2002, the Job Creation and Worker Assistance Act of 2002 ("JCWA Act") was
signed into law. One of the provisions of the JCWA Act extended the net
operating loss carryback provisions of the Internal Revenue Code from two years
to five years for losses incurred in 2001 and 2002. Prior to the passage of the
JCWA Act, we did not have the ability to utilize our 2001 tax loss to reduce
prior year taxable income because we had no taxable income in 2000 or 1999.
However, with the passage of the JCWA Act, we were able to carryback our 2001
tax loss to reduce taxable income in 1997. From the carryback, we received a tax
refund of $1,046,296
53
which was recorded in 2002, in accordance with the provisions of Statement of
Financial Accounting Standards No. 109, Accounting for Income Taxes.
A reconciliation between the statutory federal income tax rate of 34% and our
(38.8%), 0.0% and (5.9%) effective tax rates for the years ended December 31,
2002, 2001 and 2000, respectively, is as follows:
2002 2001 2000
------- ------- ------
Federal statutory income tax rate (34.0)% (34.0)% (34.0)%
State income taxes, net of federal benefit (4.8) (5.1) (5.6)
Non-deductible goodwill amortization
and impairment, business acquisition
and other costs 24.6 5.3 3.7
Miscellaneous (1.7) (0.8) (2.9)
Deferred tax asset valuation allowance (22.9) 34.6 32.9
------ ----- -----
Effective income tax rate (38.8)% 0.0% (5.9)%
====== ===== =====
We have approximately $18,000,000 in net operating loss carryforwards, which
expire during 2019 through 2022. Certain changes in our stock ownership can
result in a substantial limitation on the amount of the net operating loss
carryforwards that can be utilized following an ownership change. We have
determined that we experienced such an ownership change during 2001.
Consequently, future utilization of approximately $15,000,000 of our net
operating loss carryforwards will be subject to these limitations. Additionally,
approximately $4,500,000 of the net operating loss carryforwards relate to our
former wholly-owned subsidiary, Healthcare Ratings, Inc., and are subject to
Separate Return Limitation Year ("SRLY") limitations. The SRLY limitations
permit an offset to consolidated taxable income only to the extent of taxable
income attributable to the member with the SRLY loss.
13. LEGAL PROCEEDINGS
On or about October 10, 2002, Strategic Performance Fund -- II ("SPF-II")
commenced an action in the Circuit Court of the 17th Judicial Circuit in and for
Broward County, Florida against us, alleging breach of two leases. These leases
relate to two buildings in which one of our former affiliated practices,
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
leased office space. Park Place ceased the payment of its rental obligations
with respect to the two leases in May 2000, and subsequently filed a petition
for bankruptcy, under Chapter 11 of the Bankruptcy Code, in the United States
Bankruptcy Court, Southern District of Florida, Ft. Lauderdale Division. SPF-II
is seeking damages against HealthGrades in the amount of approximately $4.7
million.
The basis of the allegation against HealthGrades is that while under the
corporate name of Specialty Care Network, Inc., we entered into an Assignment,
Assumption and Release Agreement dated July 8, 1997, under which we assumed the
obligations of Orthopaedic Management Services, Inc., as lessee, under its Lease
Agreement with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The
agreement was executed in connection with our acquisition of most of the
non-medical assets of the Park Place practice. On October 1, 1997, the owner of
the leased property sold its interests in the leasehold estates to SPF-II, Inc.
On June 10, 1999, we sold the assets of the Park Place practice, including the
leasehold interests, back to Park Place and entered into an Absolute Assignment
and Assumption Agreement with Park Place, under which Park Place agreed to
indemnify us in connection with the leasehold obligations. In addition, we
entered into an Indemnification Agreement with Park Place and its individual
physician owners, under which the individual physician owners (severally up to
their ownership interest in the practice) agreed to indemnify us in connection
with the leasehold obligations. SPF-II alleges that, notwithstanding the
assignment of our leasehold interests to Park Place, HealthGrades remains liable
for all lessee obligations under the leases.
We have filed a response to the initial complaint instituted by SPF-II, denying
all liability with respect to the subject leases. In addition, we have filed a
third-party complaint against the individual physician owners seeking
indemnification from each of these individuals under the terms of the
Indemnification Agreement. The physician owners have filed a response to our
complaint denying their liability under the Indemnification Agreement, and
asserting several affirmative defenses, including, among others, our failure to
mitigate damages, lack of consideration, our assertion of a premature claim as
liability and damages have not been established by SPF-II, rejection of the
leases by the bankruptcy court, and, in the case of one physician owner, a claim
that an "agent" of ours (who was, in fact, an employee of Park Place both before
and after our affiliation with the practice) fraudulently induced the purchase
of the Park Place practice's assets from us. The physician owners have also
filed a motion to enjoin further prosecution of the action instituted against
them by HealthGrades and Bank of America, the lender in connection with their
repurchase of the assets of the Park Place practice, pending resolution of the
bankruptcy proceeding.
54
The parties are currently engaged in a mediation process in an attempt to
resolve this matter. If the mediation is not successful, we intend to contest
our obligations under the Assignment, Assumption and Release Agreement, fully
explore SPF-II's obligations to mitigate damages and vigorously pursue our
rights against Park Place and the individual physician owners.
We are subject to other legal proceedings and claims that arise in the ordinary
course of our business. In the opinion of management, these actions are unlikely
to materially affect our financial position.
14. COMMITMENTS
We have entered into employment agreements that provide two executives with
minimum base pay, annual incentive awards and other fringe benefits. We expense
all costs related to the agreements in the period that the services are rendered
by the employee. In the event of death, disability, termination with or without
cause, voluntary employee termination, or change in ownership of HealthGrades,
we may be partially or wholly relieved of our financial obligations to such
individuals. However, under certain circumstances, a change in control of
HealthGrades may provide significant and immediate enhanced compensation to the
executives. At December 31, 2002, we were contractually obligated to pay base
pay compensation to these executives of approximately $481,000 through December
31, 2003.
15. EARNINGS PER SHARE
For the years ended December 31, 2002, 2001 and 2000, we had no dilutive
securities and therefore, basic and fully diluted earnings per share were based
upon the same number of common shares outstanding.
Options to purchase 9,857,426, 4,814,278 and 6,537,083 shares of common stock
were outstanding during 2002, 2001 and 2000, respectively, but were not included
in the computation of diluted earnings per common share for the respective years
because the effect would be antidilutive based on our net loss for the year.
16. EMPLOYEE BENEFIT PLAN
We maintain a defined contribution employee benefit plan ("the Plan"). The Plan
covers substantially all HealthGrades' employees and includes a Qualified
Non-Elective Contribution equal to 3% of annual compensation, applicable to all
eligible participants, regardless of whether or not the participant contributes
to the plan.
Expense under the benefit plan, including the Qualified Non-Elective
Contribution, aggregated approximately $114,000, $122,000 and $108,000 for 2002,
2001 and 2000, respectively.
17. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a summary of the quarterly results of operations for the years
ended December 31, 2002 and 2001. Certain reclassifications have been made to
previously reported amounts to conform to the current period presentation.
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
2002 ----------- ----------- ------------ ------------
Revenue:
Ratings and advisory $ 1,084,955 $ 1,196,017 $ 1,287,436 $ 1,523,483
Physician practice service fees 111,831 83,661 -- --
Other 2,021 670 468 16,841
----------- ----------- ----------- -----------
Total revenue 1,198,807 1,280,348 1,287,904 1,540,324
Expenses:
Cost of ratings and advisory revenue 371,237 332,882 393,347 370,631
Cost of physician practice management
revenue 19,812 15,872 16,183 39,184
----------- ----------- ----------- -----------
Gross margin 807,758 931,594 878,374 1,130,509
Operating expenses:
Sales and marketing 469,199 494,203 602,122 508,901
Product development 306,803 318,925 324,475 371,308
General and administrative 538,308 527,154 488,575 568,817
Amortization of goodwill -- -- -- --
----------- ----------- ----------- -----------
Loss from operations (506,552) (408,688) (536,798) (318,517)
Other:
55
Gain on sale of assets and other -- 141,668 6,000 100
Interest income 4,106 2,961 3,775 3,167
Interest expense -- -- -- --
----------- ----------- ----------- -----------
Loss before income taxes and
cumulative effect of a change in
accounting principle (502,446) (264,059) (527,023) (315,250)
Income tax benefit 1,046,296 -- -- --
----------- ----------- ----------- -----------
Loss before cumulative effect of a
change in accounting principle 543,850 (264,059) (527,023) (315,250)
----------- ----------- ----------- -----------
Cumulative effect of a change in
accounting principle -- (1,088,311) -- --
----------- ----------- ----------- -----------
Net loss 543,850 (1,352,370) (527,023) (315,250)
=========== =========== =========== ===========
Net income (loss) per share (basic
and diluted) $ 0.02 $ (0.04) $ (0.01) $ (0.02)
=========== =========== =========== ===========
Weighted average shares outstanding
(basic and diluted) 35,526,744 36,406,731 36,406,731 36,406,731
=========== =========== =========== ===========
2001 MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
----------- ------------ ------------ ------------
Revenue:
Ratings and advisory $ 558,862 $ 678,310 $ 893,505 $ 957,774
Physician practice service fees 136,016 136,015 135,716 143,878
Other 2,709 877 -- 1,204
------------ ------------ ------------ ------------
Total revenue 697,587 815,202 1,029,221 1,102,856
Expenses:
Cost of ratings and advisory revenue 313,549 312,998 321,575 359,803
Cost of physician practice management
revenue 79,937 403,977 273,982 --
------------ ------------ ------------ ------------
Gross margin 304,101 98,227 433,664 743,053
Operating expenses:
Sales and marketing 844,892 805,829 883,048 693,829
Product development 410,863 371,036 380,897 315,275
General and administrative 1,145,459 1,271,974 773,740 464,077
Amortization of goodwill 209,725 209,724 209,725 209,725
------------ ------------ ------------ ------------
Loss from operations (2,306,838) (2,560,336) (1,813,746) (939,853)
Other:
Gain on sale of assets and other 325 -- (29) 191,619
Interest income 54,566 23,642 6,756 5,445
Interest expense (28,563) (231) -- --
------------ ------------ ------------ ------------
Loss before income taxes and
cumulative effective of a change in
accounting principle (2,280,510) (2,536,925) (1,807,019) (742,789)
Income tax benefit -- -- -- --
------------ ------------ ------------ ------------
Net loss (2,280,510) (2,536,925) (1,807,019) (742,789)
============ ============ ============ ============
Net loss per share (basic and diluted) $ (0.11) $ (0.12) $ (0.08) $ (0.02)
============ ============ ============ ============
Weighted average shares outstanding
(basic and diluted) 21,507,758 21,273,425 21,273,425 33,447,338
============ ============ ============ ============
18. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental noncash investing and financing activities are as follows:
In 2000, we received 888,779 shares of our common stock under the terms of a
settlement agreement with one of our former affiliated practices.
In February 2000, we merged a majority-owned subsidiary, HG.com, Inc. into a
recently formed, wholly-owned subsidiary, HealthCare Ratings, Inc. (the "Merger
Transaction"). In connection with the Merger Transaction, the minority
shareholders of HG.com were given 800,000 shares of HealthGrades common stock.
In March 2000, certain of our officers exchanged $3.2 million in notes payable
for an aggregate of 1.6 million shares of HealthGrades common stock and
five-year warrants to purchase 560,000 shares of HealthGrades common stock at
$4.00 per share.
56
19. SUBSEQUENT EVENTS
Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003,
between Chancellor and us, we repurchased from Chancellor 12,004,333 shares of
our common stock and warrants to purchase 1,971,820 shares of our common stock
for a total purchase price of $500,000. Chancellor initially acquired the common
stock and warrants from us in two private transactions in 2000 and 2001.
Immediately prior to the repurchase, Chancellor's ownership of HealthGrades
common stock represented 33% of our outstanding common stock, and Chancellor's
ownership of HealthGrades common stock and warrants represented 36% of our total
outstanding common stock (assuming full exercise of the warrants held by
Chancellor, but assuming no exercise of any other warrants or options).
Effective March 11, 2003, we executed an amendment to our line of credit
arrangement with Silicon Valley Bank. The terms of the amendment provide for an
extension of the maturity date of the $1,000,000 line of credit arrangement to
February 20, 2004. To date, we have not borrowed any funds under the line of
credit. In addition, the amendment provides for a term loan of $500,000. The
term loan accrues interest at 5.94% and requires us to pay twenty-four equal
installments of principal and interest over the term, beginning on April 1,
2003. We have the ability, at our option, to prepay all, but not less than all,
of the term loan without penalty after August 21, 2003, provided we give Silicon
Valley Bank at least thirty days written notice prior to such repayment.
57
Health Grades, Inc. and Subsidiaries
Schedule II -- Valuation and Qualifying Accounts
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD
------------------------------- ---------- ---------- ---------- ---------------- ----------
Year ended December 31, 2002
Allowance for doubtful
accounts on trade
receivables $ 57,419 $ -- $ -- $ (57,4719)(1) $ --
Year ended December 31, 2001
Allowance for doubtful
accounts on management fee
receivables $ 231,895 $ -- $ -- $ (231,895)(1) $ --
Allowance for doubtful
accounts on trade
receivables $ 80,183 $ 85,319 $ -- $ (108,083)(1) $ 57,419
Year ended December 31, 2000
Allowance for contractual
adjustments and doubtful
accounts on receivables
due from affiliated
Physician practices in
litigation $ 839,032 $ -- $ -- $ (839,032)(2) $ --
Allowance for doubtful
accounts on management fee
receivables $1,434,073 $ 35,090 $ -- $ (357,876)(1) $ 231,895
$ (879,392)(2)
Allowance for doubtful
accounts on trade
receivables $ -- $ 80,183 $ -- $ -- $ 80,183
(1) Represents actual amounts charged against the allowance for the periods
presented.
(2) Sold in conjunction with disposition of restructured affiliated practices.
F-1
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
3.1 Certificate of Amendment of Amended and Restated
Certificate of Incorporation and Amended and Restated
Certificate of Incorporation (incorporated by
reference to Exhibit 3.1 to our Annual Report on Form
10-K for the year ended December 31, 2001.)
3.2 Amended and Restated Bylaws (incorporated by
reference to Exhibit 3.2 to our Annual Report on Form
10-K for the year ended December 31, 2001.)
10.1* 1996 Equity Compensation Plan, as amended
10.2.1 Loan and Security Agreement by and between Health
Grades, Inc., Healthcare Ratings, Inc.,
ProviderWeb.net, Inc., and Silicon Valley Bank
(incorporated by reference to Exhibit 10.1 to our
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2002.)
10.2.2 Loan Modification Agreement by and between Health
Grades, Inc. and Silicon Valley Bank
10.3 Stock and Warrant Repurchase Agreement
10.4* Employment Agreement dated as of April 1, 1996 by and
between Specialty Care Network, Inc. and Kerry R.
Hicks (incorporated by reference to Exhibit 10.3 to
the Company's Registration Statement on Form S-1
(File No. 333-17627))
10.5.1* Employment Agreement between Specialty Care Network,
Inc. and David Hicks, dated March 1, 1996
(incorporated by reference to Exhibit 10.8 to the
Company's Registration Statement of Form S-1 (File
No. 333-17627))
10.5.2* Amendment to Employment Agreement between Specialty
Care Network, Inc. and David Hicks, dated December 2,
1997. (incorporated by reference to Exhibit 10.8.1 to
the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997)
23.1 Consent of Grant Thornton LLP
23.2 Consent of Ernst & Young LLP
99.1 Certificate of the Chief Executive Officer of Health
Grades, Inc. pursuant to Title 18, Section 1350 of
the United States Code.
99.2 Certificate of the Chief Financial Officer of Health
Grades, Inc. pursuant to Title 18, Section 1350 of
the United States Code.
* - Constitutes a management contract, compensatory plan or arrangement
required to be filed as an exhibit to this report.