Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS

13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

OR

For the transition period from                      to                     

Commission File Number: 1-13263

CASTLE DENTAL CENTERS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

(State or other jurisdiction of incorporation or organization)

76-0486898

(I.R.S. Employer Identification No.)

3701 Kirby Drive, Suite 550

Houston, Texas

(Address of principal executive offices)

77098

(Zip Code)

(713) 490-8400

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $.000001 Par Value

(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 the 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 definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes. ¨ No. x

The aggregate market value of the voting and non-voting common equity held by non-affiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, was $2.7 million. As of March 29, 2004, issued and outstanding voting stock of Castle Dental Centers, Inc. consisted of 8,265,323 shares of Common Stock, $.000001 par value; 195,838 shares of Series A-1 Preferred Stock, par value $.000001, convertible into 35,776,356 shares of Common Stock, and; 79,190 shares of Series B Preferred Stock, par value $.000001, convertible into 165,022,853 shares of Common Stock. The total equivalent shares of Common Stock, issued and outstanding at March 29, 2004, was 209,064,532 shares.

Documents Incorporated by Reference: None

Table of Contents

TABLE OF CONTENTS

i

Table of Contents

NOTE ON FORWARD-LOOKING STATEMENTS

This Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included in this Form 10-K are forward-looking statements. When used in this document, the words, “anticipate,” “believe,” “estimate” and “expect” and similar expressions are intended to identify such forward-looking statements. Such statements reflect the Company’s current views with respect to future events and are subject to certain uncertainties and assumptions. Important factors that could cause actual results to differ materially from expectations (“Cautionary Statements”) are disclosed in this Form 10-K, including without limitation in conjunction with the forward-looking statements included in this Form 10-K. Should one or more of these uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from expectations. All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by the Cautionary Statements.

ii

Table of Contents

The Company

The Company manages and operates integrated dental networks through contractual affiliations with general, orthodontic and multi-specialty dental practices in the United States. The Company currently conducts operations in the states of Texas, Florida, Tennessee and California. The Company does not engage in the practice of dentistry but rather establishes integrated dental networks by entering into management services agreements with affiliated dental practices to provide, on an exclusive basis, management and administrative services to affiliated dental practices. The Company seeks to achieve operating efficiencies by consolidating and integrating affiliated practices into regional networks, realizing economies of scale in such areas as marketing, administration and purchasing and enhancing the revenues of its affiliated dental practices by increasing both patient visits and the range of specialty services offered. As of March 15, 2004, the Company provided management services to 74 dental centers with approximately 158 affiliated dentists, orthodontists and other dental specialists.

The Company’s objective is to make each of its dental networks the leading group dental care provider in each market it serves. Since its formation, the Company has applied traditional retail principles of business and marketing techniques to the practice of dentistry, including locating practices in high-profile locations, offering more affordable fees and payment plans, expanding the range of services offered, increasing market share through targeted advertising and offering extended office hours. By using the Castle Dental Centers’ approach to managing affiliated dental practices, the Company believes it enables affiliated dentists, orthodontists and other dental specialists to focus on delivering quality patient care and realize significantly greater productivity than traditional individual and small-group dental practices.

The Company believes that the provision of a full range of dental services through an integrated network is attractive to managed care payers and intends to continue to pursue managed care contracts. The Company negotiates capitated managed care contracts on behalf of its affiliated dental practices, which maintained capitated managed care contracts covering approximately 136,000 members at December 31, 2003. The Company believes that the continued development of its networks will assist it in negotiating national and regional capitated arrangements with managed care payors on behalf of the affiliated practices.

The Company intends to establish a consistent national identity for its business by implementing common practice management policies and procedures in all of its dental centers and affiliated dental practices nationwide. Moreover, the Company believes that its experience and expertise in managing multi-specialty dental group practices, as well as the development of name recognition associated with the name “Castle Dental Centers” will provide its affiliated dental practices with a competitive advantage in attracting and retaining patients and realizing practice efficiencies.

The Company was formed in 1981 as a single location, multi-specialty dental practice in Houston, Texas. From 1982 through 1996, the Company expanded to a total of 10 locations with 39 dentists in the Houston metropolitan area. During this period the Company developed, implemented and refined the integrated dental network approach that it utilized as a basis for its expansion. In the period from 1996 through the first half of 2000, the Company expanded through the acquisition of dental practices and the development of new (“de novo”) dental centers in its markets. Practices were acquired in Tennessee, Florida, Austin, Fort Worth and San Antonio in Texas, and in Los Angeles, California. A total of 33 de novo dental centers were opened during this period while 8 dental centers were closed or consolidated in 1999 and 2000. From 2001 through 2003, as part of its restructuring and cost reduction program, the Company closed, consolidated or sold 26 dental centers, 11 of which were de novo centers that had been built in 1998 and 1999. At March 15, 2004, the Company operated 47, 10, 12 and 5 dental centers in Texas, Tennessee, Florida and California, respectively.

1

Table of Contents

Recent Developments

On May 15, 2003, the Company entered into a series of agreements to restructure certain of its outstanding debt and equity (the “2003 Restructuring”). As of May 14, 2003, the Company had $46.7 million outstanding under a bank agreement (the “Old Credit Agreement”) with its senior secured lenders, a bank group that included, among other banks Bank of America Strategic Solutions, Inc. (“BofA”) and GE Capital Corporation (“GECC”), (collectively, the “Senior Secured Lenders”), of which $38.3 million was due the Senior Secured Lenders excluding GECC. In addition, at May 14, 2003, the Company had outstanding $1.9 million in principal and accrued interest under 15% convertible notes (“Senior Notes”) due Heller Financial, Inc. (“Heller”), Midwest Mezzanine Fund II, L.P. (“Midwest”) and the Company’s Chief Executive Officer at the time, James Usdan (collectively “Senior Subordinated Lenders”). The Restructuring transaction consisted of the following:

As a result of these transactions, the total equivalent shares of Common Stock, issued and outstanding at December 31, 2003, was 209.1 million. Sentinel owns more than 50% of the voting stock of the Company and therefore is the controlling stockholder of the Company.

In connection with the 2003 Restructuring, the Company entered into a management agreement with Sentinel (“Sentinel Management Agreement”), whereby Sentinel is to provide various strategic financial planning, advisory and consulting services to the Company. In consideration of the services provided by Sentinel, an annual consulting fee of $275,000 is payable quarterly in advance on the last business day of each February, May, August and November. The consulting fee increases to $300,000 annually after the date that the Company’s EBITDA (as defined in the Credit Agreement) exceeds $10.0 million for the preceding twelve months. Unless earlier terminated by the parties, the Sentinel Management Agreement will remain in effect as long as Sentinel owns stock of the Company. If, during the term of the Sentinel Management Agreement, Sentinel holds less than 50% of the shares of Company Common Stock held by Sentinel on a fully diluted basis as of May 15, 2003, the fees payable to Sentinel will be prorated based on the number of

2

Table of Contents

fully diluted shares of Company Common Stock held by Sentinel on such date. Pursuant to the terms of the Sentinel Management Agreement, the Company paid Sentinel approximately $0.5 million at closing for consulting services related to the 2003 Restructuring.

The Dental Industry

Dental care services in the United States are delivered through a fragmented system of local providers, primarily sole practitioners, or small groups of dentists, orthodontists or other dental specialists, practicing at a single location with a limited number of professional assistants and business office personnel. According to the American Dental Association 2002 Survey of Dental Practice (“ADA Survey”), in 2002, there were approximately 153,000 actively practicing dentists in the U.S., of which approximately 8,900 were orthodontists. Nearly 80% of the nation’s private practitioners work either as sole practitioners or in a practice with one other dentist. Since 1991, the number of dentists practicing in groups has grown from 4% to 20% of all dentists, as the practice of dentistry becomes more complex and the investment required to open a practice increased. Dental, orthodontic and other specialty practices have followed the trend of the health care industry generally and are increasingly forming larger group practices.

As the trend towards consolidation is expected to continue, the number of dentists graduating from dental schools has been falling, from a peak of 6,300 annually in the 1970’s to 4,200 in recent years. This is leading to an increase in the average age of dental practitioners. In addition, the character of the graduating dentist is changing, with women comprising about 40% of graduating classes compared to less than 5% thirty years ago. The combination of increasing demand for dental services and the slow growth in the number of practicing dentists should result in a positive pricing environment for dental services over the next decade. The tightening supply of dentists will create more competitive recruiting and higher compensation for qualified dentists.

The annual aggregate domestic market for dental services was estimated by the Health Care Financing Administration, Health Care Financing Review (1999) to be approximately $65.4 billion for 2001, and is projected to reach $109 billion by 2010. Within the total market for dental services in the United States, there are, in addition to general dentistry, a number of specialties, including orthodontics (the straightening of teeth and remedy of occlusion), periodontics (gum care), endodontics (root canal therapy), oral surgery (tooth extraction) and pedodontics (care of children’s teeth). The dental services market has grown at a compound annual growth rate of approximately 8% from 1980 to 2000, and is projected to grow at a compound annual growth rate of approximately 6.1% through the year 2010. In contrast to other health care expenditures, dental services are primarily paid for by the patient. According to the U.S. Department of Health and Human Services, in 1998, consumer out-of-pocket expenditures accounted for 48% of the payment for dental services, compared to 16% for other medical services.

Management believes that the growth in the dental industry has largely been driven by four factors: (i) an increase in the availability and types of dental insurance as employers have added dental benefits to employee healthcare programs; (ii) an increasing demand for dental services from an aging population as people live longer and retain their teeth throughout their lives; (iii) the evolution of new technology which has made dental care less traumatic; and (iv) an increased focus on preventive and cosmetic dentistry.

Concerns over the accelerating cost of health care have resulted in the increasing importance of various forms of insurance coverage in the dental industry. The National Association of Dental Plans (“NADP”) estimates that some form of dental care plan covered 162 million people, or about 57% of the U.S. population in 2000, compared to 47% of the population that had such coverage in 1995. These plans include traditional indemnity insurance, preferred provider (“PPO”) plans, capitated managed care (“DHMO”) plans, and referral plans. Patients covered by indemnity insurance plans typically are charged the same fees for dental services that are charged to uninsured patients, with insurance generally paying for 50% to 80% of covered procedures. Under a PPO plan, the dentist charges a discounted fee for each service based on a fee schedule negotiated with the insurance provider. Capitated managed care (“DHMO”) plans provide a fixed monthly fee for each enrolled member that selects the dentist as his or her dental care provider, plus supplemental or patient co-payments based on the type of service provided. Referral plans are not insurance

3

Table of Contents

products but are a network-based product that provides dental care at a discounted guaranteed rates and usually charge the subscriber a monthly fee. According to the NADP, of the estimated 162 million people covered by dental benefits in 2000, approximately 37% were covered by indemnity plans, 34% were covered by PPO plans, 17% were enrolled in capitated managed care programs, including government (Medicaid) programs and 12% were enrolled in referral plans. The highest growth in dental insurance benefits has come in PPO and referral plans that have increased enrollment from 23 million members in 1995 to 76 million members in 2000. Growth in managed care plans, on the other hand, slowed in 1997 and enrollment of approximately 27 million members has grown by only 5.3% per year since 1995. Growth in PPO plans should continue as employers switch from traditional indemnity insurance benefits to lower cost PPO programs. As a result, enrollment in traditional indemnity plans actually decreased by 4.8% per year from 1995.

Business Strategy

The Company’s strategy is to develop integrated networks for the provision of a broad range of dental services that provide high-quality, cost-effective dental care in target markets. Key elements of this strategy are to:

Provide High-Quality, Comprehensive, One-Stop Family Dental Health Care. The prototypical Castle Dental Center provides general dentistry as well as a full range of dental specialties (including orthodontics, pedodontics, periodontics, endodontics, oral surgery and implantology), thereby allowing the majority of specialty referrals to remain in-house within the Company’s network of facilities. By bringing together multi-specialty dental services within a single practice, the Company is able to realize operating efficiencies and economies of scale and to promote increased productivity, higher utilization of professionals and facilities, and the sharing of dental specialists among multiple locations. The Company’s practice model also incorporates quality assurance and quality control programs, including peer review and continuing education and technique enhancement. The Company believes that its multi-specialty strategy differentiates it from both individual and multi-center practices that typically offer only general dentistry, orthodontics or other single specialty dental services.

Develop Comprehensive Dental Networks in Target Markets. The Company seeks to consolidate and integrate its affiliated practices to establish regional dental care networks. The Company believes this network system will enable it to reduce the operating costs of its affiliated practices by centralizing certain functions such as telemarketing and advertising, billing and collections, payroll and accounting and by negotiating regional and national contracts for supplies, equipment, services and insurance. Once practice affiliations are established in a market, the Company seeks to assist the affiliated practices in expanding their range of services to make available specialty dental services not previously offered.

Apply Traditional Retail Principles of Business to Dental Care. The Company believes it can enhance revenues and profitability by applying traditional retail principles of business to the provision of dental services in its target markets. These principles include professionally produced broadcast and print advertisements targeting specific audiences, and extended hours of operation which are convenient for patients, including weekend and evening hours. As part of its retail-oriented strategy, the Company seeks to establish or, where appropriate, relocate each Castle Dental Center in a convenient location in or near a high-profile neighborhood retail area and utilizes innovative sales and marketing programs designed to create strong name recognition and increase patient visits. In addition, the Company stresses the breadth and affordability of its services and works closely with patients to establish treatment schedules and affordable payment plans tailored to the patients’ needs.

Dental Network Development

Prior to 1999, the Company expanded into new markets through the acquisition of multi-location group dental practices. Once the market entry acquisition was made, the Company expanded within its target markets primarily through the de novo development of new dental centers. During 1999 and 2000, the Company expanded solely through the development of de novo centers and did not complete any acquisitions of dental practices. In 2000, four de novo dental centers were opened, four dental centers were closed and two dental centers in Houston were consolidated into a new dental center. The Company developed no new

4

Table of Contents

dental centers in 2001, 2002 and 2003. Between January 1, 2001 and December 31, 2003, as part of its restructuring and cost reduction program, the Company closed, sold or consolidated 26 unprofitable or under performing dental centers, 11 of which were de novo centers that had been built in 1998 and 1999.

De novo Development

The Company has opened 33 newly developed dental centers since 1997; seven in Houston, four in Austin, five in Dallas/Fort Worth, five in San Antonio, two in Corpus Christi, Texas, seven in Nashville, Tennessee and three in the Tampa/Clearwater area in Florida. All of the new centers were located in leased facilities in neighborhood retail shopping centers areas. Development of each de novo dental center cost approximately $330,000 in leasehold improvements, signage, and dental and office equipment, depending primarily on the size of the dental facility. All new dental centers in the Company’s existing markets utilize the Castle Dental Centers name and logo. Six of the de novo dental centers were closed in 2001, two were closed and three were sold in 2002 and two were closed and one was sold in 2003 as part of the restructuring and cost reduction programs that were implemented in 2001 and 2002. The Company is continually monitoring the performance of all its dental centers to determine if additional closings will be necessary.

The Company expanded through development of de novo dental centers in existing markets because management believes that opening new dental centers that conform to the Company’s operating model is more effective in creating brand awareness and increasing market share in existing markets than acquiring dental practices that have different operating characteristics. In addition, the cost of building and equipping a new dental center has generally been less than the cost of acquiring dental centers. Due to the lack of capital necessary for continued expansion, the Company ceased development of new dental centers in early 2000, and did not have any centers under construction at December 31, 2003. The Company anticipates that it will open 2 additional dental centers in 2004, relocate three dental centers into newly built facilities and will refurbish other dental centers.

Management Services Agreement

The Company has entered into a management services agreement with each of its affiliated dental practices pursuant to which the Company becomes the exclusive manager and administrator of all non-dental services relating to the operation of the practice. The amount of the management fee charged by the Company to an affiliated dental practice is intended to reflect and is based on the fair value of the management services rendered by the Company to the affiliated dental practice. Subject to applicable law, the management fee earned by the Company, except for the professional corporation located in California, is generally comprised of three components: (i) the costs incurred by it on behalf of the affiliated dental practice; (ii) a base management fee ranging from 12.5% to 20.0% of net patient revenues; and, (iii) a performance fee equal to the net patient revenues of the affiliated dental practice less (a) the expenses of the affiliated dental practice and (b) the sum of (i) and (ii), as described in each agreement. In California, the Company is paid a monthly management fee comprised of two components: (i) the costs incurred by it on behalf of the affiliated practice and (ii) a management fee in an amount of 30.0% of net patient revenues; plus a bonus equal to 30.0% of net patient revenues in excess of average monthly patient revenues over the prior two-year period. The amount of the management fee is reviewed by the Company and the affiliated dental practice at least annually in order to determine whether such fee should be adjusted to continue to reflect the fair value of the management services rendered by the Company.

The obligations of the Company under its management services agreements include assuming financial and other responsibility, for the following (subject to limitations imposed by applicable state law): facilities, equipment and supplies; advertising, marketing and sales; training and development; operations management; provision of support services; risk management and utilization review; application and maintenance of applicable local licenses and permits; negotiation of contracts between the affiliated dental practice and third parties, including third-party payors, alternative delivery systems and purchasers of group health care services; establishing and maintaining billing and collection policies and procedures; fiscal matters, such as annual budgeting, maintaining financial and accounting records, and arranging for the preparation of tax returns; and maintaining insurance. The Company does not assume any authority, responsibility, supervision or control over the provision of dental services to patients or for diagnosis,

5

Table of Contents

treatment, procedure or other health care services, or the administration of any drugs used in connection with any dental practice.

The typical management services agreement is for an initial term of 25 years, and is automatically renewed for successive five-year terms unless terminated at least 90 days before the end of the initial term or any renewal term. As part of the management services agreement, the Company requires that the majority shareholder of the affiliated dental practice execute an option agreement that grants the Company’s designee the right to acquire all the shareholder’s interest in the practice at a nominal cost. Upon the occurrence of certain events, the Company can exercise the option at any time with 10 days written notice. The Company may nominate without restriction any licensed dentist as its designee and may transfer the option at any time to any qualified person, subject to applicable state regulations governing the practice of dentistry. The management services agreement does not limit the number of times that the option may be exercised. At December 31, 2003, each of the Company’s affiliated dental practices was wholly owned by an individual dentist. Additionally, the management services agreement may be terminated by the Company or the affiliated dental practice only in the event of default in the performance of the material duties of the non-terminating party.

Dentist Employment Agreements

Each affiliated dental practice has entered into employment agreements with substantially all of its full-time dentists, orthodontists and other dental specialists. Although the form of contract varies somewhat among practices and among dentists with different specialties, the typical contract for a full-time dentist provides for a defined compensation arrangement, including performance-based compensation and, where market conditions permit and to the extent deemed enforceable under applicable law, a covenant not to compete. Each full-time dentist, whether or not a party to a dentist employment agreement, is required to maintain professional liability insurance, and mandated coverage limits are generally at least $1.0 million per claim and $3.0 million in the aggregate. In addition, many affiliated dental practices employ part-time dentists. Not all part-time dentists have employment agreements, but all part-time dentists are required to carry professional liability insurance in specified amounts. Certain part-time dentists retained by some of the affiliated dental practices are independent contractors and have entered into independent contractor agreements.

Services

The Company provides management expertise, marketing, information systems, capital resources and acquisition services to its affiliated dental practices. As a result, the Company is involved in the financial and administrative management of the affiliated dental practices, including legal, financial reporting, cash management, human resources and insurance assistance. The Company’s goals in providing such services are (i) to allow the dentists associated with affiliated dental practices to dedicate their time and efforts more fully to patient care and professional practice activities; (ii) to improve the performance of affiliated dental practices in these administrative and sales activities; and (iii) to enhance the financial return to the Company.

Aside from the centralization of functions mentioned above, the affiliated dental practices are encouraged to administer their practices in accordance with the needs of their specific patient populations. The practice of dentistry at each affiliated dental practice is under the exclusive control of the dentists who practice at those locations.

The majority of services provided by the Company’s affiliated dental practices are classified as general dentistry. General dentistry includes diagnostics, treatment planning, preventive care, removal of infection, fillings, crowns, bridges, partials, dentures, and extractions, all of which are currently being provided by the affiliated dental practices. Within its networks, the Company provides a wide range of specialty dental services. The Company seeks to expand the services offered by affiliated practices beyond general dentistry to include other dental specialty services and to improve efficiency by improving appointment availability, increasing practice visibility and assisting the practices in adding complementary services. These complementary services include orthodontics, periodontics (the diagnosis, treatment and prevention of infection of the gums and supporting bone around the teeth), endodontics (the diagnosis, treatment and prevention of infection of the oral tissues), oral surgery and implantology (the placement of abutments

6

Table of Contents

(implants) in the jaw bones to support tooth replacement). By adding these complementary services to the practice, the affiliated dental practices will retain the majority of specialty service referrals in-house, thereby increasing patient revenues.

Operations

Center Design and Location

The Company’s dental centers are generally located in retail environments. Many of the dental centers include semi-private general dentistry treatment rooms, private treatment rooms and orthodontic bays. Currently, the Company’s dental centers include from four to 22 treatment rooms and range in size from approximately 1,000 square feet to approximately 6,000 square feet. New dental centers, developed by the Company, range in size from 2,400 square feet to 4,000 square feet, and have from six to fourteen operatories.

Since its formation, the Company has adapted its locations to accommodate the full range of dental specialties, where feasible. The Company believes the application of its method of designing and locating dental centers will facilitate the expansion of services offered by the acquired practices. Where a dental center is not able, due to limitations of floor space, zoning or other reasons, to accommodate new services or specialists, the Company may seek to relocate such dental center to a more desirable retail location as soon as practicable.

Staffing and Scheduling

The Company believes that making its facilities available at times which are convenient to its patients is an important element of its strategy. As a result, the affiliated dental practices maintain extended hours of operation, with some dental centers opening as early as 8:00 a.m. and closing as late as 9:00 p.m. on weekdays and 5:00 p.m. on Saturdays. The dental centers are staffed with dentists and dental assistants every day they are open, with orthodontists and other specialists rotating among several centers in order to utilize their time optimally. Each patient typically is assigned to and sees the same dentist or specialist on all visits to the center. Each dental center is also regularly staffed with an office manager, front office staff and other support staff.

Fees and Payment Plans

The Company believes that fees charged by its affiliated practices are typically lower than usual and customary fees within their respective markets. The affiliated practices generally provide a wide range of payment options, including cash, checks, credit cards, third party insurance and various forms of credit. In general, most general dentistry and specialty services, other than orthodontics, are paid for by the patient, or billed to the patient’s insurance carrier, on the date the service is rendered. In some instances, the Company will extend credit in accordance with its established credit policies. The Company believes that its lower fees and ability to assist patients in obtaining financing provides it with a competitive advantage compared to sole practitioners and small group practices.

The Company’s typical orthodontic payment plan consists of no initial down payment and equal monthly payments during the term of treatment of $98 to $109 per month, with an average contract period of approximately 26 – 30 months. After consultation with the orthodontic staff at the initial visit, the patient signs a contract outlining the terms of the treatment, including the anticipated length of treatment and the total fees. The number of required monthly payments is fixed at the beginning of the case and corresponds to the anticipated number of monthly treatments. The Company maintains a payment policy requiring that new orthodontic patients arrange for an automatic monthly bank draft.

Quality Assurance

Affiliated dental practices are solely responsible for all aspects of the practice of dentistry. The Company has responsibility for the business and administrative aspects of the practices and exercises no control over the provision of dental services. The Company’s management structure is designed to assist its affiliated dental practices in their recruiting and professional training. The Company expects that the increased visibility of the Company, the ability to offer career paths previously unavailable to dentists and the ability to

7

Table of Contents

recruit for multiple markets will give it an advantage in recruiting and retaining dentists. In addition, the Company believes that the ability to offer dentists in private practice the chance to practice in an environment where they do not assume capital risks and administrative burdens normally associated with private practice will make joining the Company an attractive choice for private practitioners.

Sales and Marketing

Since its founding, the Company has applied retail-marketing concepts to the practice of dentistry. This strategy has been based on the relatively high level of patient payments (as opposed to insurance and other third-party payers), the discretionary nature of many procedures such as cosmetic dentistry and orthodontics and the large number of uninsured patients that require dental treatment. These principles include network development and densification within markets, common branding of all dental centers utilizing the Castle Dental logo and trademark, extended hours of operation, location optimization, consistent signage, affordable fees and payment plans. The Company uses both print advertising and professionally produced broadcast advertising to market its dental services to potential patients in its markets. As part of its retail-oriented strategy, the Company seeks to establish or, where appropriate, relocate each of its dental centers in a convenient location in or near a high-profile neighborhood retail area and utilize marketing programs designed to create strong name recognition and increase patient visits. In addition, the Company stresses the breadth and affordability of its services and works closely with patients to establish treatment schedules and affordable payment plans tailored to the patients’ needs.

The Company has also established a national telemarketing system in Houston, Texas to field calls generated by advertising, to confirm upcoming scheduled patient visits and to encourage patients to return for follow-up visits. The national telemarketing system is based on a national 800 number (1-800-TO SMILE) and utilizes state-of-the-art software to identify patients and direct them to the nearest Company operated dental center. The telemarketers can enter all relevant information into the practice management information system for patients making appointments for an initial visit, including pre-screening patients for insurance and other credit information.

Managed Care Contracts

The Company negotiates contracts with dental healthcare maintenance organizations, insurance companies, self insurance plans and other third-party payers pursuant to which services are provided on some type of discounted fee-for-service or capitated basis. Under capitated contracts the affiliated dental practice receives a predetermined amount per patient per month in exchange for providing certain necessary covered services to members of the plan. Usually, the capitated plans also provide for supplemental payments and/or co-payments by members for certain higher cost procedures such as crowns, root canal therapy and dentures. These contracts typically result in lower average fees for services than the usual and customary fees charged by the Company and may, in certain instances, expose the Company to losses on contracts where the total revenues received are less than the costs of providing such dental care. However, most of these contracts are cancelable by either party on 60 to 90 days written notice, thereby reducing the risk of long-term adverse impact on the Company.

Because of the rapid growth of capitated managed care plans in the 1990’s, the Company increased its participation in such plans by negotiating national agreements with major managed care plans. As a result, the number of members enrolled at Castle Dental offices increased from 55,000 in 1997 to approximately 172,000 in 2001. As a result of the reduction in dental offices since 2001, and the limits placed on additional managed care enrollment by the Company, the number of managed care members had fallen to approximately 136,000 by the end of 2003.

At December 31, 2003, the Company and its affiliated dental practices maintained capitated managed care contracts covering approximately 136,000 members. Capitation fees, including supplemental fees and excluding co-payments by members, totaled $8.2 million, or approximately 8.7% of net patient revenues in 2003. One managed care contract with a national insurance company accounted for $6.5 million in revenues ($2.8 million in capitation payments and $3.7 million in patient co-payments) in 2003, equal to 6.9% of total net patient revenues. The Company periodically evaluates its capitated managed care contracts by comparing

8

Table of Contents

the average reimbursement per procedure plus the total capitation fees per contract to the usual and customary fees charged by the affiliated dental practice. If the aggregate reimbursement percentage for the capitated contract exceeds 50% of the usual and customary fees, the Company believes that the incremental costs of providing covered services are being recovered. Management believes that capitated managed care contracts, in the aggregate, are profitable, however, the Company periodically reviews its contracts with managed care companies in order to improve the financial performance of these plans and to limit the growth of enrolled members in such plans.

Competition

The dental care industry is highly fragmented, comprised principally of sole practitioners and group practices of dental and orthodontic services. The dental practice management industry is subject to continuing changes in the provision of services and the selection and compensation of providers. The Company is aware of several dental practice management companies, both publicly-traded and privately owned, that it competes with in its markets. Publicly traded dental practice management companies that compete with the Company include American Dental Partners, Inc., Interdent, Inc., Coast Dental Services, Inc., and Orthodontic Centers of America, as well as others. Certain of these competitors are larger and better capitalized, may provide a wider variety of services, may have greater experience in providing dental care management services and may have longer established relationships with buyers of such services.

In certain markets, the demand for dental care professional personnel presently exceeds the supply of qualified personnel. As a result, the Company experiences competitive pressures for the recruitment and retention of qualified dentists to deliver their services. The Company’s future success depends in part on its ability to continue to recruit and retain qualified dentists to serve as employees or independent contractors of the affiliated dental practices. There can be no assurance that the Company will be able to recruit or retain a sufficient number of competent dentists to continue to expand its operations.

Management Information Systems

The Company uses an integrated dental practice management system in all its dental centers, provided by a third party, that is located in Houston. This system monitors and controls patient treatment, scheduling, invoicing of patients and insurance companies, productivity of clinical staffs and other practice related activities. The Company also has implemented a web-based purchase order system to enable management to monitor and control dental and office supplies purchasing.

The Company also utilizes centralized financial information and accounting systems. These systems are linked to the practice management system allowing for automatic transfer of certain data between the practice management and financial information systems.

In 2004, the Company plans to upgrade and improve its financial information and accounting systems, convert its purchase order system to a sequel based platform and to determine the feasibility of upgrading its practice management system.

Regulation

General

The practice of dentistry is highly regulated, and there can be no assurance that the regulatory environment in which the affiliated dental practices and the Company operate will not change significantly in the future. In general, regulation of health care related companies also is increasing.

Every state imposes licensing and other requirements on individual dentists and dental facilities and services. In addition, federal and state laws regulate health maintenance organizations and other managed care organizations for which dentists may be providers. Consequently the Company may become subject to compliance with additional laws, regulations and interpretations or enforcement thereof. The ability of the Company to operate profitably will depend, in part, upon the Company and its affiliated dental practices obtaining and maintaining all necessary licenses, certifications and other approvals and operating in compliance with applicable health care regulations.

9

Table of Contents

Dental practices must meet federal, state and local regulatory standards in the areas of safety and health. Historically, those standards have not had any material adverse effect on the operations of the dental practices managed by the Company. Based on its familiarity with the operations of the dental practices managed by the Company, management believes that it, and the practices it manages, are in compliance in all material respects with all applicable federal, state and local laws and regulations relating to safety and health.

Medicare and Medicaid Fraud and Abuse

Federal law prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for, or in order to induce, (i) the referral of a person for services, (ii) the furnishing or arranging for the furnishing of items or services or (iii) the purchase, lease or order or arranging or recommending purchasing, leasing or ordering of any item or service, in each case, reimbursable under Medicare or Medicaid. Because dental services are covered under various government programs, including Medicare, Medicaid or other federal and state programs, the law applies to dentists and the provision of dental services. Pursuant to this anti-kickback law, the federal government announced a policy of increased scrutiny of joint ventures and other transactions among health care providers in an effort to reduce potential fraud and abuse related to Medicare and Medicaid costs. Many states have similar anti-kickback laws, and in many cases these laws apply to all types of patients, not just Medicare and Medicaid beneficiaries. The applicability of these federal and state laws to many business transactions in the health care industry, including the Company’s operations, has not yet been subject to judicial interpretation.

Significant prohibitions against physician self-referrals, including those by dentists, for services covered by Medicare and Medicaid programs were enacted, subject to certain exceptions, by Congress in the Omnibus Budget Reconciliation Act of 1993. These prohibitions, commonly known as “Stark II” amended prior physician and dentist self-referral legislation known as “Stark I” (which applied only to clinical laboratory referrals) by dramatically enlarging the list of services and investment interests to which the referral prohibitions apply. Effective January 1, 1995 and subject to certain exceptions, Stark II prohibits a physician or dentist or a member of his immediate family from referring Medicare or Medicaid patients to any entity providing “health services” in which the physician or dentist has an ownership or investment interest, or with which the physician or dentist has entered into a compensation arrangement, including the “physician’s or dentist’s” own group practice unless such practice satisfies the group practice exception. The designated health services include the provision of clinical laboratory services, radiology and other diagnostic services (including ultrasound services), radiation therapy services, physical and occupational therapy services, durable medical equipment, parenteral and enteral nutrients, certain equipment and supplies, prosthetics, orthotics, outpatient prescription drugs, home health services and inpatient and outpatient hospital services. A number of states also have laws that prohibit referrals for certain services such as x-rays by dentists if the dentist has certain enumerated financial relationships with the entity receiving the referral, unless an exception applies.

Noncompliance with, or violation of, the federal anti-kickback legislation or Stark II can result in exclusion from Medicare and Medicaid as well as civil and criminal penalties. Similar penalties are provided for violation of state anti-kickback and self-referral laws. To the extent that the Company or any affiliated dental practice is deemed to be subject to these federal or similar state laws, the Company believes its intended activities will comply in all material respects with such statutes and regulations.

State Legislation

In addition to the anti-kickback laws and anti-referral laws noted above, the laws of many states prohibit dentists from splitting fees with non-dentists and prohibit non-dental entities such as the Company from engaging in the practice of dentistry and from employing dentists to practice dentistry. The specific restrictions against the corporate practice of dentistry, as well as the interpretation of those restrictions by state regulatory authorities, vary from state to state. However, the restrictions are generally designed to prohibit a non-dental entity from controlling the professional assets of a dental practice (such as patient records, payer contracts and, in certain states, dental equipment), employing dentists to practice dentistry (or, in certain states, employing dental hygienists or dental assistants), controlling the content of a dentist’s advertising or professional practice or sharing professional fees. The laws of many states also prohibit dental

10

Table of Contents

practitioners from paying any portion of fees received for dental services in consideration for the referral of a patient. In addition, many states impose limits on the tasks that may be delegated by dentists to dental assistants.

State dental boards do not generally interpret these prohibitions as preventing a non-dental entity from owning non-professional assets used by a dentist in a dental practice or providing management services to a dentist provided that the following conditions are met: a licensed dentist has complete control and custody over the professional assets; the non-dental entity does not employ or control the dentists (or, in some states, dental hygienists or dental assistants); all dental services are provided by a licensed dentist; licensed dentists have control over the manner in which dental care is provided and all decisions affecting the provision of dental care. State laws generally require that the amount of a management fee be reflective of the fair market value of the services provided by the management company and certain states require that any management fee be a flat fee or cost-plus fee based on the cost of services performed by the Company. In general, the state dental practice acts do not address or provide any restrictions concerning the manner in which companies account for revenues from a dental practice subject to the above-noted restrictions relating to control over the professional activities of the dental practice, ownership of the professional assets of a dental practice and payments for management services.

The Company does not control the practice of dentistry or employ dentists to practice dentistry. Moreover, in states in which it is prohibited the Company does not employ dental hygienists or dental assistants. The Company provides management services to its affiliated practices, and the management fees the Company charges for those services are consistent with the laws and regulations of the jurisdictions in which it operates.

On March 27, 2003, a Federal District Judge in Dallas, Texas issued a Memorandum Opinion and Order (“Opinion”) in the case of Robert C. Penny et al vs. Orthalliance, Inc., granting Plaintiffs’ amended Motion for Partial Summary Judgment. Orthalliance, Inc. (“Orthalliance”) is a dental practice management company with similarities in its purpose, organizational structure and management relationships to the Company’s. The issuance of this Opinion has potential implications for the Company since the Opinion held that the management relationship between Orthalliance and certain dentists is in violation of the prohibition against the corporate practice of dentistry as defined in the Texas Dental Practices Act (“TDPA”) and is therefore void. Management believes that the Opinion, at this stage, does not significantly increase the risk that the Company’s management relationships will be considered illegal. There are material distinctions between the Company’s management arrangements and the Orthalliance arrangements, which would suggest that this or another judge would not reach the same conclusion in applying the law to the Company’s arrangements. In addition, the Company is not currently party to any lawsuits alleging that its business arrangements violate the TDPA. However, the Company can give no assurance that another judge would not apply a similar analysis to its arrangements and hold that such arrangements also violate the TDPA. Such a ruling against the Company would have material adverse consequences on its financial position and results of operations.

In addition, there are certain regulatory risks associated with the Company’s role in negotiating and administering managed care and capitation contracts. The application of state insurance laws to reimbursement arrangements other than various types of fee-for-service arrangements is an unsettled area of law and is subject to interpretation by regulators with broad discretion. As the Company or its affiliated practices contract with third-party payors, including self-insured plans, for certain non-fee-for-service basis arrangements, the Company or the affiliated dental practices may become subject to state insurance laws. In the event that the Company or the affiliated practices are determined to be engaged in the business of insurance, these parties could be required either to seek licensure as an insurance company or to change the form of their relationships with third-party payors, and may become subject to regulatory enforcement actions. In such events, the Company’s revenues may be adversely affected.

Regulatory Compliance

The Company regularly monitors developments in laws and regulations relating to dentistry. The Company may be required to modify its agreements, operations or marketing from time to time in response to changes in the business, statutory and regulatory environments. The Company plans to structure all of its

11

Table of Contents

agreements, operations and marketing in compliance with applicable law, although there can be no assurance that its arrangements will not be successfully challenged or that required changes may not have a material adverse effect on operations or profitability.

Employees

As of December 31, 2003, the Company and its affiliated dental practices employed approximately 860 administrative and dental office personnel on a full-time or part-time basis, and the affiliated dental practices employed approximately 165 general dentists and specialists on a full-time or part-time basis. The affiliated dental practices generally enter into employment or independent contractor agreements with their affiliated dentists. The Company believes that its relations with its employees are good.

Corporate Liability and Insurance

The provision of dental services entails an inherent risk of professional malpractice and other similar claims. Although the Company does not influence or control the practice of dentistry by dentists or have responsibility for compliance with certain regulatory and other requirements directly applicable to dentists and dental groups, the contractual relationship between the Company and the affiliated dental practices may subject the Company to some medical malpractice actions under various theories, including successor liability. There can be no assurance that claims, suits or complaints relating to services and products provided by managed practices will not be asserted against the Company in the future. The availability and cost of professional liability insurance has been affected by various factors, many of which are beyond the control of the Company. Significant increases in the cost of such insurance to the Company and its affiliated dental practices may have an adverse effect on the Company’s operations.

The Company provides each affiliated dental practice with comprehensive general liability, workers compensation and professional liability coverage covering the practice. Each dentist retained or employed by the affiliated dental practice, is required to provide professional liability coverage of not less than $1.0 million for each occurrence and $3.0 million annual aggregate.

The Company maintains other insurance coverage including general liability, property, business interruption and workers’ compensation, which management considers to be adequate for the size of the Company and the nature of its business.

The Company leases approximately 9,000 square feet of space for executive, administrative, sales and marketing and operations offices in Houston, Texas. The lease expires in July 2006 and is subject to renewal options.

All of the Company’s existing dental centers are leased. Two of the dental centers are owned by an affiliate of the Company.

The Company intends to lease centers or enter into build-to-suit arrangements with third parties for dental centers to be leased by the Company. Certain leases provide for fixed minimum rentals and provide for additional rental payments for common area maintenance, insurance and taxes. The leases carry varying terms expiring between 2003 and 2011 excluding options to renew.

The majority of the centers are located in retail locations. The Company believes that its leased facilities are well maintained, in good condition and adequate for its current needs. Furthermore, the Company believes that suitable additional or replacement space will be available when required.

On May 30, 2002, litigation was filed in the Circuit Court for Putnam County, Tennessee against the Company and one of its subsidiaries by the spouse and children of a patient of an affiliated dental practice alleging that the defendants were negligent and vicariously liable in the care and treatment of the patient, resulting in his death. The Company filed a response to the litigation denying liability in this matter. The matter was settled in October 2003, within the Company’s insurance policy limits. On February 9, 2004,

12

Table of Contents

Mr. Herren’s daughter filed suit in the Circuit Court for Putnam County, Tennessee, seeking an injunction or restraining order preventing the disbursement of funds from the settlement, and seeking to amend the settlement to reflect that the plaintiff receive her proper share of the settlement, or alternatively, to set the settlement aside and reinstate the original lawsuit. The Company has filed a response to the lawsuit denying any liability in this matter and intends to vigorously defend itself.

In June 2000, the Company recorded litigation expenses of $1.5 million resulting from an arbitration award against two subsidiaries of the Company in an arbitration proceeding in Los Angeles, California. The arbitrator found that the subsidiaries had breached a contractual agreement to acquire a dental practice and awarded the plaintiffs actual damages and costs of $1.1 million, plus interest at 10 percent from the date that the judgment was filed. In connection with the restructuring of certain indebtedness in July 2002, the Company entered into a forbearance agreement with the plaintiffs regarding this judgment. The Company agreed to make the following payments in exchange for forbearance in enforcing the judgment (1) $100,000 interest payment paid in July 2002, (2) twenty-three monthly installments of $30,000 each beginning August 2002 and (3) then $25,000 monthly installments until paid in full. Pursuant to an Amendment to the forbearance agreement, dated as of May 15, 2003, the plaintiffs consented to GECC filing liens against the Company’s assets to secure its obligations under the Credit Agreement and the Company agreed to increase by $5,000 per month the amounts being paid on the forbearance agreement. The Company entered into a Pay-Off Agreement on November 4, 2003, and made one final payment of approximately $0.5 million in full satisfaction of the outstanding judgment. Pursuant to the Pay-Off Agreement the Company has been released from all claims under the judgment.

In May 2003, the Company was notified that its former malpractice insurance provider had filed for liquidation and that payment of claims and legal defense in various malpractice lawsuits filed against the Company and its affiliated dental practices had been terminated. The insolvent insurance company provided malpractice coverage for the Company and its affiliated dental practices in 2000 and 2001. Therefore the Company is potentially liable for payment of any claims, judgments or other costs associated with these lawsuits. Management has reviewed all open claims and lawsuits still pending that this insurance company was covering and does not believe that the potential liability, if any, will have a material impact on the Company’s financial results.

The Company has been informed of an investigation by Texas Medicaid concerning alleged overpayments for services for certain procedures performed by the Company’s affiliated dental practice in Texas. Texas Medicaid has alleged that certain advertised specials were not offered to Medicaid patients from 1997 through 2001. Texas Medicaid has preliminarily claimed overpayments of approximately $280,000. The Company disputes Texas Medicaid’s claims and intends to vigorously contest the findings of the Texas Medicaid investigative offices.

The Company is from time to time subject to claims and suits arising in the ordinary course of operations. In the opinion of management, the ultimate resolution of such pending legal proceedings will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.

None

13

Table of Contents

PART II

The Company’s common stock is traded in the over-the-counter market and quoted on the OTC Bulletin Board under the symbol “CASL.OB.” The following table presents the quarterly high and low sale prices as reported by the OTC Bulletin Board. These quotations reflect the inter-dealer prices, without retail mark-up, markdown or commission and may not necessarily represent actual transactions.

As of March 15, 2004, there were 8,265,323 shares of the Company’s Common Stock outstanding held by approximately 40 stockholders of record. The Company believes there are approximately 800 beneficial owners of the Common Stock. As of March 15, 2004, there were 195,838 shares of Series A-1 Convertible Preferred Stock, par value $0.000001 (“Series A-1 Stock”) outstanding held by 6 stockholders of record. The Series A-1 Stock is convertible into 35,776,356 shares of Common Stock. As of March 15, 2004, there were 79,190 shares of Series B Stock outstanding held by 22 stockholders of record. The Series B Stock is convertible into 165,022,853 shares of Common Stock. The Series A-1 Stock and the Series B Stock vote together with the holders of the common stock on an “as-converted” basis. The total number of shares of Common Stock outstanding, including the “as-converted” Series A-1 Stock and Series B Stock, is 209,064,532.

The Company has never paid a cash dividend on its Common Stock. The Company currently intends to retain earnings to finance the development of its business and does not anticipate paying any cash dividends on the Common Stock in the foreseeable future. In addition, the Company’s Credit Agreement prohibits the payment of dividends.

14

Table of Contents

The selected financial data of the Company should be read in conjunction with the related consolidated financial statements, notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere herein.

15

Table of Contents

Introduction

The Company manages and operates integrated dental networks through contractual affiliations with general, orthodontic and multi-specialty dental practices in Texas, Florida, Tennessee and California. The Company does not engage in the practice of dentistry but rather establishes integrated dental networks by entering into management services agreements with affiliated dental practices to provide, on an exclusive basis, management and administrative services to affiliated dental practices. As of December 31, 2003, the Company provided management services to 74 dental centers with approximately 165 affiliated dentists, orthodontists and other dental specialists.

Certain of the affiliated dental practices derive a significant portion of their revenues from managed care contracts, preferred provider arrangements and other negotiated price agreements. While the Company generally negotiates the terms and conditions of managed care contracts, preferred provider arrangements and other negotiated price agreements, the affiliated dental practices are the contracting parties for all such relationships, and the Company is dependent on its affiliated dental practices for the success of such relationships. The Company generally bears the risk of loss resulting from any such arrangements because it consolidates the financial results of its affiliated dental practices. However, most of these contracts are cancelable by either party on 60 to 90 days written notice, thereby reducing the risk of long-term adverse impact on the Company.

At December 31, 2003, the Company and its affiliated dental practices maintained capitated managed care contracts covering approximately 136,000 members. Capitation fees, excluding supplemental fees and co-payments by members, totaled $8.2 million, or approximately 8.7% of net patient revenues in 2003. One managed care contract with a national insurance company accounted for $6.5 million in revenues ($2.8 million in capitation payments and $3.7 million in patient co-payments) in 2003, equal to 6.9% of total net patient revenues. The Company periodically evaluates its capitated managed care contracts by comparing the average reimbursement per procedure plus the total capitation fees per contract to the usual and customary fees charged by the affiliated dental practice. If the aggregate reimbursement percentage for the capitated contract exceeds 50% of the usual and customary fees, the Company believes that the incremental costs of providing covered services are being recovered. Management believes that capitated managed care contracts, in the aggregate, are profitable and the Company will continue to contract with capitated managed care providers on a case-by-case basis.

Components of Revenues and Expenses

Net patient revenues represent amounts billed by the affiliated dental practices to patients and third-party payors for dental services rendered. Such amounts also include monthly capitation payments received from third-party payors pursuant to managed care contracts. Net revenues are reported at established rates reduced by contractual amounts based on agreements with patients, third party payers and others obligated to pay for services rendered.

Under the terms of the typical management services agreement with an affiliated dental practice, the Company becomes the exclusive manager and administrator of all non-dental services relating to the operation of the practice. While actual terms of the various management agreements may vary from practice

16

Table of Contents

to practice, material aspects of all the management service agreements, including the ability of the Company to nominate the majority shareholder and the calculation of the management fees, are consistent. The obligations of the Company include assuming responsibility for the operating expenses incurred in connection with managing the dental centers. These expenses include salaries, wages and related costs of non-dental personnel, dental supplies and laboratory fees, rental and lease expenses, advertising and marketing costs, management information systems, and other operating expenses incurred at the dental centers. In addition to these expenses, the Company incurs general and administrative expenses related to the billing and collection of accounts receivable, financial management and control of the dental operations, insurance, training and development, and other general corporate expenditures.

Results of Operations

The following table sets forth the percentages of patient revenues represented by certain items reflected in the Company’s Statements of Operations. The information that follows represents historical results of the Company.

17

Table of Contents

Twelve Months Ended December 31, 2003 Compared to Twelve Months Ended December 31, 2002

Net Patient Revenues – Net patient revenues decreased from $100.9 million for the year ended December 31, 2002, to $93.9 million for the year ended December 31, 2003, a decrease of $7.0 million or 6.9%. During 2003, the Company closed two dental centers and sold one dental center, which accounted for $4.2 million, or 4.2%, of the decrease in net patient revenues, and a decrease in net patient revenues from existing dental centers accounted for $2.8 million, or 2.8%.

Dentist Salaries and Other Professional Costs – For the year ended December 31, 2003, dentist salaries and other professional costs were $27.6 million, $1.7 million, or 5.9% lower than dentist salaries and other professional costs of $29.4 million for the year ended December 31, 2002. The decrease is attributable to the closing of three dental centers in 2003, a reduction in the number of dentists, orthodontists and hygienists employed as part of a restructuring plan the Company adopted in October 2002 to reduce costs and the decrease in net patient revenues. Expressed as a percentage of net patient revenues, dentist salaries and other professional costs were 29.4% for the year ended December 31, 2003 relatively unchanged from the year ended December 31, 2002 percentage of 29.1%.

Clinical Salaries – Clinical salaries decreased from $21.7 million for the year ended December 31, 2002 to $18.6 million for the year ended December 31, 2003, a decrease of $3.1 million, or 14.5%. The decrease is attributable to the closing of three dental centers in 2003, and a reduction in dental center staff in connection with a restructuring plan the Company adopted in October 2002. Expressed as a percentage of net patient revenues, clinical salaries decreased from 21.5% for the year ended December 31, 2002 to 19.8% for 2003.

Dental Supplies and Laboratory Fees – Dental supplies and laboratory fees decreased, from $11.6 million for the year ended December 31, 2002 to $10.3 million for the year ended December 31, 2003, a decrease of $1.3 million, or 10.9%. The closing of three dental centers over the past year and the decrease in net patient revenues attributed to the decrease in dental supplies and lab fees. Expressed as a percentage of patient revenues, dental supplies and laboratory fees decreased from 11.5% for the year ended December 31, 2002 to 11.0% for the year ended December 31, 2003.

Rental and Lease Expense – Rent and lease expense decreased from $6.0 million for the year ended December 31, 2002, to $5.9 million for 2003, a decrease of $0.1 million, or 1.5%. The decrease results primarily from the closing of three dental centers over the past year. Expressed as a percentage of net patient revenues, rent and lease expense increased from 5.9% for the year ended December 31, 2002 and to 6.3% for the same period of 2003.

Advertising and Marketing – Advertising and marketing expenses increased from $2.6 million for the year ended December 31, 2002, to $2.9 million for the same period of 2003, an increase of $0.3 million, or 10.2%. The increase is attributable primarily to an increase in television advertising during 2003, which was partially offset by reductions in direct mail and other advertising sources. Expressed as a percentage of net patient revenues, advertising and marketing expenses increased from 2.6% in 2002 to 3.1% for the year ended December 31, 2003.

Depreciation and Amortization – Depreciation and amortization decreased from $3.6 million for the year ended December 30, 2002 to $3.1 million for 2003, a decrease of $0.5 million, or 14.6%. The closing of three dental centers over the past year together with a decline in depreciation expense as property and equipment became fully depreciated have resulted in the decrease in depreciation and amortization expense. Expressed as a percentage of net patient revenues, depreciation and amortization decreased from 3.6% in 2002 to 3.3% for the year ended December 31, 2003.

Other Operating Expenses – Other operating expenses decreased from $7.9 million for the year ended December 31, 2002, to $7.2 million for the year ended December 31, 2003, a decrease of $0.7 million or 8.7%. Other operating expenses represent expenses related to the operation of the Company’s dental centers, such as utilities, maintenance and communication costs. The decrease is attributable primarily to the closing of three dental centers in 2003 and a cost reduction plan implemented as part of the Company’s restructuring plan adopted in October 2002. Expressed as a percentage of net patient revenues, other operating expenses decreased slightly from 7.8% for the year ended December 31, 2002 to 7.7% for 2003.

18

Table of Contents

Bad Debt Expense – Bad debt expense of $3.9 million for the year ended December 31, 2003 decreased by $0.9 million, or 18.7% from $4.8 million in 2002. The decrease in bad debt expense results from improved collections of patient receivables, particularly in the last half of the year. Expressed as a percentage of net patient revenues, bad debt expense decreased from 4.7% for the year ended December 31, 2002 to 4.1% for 2003.

General & Administrative Expense – General and administrative expenses of $10.3 million for the year ended December 31, 2003, increased by 0.3% from general and administrative expenses of $10.2 million in 2002. The increase in general and administrative expenses is attributable primarily to $0.2 million of severance for Mr. Usdan that was expensed in 2003, an increase in consulting fees resulting from fees paid to Sentinel pursuant to a management agreement entered into in May 2003 and increased legal fees. The increase was offset by reductions in corporate and regional staff and other overhead expenses related to a restructuring plan adopted by the Company in October 2002. On June 13, 2003, James M. Usdan, President, Chief Executive Officer, and a member of the board of directors, resigned from all of his positions as an officer and director of the Company. Expressed as a percentage of net patient revenues, general and administrative expense increased from 10.1% for the year ended December 31, 2002, to 10.7% for 2003.

Restructuring Costs and Other Charges – From June 2000 until July 2002, the Company was in default under the Old Credit Agreement with its Senior Secured Lenders (“2002 Restructuring”); (2) Senior Subordinated Notes of $15.0 million issued to the Senior Subordinated Lenders; and (3) and $3.2 million in Seller Notes. On July 19, 2002, the Company entered into the 2002 Restructuring with its Senior Secured Lenders, its Senior Subordinated Lenders and the holders of the Seller Notes regarding the debt outstanding under the Old Credit Agreement, the Senior Subordinated Notes and the Seller Notes. On May 15, 2003, the Company entered into the 2003 Restructuring. For the year ended December 31, 2003 the Company recorded restructuring costs and other charges of $0.8 million representing legal and professional fees related to the 2003 Restructuring. For the year ended December 31, 2002, the Company recorded restructuring costs and other charges of $4.3 million including remaining lease obligations on closed offices and legal and professional fees related to the 2002 Restructuring of the Old Credit Agreement.

Gain on Early Extinguishment of Debt – In connection with the 2002 Restructuring the Company recognized a gain of $17.3 million on the early extinguishment of debt in 2002. In 2003, the Company recorded a $21.9 million gain on extinguishment of debt related to the 2003 Restructuring.

Interest Expense – Interest expense decreased from $5.6 million for the year ended December 31, 2002, to $3.2 million for the year ended December 31, 2003, a decrease of $2.4 million or 43.0%. In May 2003 and July 2002, the Company entered into various agreements with its lenders to restructure its outstanding debt. Pursuant to these restructurings, a total of approximately $35.3 million in outstanding debt was forgiven and $16.4 million in debt was paid. In addition, the Company’s interest rate on its remaining debt was reduced. The reduction in outstanding debt and lower interest rates accounted for the decrease in interest expense.

Income taxes – The Company’s effective tax rate for the year ended December 31, 2003 was a benefit of 18%. This rate differs from the federal statutory tax rate of 34% primarily as a result of provisions of the federal income tax code which provide for the exclusion from taxation of the $21.8 million gain recognized upon forgiveness of indebtedness as the Company met insolvency conditions established by the tax code at the time of the forgiveness and the release of approximately $4.5 million in valuation allowance recorded against the deferred tax asset. The tax code additionally requires that the Company reduce tax attributes to the extent that it has forgiveness of indebtedness that met the insolvency conditions. Accordingly, the Company reduced its net operating loss carryforwards. The Company’s management expects that the effective tax rate for periods subsequent to 2003 will be between 30% and 40%, reflecting federal and state income tax rates.

Cumulative Effect of Change in Accounting Principle – Effective January 1, 2002, the Company adopted FASB Statement No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”. In connection with the Company’s adoption of SFAS 142, the Company recorded a $37.0 million transitional goodwill impairment charge at the beginning of the fiscal year.

19

Table of Contents

Twelve Months Ended December 31, 2002 Compared to Twelve Months Ended December 31, 2001

Net Patient Revenue – Net patient revenues increased from $97.9 million for the year ended December 31, 2001 to $100.9 million for the year ended December 31, 2002, an increase of $2.9 million or 3.0%. Patient revenues for dental centers open for more than one year increased approximately $8.2 million, or 8.3%, from 2001, partially offset by a decrease in revenues of approximately $5.1 million, or 5.3%, from the closure of 23 dental centers since January 2001. Higher net patient revenues resulted from fee increases in 2002 and better average revenue per patient.

Dentist Salaries and Other Professional Costs – For the year ended December 31, 2002, dentist salaries and other professional costs were $29.4 million, $2.3 million, or 8.4% higher than dentist salaries and other professional costs of $27.1 million for the year ended December 31, 2001. Higher dentist compensation and increased hiring of hygienists accounted for the increase. Expressed as a percentage of net patient revenues, dentist salaries and other professional costs increased from 27.7% to 29.1% for the years ended December 31, 2001 and 2002, respectively.

Clinical Salaries – Clinical salaries increased from $20.0 million for the year ended December 31, 2001 to $21.7 million for the year ended December 31, 2002, an increase of $1.7 million or 8.7%. The increase is attributable to higher compensation associated with the upgrading of dental office management and other personnel. Expressed as a percentage of net patient revenues, clinical salaries increased from 20.4% for the year ended December 31, 2001 to 21.5% for the same period of 2002.

Dental Supplies and Laboratory Fees – Dental supplies and laboratory fees decreased slightly from $11.8 million for the year ended December 31, 2001 to $11.6 million for the year ended December 31, 2002, an increase of $0.2 million or 1.3%. The decrease is attributable primarily to improved cost controls associated with the purchasing of dental supplies. Expressed as a percentage of net patient revenues, dental supplies and laboratory fees decreased from 12.0% for the year ended December 31, 2001, to 11.5% for the comparable period of 2002.

Rental and Lease Expense – Rental and lease expense of $6.0 million for the year ended December 31, 2002 decreased by $0.5 million, or 7.2% from the year ended December 31, 2001. The decrease is attributable to the closing of 23 dental centers since January 2001. Expressed as a percentage of net patient revenues, rent and lease expense decreased from 6.6% for the year ended December 31, 2001 to 5.9% for the year ended December 31, 2002.

Advertising and Marketing – Advertising and marketing expenses decreased from $3.3 million for the year ended December 31, 2001 to $2.6 million for the year ended December 31, 2002, a decrease of $0.7 million, or 20.0%. Lower expenditures on television advertising accounted for the decrease. Expressed as a percentage of net patient revenues, advertising and marketing expenses decreased from 3.4% in the prior year to 2.6% for the year ended December 31, 2002.

Depreciation and Amortization – Depreciation and amortization decreased from $6.6 million for the year ended December 31, 2001 to $3.6 million for the year ended December 31, 2002, a decrease of $3.0 million or 45.2%. Effective January 1, 2002, the Company adopted SFAS 142, Goodwill and Other Intangible Assets and reclassified approximately $54.9 million from management services agreements to goodwill, and as required by SFAS 142, the Company no longer records amortization expenses related to this goodwill. The effect of this change increased income before cumulative effect of change in accounting principle by approximately $2.7 million, or $0.07 per share, for the year ended September 30, 2002. Had the Company adopted SFAS 142 effective January 1, 2001, the effect would have been to reduce the loss before cumulative effective of change in accounting principle by approximately $2.7 million, or $0.43 per share for the year ended December 31, 2001. In the second quarter of 2002, the Company completed its quantification of the impairment charge and recorded a $37.0 million impairment charge, related to the write-down of goodwill, as a cumulative effect of change in accounting principle effective January 1, 2002. The remainder of the decrease resulted from the closing of 23 centers since January 1, 2001. Expressed as a percentage of net patient revenues, depreciation and amortization decreased from 6.7% in the prior year to 3.6% for the year ended December 31, 2002.

20

Table of Contents

Other Operating Expenses – Other operating expenses decreased from $8.0 million for the year ended December 31, 2001, to $7.9 million for the year ended December 31, 2002, a decrease of $0.1 million or 1.6%. The decrease is attributable primarily to lower communication costs. Expressed as a percentage of net patient revenues, other operating expenses decreased from 8.2% for the year ended December 31, 2001 to 7.8% for the year ended December 31, 2002 period.

Bad Debt Expense – Bad debt expense decreased from $4.9 million for the year December 31, 2001 to $4.7 million for the year ended December 31, 2002, a decrease of $0.2 million, or 4.0%. Expressed as a percentage of net patient revenues, bad debt expense decreased from 5.1% for the year ended December 31, 2001 to 4.7% for the year ended December 31, 2002. The decrease is attributable to a slight improvement in the collections of accounts receivable.

General & Administrative Expense – General and administrative expenses decreased from $11.3 million for the year ended December 31, 2001 to $10.2 million for the year ended December 31, 2002, a decrease of $1.1 million, or 9.5%. Expressed as a percentage of net patient revenues, general and administrative expense decreased from 11.5% to 10.1% for the year ended December 31, 2001 and 2002, respectively. The decrease is attributable primarily to a reduction of regional personnel costs, and lower professional and recruiting fees.

Restructuring Costs and Other Charges – For the nine months ended December 31, 2002, the Company recorded restructuring costs and other charges of $4.3 million attributable primarily to legal and professional fees related to the restructuring of the Company’s senior credit facility, remaining lease obligations on closed dental centers and severance cost associated with a restructuring of the Company’s corporate and regional management and administrative personnel adopted in September 2002. Additionally, $0.3 million in employee bonuses associated with the restructuring of the Credit Agreement have been included, fifty percent of which was paid in July 2002 and the balance was paid in the first quarter of 2003. For the year ended December 31, 2001 the Company recorded restructuring costs and other charges of $2.3 million including severance costs, remaining lease obligations on closed offices and legal and professional fees related to the implementation of the plan to improve operating results and restructure the Company’s credit facilities.

Interest Expense – Interest expense decreased from $8.0 million for the year ended December 31, 2001 to $5.6 million for the year ended December 31, 2002, a decrease of $2.3 million or 29.3%. The decrease resulted from a decrease in the variable interest rate under the bank credit facility and senior subordinated note agreements and the restructuring of the Company’s debt, which resulted in lower debt levels in the last half of 2002.

Gain on early extinguishment of debt – In connection with the Restructuring of the Company’s Senior Subordinated Notes and Old Notes, the Company recognized a gain of approximately $17.3 million on extinguishment of the debt in the third quarter of 2002. (See Note 2 of Notes to Consolidated Financial Statements).

Cumulative Effect of Change in Accounting Principle – In connection with the Company’s adoption of SFAS 142, the Company recorded a $37.0 million transitional goodwill impairment charge effective January 1, 2002. (See Note 2 of Notes to Condensed Consolidated Financial Statements). During September 1998, the Financial Accounting Standards Board issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, which requires that companies recognize all derivative instruments as either assets or liabilities on the balance sheet and measure those instruments at fair value. SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities – Deferral of the Effective Date of FASB Statement No. 133,” deferred the implementation of SFAS 133 until the fiscal year ending December 31, 2001. The Company implemented SFAS 133 effective January 1, 2001, resulting in a cumulative effect adjustment of $0.3 million during 2001

Asset Impairment – For the year ended December 31, 2002 the Company recorded a $0.4 million asset impairment, resulting primarily from the closing of three centers in Texas and one center in Florida and the sale of two centers in Texas, two centers in Florida and two centers in California. For the year ended December 31, 2001 the Company recorded a $2.9 million asset impairment, resulting primarily from the closing of two dental centers in Texas and Tennessee, a charge to reflect the impairment in value of fixed

21

Table of Contents

assets for two under-performing dental centers and the write-off of intangible assets associated with certain acquisitions. As a result, the Company reduced intangible assets by approximately $2.4 million and leasehold improvements by approximately $0.5 million.

Liquidity and Capital Resources

In July 2002, the Company completed a restructuring of certain indebtedness, which included extinguishing certain subordinated debt due by the Company and extending payments due under the Company’s Old Credit Agreement. In October 2002, the Company undertook additional restructuring activities to improve operating results. Components of this plan included: (i) phasing-out doctor compensation guarantees and restructuring staff bonus incentive programs; (ii) continuing to monitor and close unprofitable and under-performing dental centers; (iii) continuing to upgrade dental office management personnel; (iv) reducing general and administrative expenses, including the reduction of corporate and regional management and administrative staff; (v) decentralizing and or outsourcing certain processes including the call center, marketing, billing, and collections; and (vi) reducing marketing expenses.

In May 2003, the Company completed the 2003 Restructuring. Management believes this is an important step in its operational plan as it provides financial flexibility and the ability to invest in upgrading of equipment and facilities. For 2003, management focused on: (i) aggressive cost control and full implementation of the cost reduction program initiated in October 2002; (ii) refurbishing and modernizing existing dental centers; (iii) upgrading dental office management personnel; and (iv) training of dental office staff personnel to improve patient services, office efficiency and effectiveness, and implementing improvements to the practice management system.

On May 15, 2003, the Company entered into a series of agreements to restructure certain of its outstanding debt and equity. Prior to May 15, 2003, the Company maintained the Old Credit Agreement with a bank group that included, among other banks, BofA and GECC. As of May 14, 2003, the Company had $46.7 million outstanding under the Old Credit Agreement, of which $38.3 million was due the lenders excluding GECC. In addition, the Company maintained the Senior Notes due Heller, Midwest and James M. Usdan, its Chief Executive Officer at that time. The 2003 Restructuring transaction consisted of the following:

22

Table of Contents

At December 31, 2003, the Company had a net working capital deficit of $3.4 million. Current assets totaled $10.1 million, consisting of cash and cash equivalents of $0.5 million, billed and unbilled accounts receivable of $8.5 million and prepaid expenses and other current assets of $1.0 million. Current liabilities totaled $13.5 million, consisting of $2.3 million in accounts payable, $8.3 million in accrued liabilities, $1.1 million in deferred income taxes and $1.9 million in current maturities of long-term debt and revolving line of credit.

For the year ended December 31, 2003, cash provided by operating activities was $4.3 million. In the year ended December 31, 2002, cash used in operating activities amounted to $2.3 million. The improvement resulted primarily from an increase in net earnings, which increased from a net loss of approximately $9.9 million for the year ended December 31, 2002, excluding a $17.3 million gain on extinguishment of debt and a $37.0 million cumulative effect of change in accounting principle, to net income of approximately $0.1 million for the year ended December 31, 2003, excluding a $21.9 million gain on extinguishment of debt and a $4.2 million income tax benefit.

For the year ended December 31, 2003, cash used in investing activities was $1.0 million, consisting of capital expenditures. For the year ended December 31, 2002, cash used in investing activities was $0.6 million, consisting of $0.9 million in capital expenditures, offset by $0.3 million in proceeds from sale of property and equipment.

For the year ended December 31, 2003, cash used in financing activities totaled $4.3 million, representing $19.8 million in repayments of long-term debt and capital lease obligations, $0.6 million to repurchase outstanding warrants to purchase Series A Stock, $0.1 million to purchase Company common stock and $2.3 million in debt and equity issuance costs, offset by $12.4 million in proceeds from the issuance of long-term debt and $6.0 million in proceeds from the issuance of Series B Stock. For the year ended December 31, 2002, cash provided by financing activities totaled $0.4 million, resulting from $1.7 million in proceeds from issuance of long-term debt, offset by $0.6 million in repayments of long-term debt and capital lease obligations and $0.7 million in debt and equity issuance costs. The Company has budgeted $3.0 million in capital expenditures for 2004, which it expects to fund through internally generated funds and borrowings under the Credit Agreement.

The Company anticipates that cash flow from operations, the existing cash balance as of December 31, 2003, and additional borrowing capacity of $3.5 million under its revolving line of credit will provide adequate cash flows and liquidity for 2004 for the Company to operate normally and to be able to satisfy the capital expenditures, scheduled debt payments and operational budgets of the Company for the upcoming year. There was approximately $0.4 million outstanding under the revolving line of credit at December 31, 2003.

The following table summarizes, as of December 31, 2003, the Company’s contractual commitments related to debt, leases and other arrangements during the next five years (in thousands):

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires

23

Table of Contents

management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, management evaluates these estimates, including those related to net patient revenues, accounts receivable, intangible assets and contingent liabilities. The Company believes that of its significant accounting policies (Note 2 of Notes to Consolidated Financial Statements), the accounting policies described below may involve a higher degree of judgment and complexity.

The consolidated financial statements include the accounts of the Company and all wholly-owned and beneficially-owned subsidiaries and the accounts of affiliated dental practices in which the Company has a long-term controlling financial interest. Because of corporate practice of medicine laws in the states in which the Company operates, the Company does not own dental practices but instead enters into exclusive long-term management services agreements (“Management Services Agreements”) with professional corporations that operate the dental practices. In addition, the Company has the contractual right to designate, upon the occurrence of certain events, the licensed dentist who is the majority shareholder of the capital stock of the professional corporation at a nominal cost (“nominee arrangements”). At December 31, 2003, all of the affiliated dental practices were owned by dentists with whom the Company had a nominee arrangement. Under the Management Services Agreements, the Company establishes annual operating and capital budgets for the professional corporations and compensation guidelines for the licensed dental professionals. The Management Services Agreements have initial terms of twenty-five years. The management fee charged by the Company to an affiliated dental practice is intended to reflect and is based on the fair value of the management services rendered by the Company to the affiliated dental practice. Subject to applicable law, the management fee earned by the Company, except from professional corporations located in California, is generally comprised of three components: (i) the costs incurred by it on behalf of the affiliated dental practice; (ii) a base management fee ranging from 12.5% to 20.0% of net patient revenues; and, (iii) a performance fee equal to the net patient revenues of the affiliated dental practice less (a) the expenses of the affiliated dental practice and (b) the sum of (i) and (ii), as described in the agreements. In California, the Company is paid a monthly management fee comprised of two components: (i) the costs incurred by it on behalf of the affiliated dental practice and (ii) a management fee in an amount of 30.0% of net patient revenues; plus a bonus equal to 30% of net patient revenues in excess of average monthly net patient revenues over the prior two-year period. The amount of the management fee is reviewed by the Company and the affiliated dental practice at least annually in order to determine whether such fee should be adjusted to continue to reflect the fair value of the management services rendered by the Company.

Through the Management Services Agreements and the nominee arrangements, the Company has a significant long-term controlling financial interest in the affiliated dental practices and, therefore, according to Emerging Issues Task Force Issue No. 97-2, “Application of FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries, and APB No. 16, Business Combinations, to Physician Practice Management Entities and Certain Other Entities with Contractual Management Agreements,” consolidates the results of the affiliated practices with those of the Company. Net patient revenues are presented in the accompanying statement of operations because the Company must present consolidated financial statements. All significant intercompany accounts and transactions, including management fees, have been eliminated in consolidation.

Net patient revenues represent the estimated realizable amounts to be received from patients, third-party payors and others for services rendered by affiliated dentists. They are reported at established rates reduced by contracted amounts based on agreements with patients, third party payers and others obligated to pay for service rendered. Patient revenues from general dentistry are recognized as the services are performed. Patient revenues from orthodontic services are recognized in accordance with the proportional performance method. Under this method, revenue is recognized as services are performed under the terms of contractual agreements with each patient. Approximately 25% of the services are performed in the first month with the remaining services performed and recognized over the remainder of the contract. Billings under each contract, which average approximately 26 months, are made equally throughout the term of the contract, with final payment at the completion of the treatment.

Net patient revenues include amounts received from capitated managed care contracts that the Company negotiates on behalf of its affiliated dental practices. Under capitated contracts the affiliated dental practice

24

Table of Contents

receives a predetermined amount per patient per month in exchange for providing certain covered services to members of the plan. Usually, the capitated plans also provide for supplemental payments and/or co-payments by members for certain higher cost procedures. These contracts typically result in lower average fees for services than the usual and customary fees charged by the Company’s affiliated dental practices and may, in certain instances, expose the Company to losses on contracts where the total revenues received are less than the costs of providing such dental care. The Company generally bears the risk of such loss because it consolidates the financial results of its affiliated dental practices. However, most of these contracts are cancelable by either party on 30 to 90 days written notice thereby reducing the risk of long-term adverse impact on the Company.

Accounts receivable consist primarily of receivables from patients, insurers, government programs and contracts between the affiliated dental practices and third-party payors for dental services provided by dentists. The Company does not believe that change in the reimbursement arrangements for its affiliated dental practice contracts with third-party payors would have a material impact on revenues. An allowance for doubtful accounts is recorded by the Company based on historical experience and collection rates.

The Company’s acquisitions involved the purchase of tangible and intangible assets and the assumption of certain liabilities of the affiliated dental practices. As part of the purchase allocation, the Company allocated the purchase price to the tangible assets acquired and liabilities assumed, based on estimated fair market values. In connection with each acquisition, the Company enters into a long-term management services agreement with each affiliated dental practice, which cannot be terminated by either party without cause. Prior to January 1, 2002, the cost of the management services agreements were amortized on a straight line basis over their term, or such shorter period as may have been indicated by the facts and circumstances. Amortization periods of the management services agreements acquired through December 31, 2001 were 25 years. Effective January 1, 2002, the Company adopted SFAS No. 142 (“SFAS 142”), Goodwill and Other Intangible Assets, and reclassified approximately $54.9 million from management services agreements to goodwill. Under SFAS 142, substantially all of the Company’s goodwill is no longer amortized, and the Company must perform an annual impairment test for goodwill and intangible assets. The Company allocates goodwill to its four reporting units, which are Texas, Florida, California and Tennessee. SFAS 142 requires the Company to compare the fair value of the reporting unit to its carrying amount on an annual basis to determine if there is potential impairment. If the fair value of the reporting unit is less than its carrying value, an impairment loss would be recorded to the extent of that difference. The Company based the fair values of its reporting units on discounted cash flow methodology and other company comparisons. Under SFAS 142, the Company recorded a transitional goodwill impairment charge of $37.0 million, presented as a cumulative effect of accounting change at the beginning of 2002. This transitional goodwill impairment charge was attributable to market declines in its reporting units in Texas, Florida, California and Tennessee. The Company recorded a $3.0 million impairment charge for the year ended December 31, 2002, as a result of lower than projected earnings in the California and Florida units. For the year ended December 31, 2003, the Company did not incur an impairment on any of its reporting units

The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amount of tax-related assets and liabilities and income tax provisions. The Company evaluates the recoverability of its deferred tax assets on an ongoing basis. In making this evaluation the Company considers all available positive and negative evidence, to determine whether, based on such evidence, it is more likely than not that some portion or all of the net deferred tax assets will be realized in future periods. This evaluation requires significant judgment. In addition, the Company has made significant estimates involving current and deferred income taxes, tax attributes relating to the interpretation of various tax laws, historical bases of tax attributes associated with certain tangible and intangible assets and limitations surrounding the future realization of the deferred tax assets.

Based on the Company’s operating results in prior years, the Company had established a valuation allowance against its net deferred tax asset as it was deemed more likely than not that the net deferred tax assets would not be realized. During the fourth quarter of 2003, the Company determined, based on the 2003 Restructuring, operating results for the period subsequent to the 2003 Restructuring and anticipated operating

25

Table of Contents

income and cash flows for future periods that it is more likely than not the certain deferred tax assets will be realized in the future and accordingly, it was appropriate to release the valuation allowance recorded against the net deferred tax asset.

The Company believes that it is more likely than not that the net deferred tax asset of $4.6 million will be recovered through reductions in tax liabilities in future periods. However, recovery is dependent on achieving its forecast of future operating income over a period of time. The Company will review its forecast in relation to actual results and expected trends on an ongoing basis. Failure to achieve its operating income targets may change the assessment regarding the recoverability of the net deferred tax assets and such change could result in an allowance being recorded against some or all of the net deferred tax assets. Any increase in a valuation allowance would result in additional income tax expense, lower stockholders’ equity and could have a significant impact on net in future periods.

The Company accounts for its stock-based compensation plans in accordance with APB 25, “Accounting for Stock Issued to Employees” (“APB 25”). In accordance with the provisions of APB 25, stock-based employee compensation cost is not reflected in net income for options granted at an exercise price equal to or in excess of the market value of the underlying Common Stock on the date of grant. The Company recognizes compensation cost on options granted at an exercise price less than the market value of the underlying Common Stock on the date of grant. In August 2003, the Company issued approximately 3.9 million stock options with an exercise price of $0.05 per share while the market value of the underlying Common Stock on the date of grant was $0.15 per share. The Company recorded approximately $0.4 million in deferred compensation, which is expensed over the vesting period of five years. The Company expensed approximately $32,000 in compensation expense during 2003. All stock options granted by the Company prior to August 2003 were issued with an exercise price equal to the market value of the underlying Common Stock on the date of grant.

The Company carries insurance with coverages and coverage limits that it believes to be customary in the dental industry. Although there can be no assurance that such insurance will be sufficient to protect the Company against all contingencies, management believes that its insurance protection is reasonable in view of the nature and scope of the Company’s operations.

The Company is, from time to time, subject to claims and suits arising in the ordinary course of operations. In the opinion of management, the ultimate resolution of such pending legal proceedings will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.

Inflation

Inflation has not had a significant impact on the results of operations of the Company during the last three years.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities,” which addresses the consolidation of variable interest entities (VIEs) by business enterprises that are the primary beneficiaries. A VIE is an entity that does not have sufficient equity investment at risk to permit it to finance its activities without additional subordinated financial support, or whose equity investors lack the characteristics of a controlling financial interest. The primary beneficiary of a VIE is the enterprise that has the majority of the risks or rewards associated with the VIE. In December 2003, the FASB issued a revision to FIN 46, Interpretation No. 46R (FIN 46R), to clarify some of the provisions of FIN 46, and to exempt certain entities from its requirements. Application of FIN 46R is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application for all other types of VIEs is required in financial statements for periods ending after March 15, 2004. The Company does not have interests in structures that are commonly referred to as special-purpose entities and therefore has not adopted FIN 46R as of December 31, 2003. The Company does not expect its adoption of FIN 46R, to materially affect its financial position, results of operations or cash flows.

26

Table of Contents

In April 2003, the FASB issued Statement No. 149, Amendment of FASB Statement No. 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under FASB Statement No. 133. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, and should be applied prospectively. The provisions of SFAS 149, relating to FASB Statement No. 133 implementation issues that have been effective for fiscal quarters beginning prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. The impact of adoption of SFAS 149 did not have a material effect on the Company’s financial position, results of operations or cash flows.

In May 2003, the FASB issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. In accordance with the standard, financial instruments that embody obligations for the issuer are required to be classified as liabilities. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 had no material impact on the Company’s financial position, results of operations or cash flows as of and for the year ended December 31, 2003.

In its October 29, 2003 meeting, the FASB proposed to make the expensing of stock options mandatory beginning in 2005. The guidance regarding this change is expected to be released in 2004. Additionally, the FASB proposed to specify the approach that companies can use in making the transition to the expensing of options, allowing companies to include previously granted unvested options in their calculations as well as the ones granted in the current year. When the rules are finalized, the Company will evaluate the impact on its financial position, results of operations and cash flows.

In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition. SAB 104 clarifies existing guidance regarding revenues for contracts that contain multiple deliverables to make it consistent with Emerging Issues Task Force No. 00-21 (“EITF 00-21). The adoption of SAB 104 and EITF 00-21 did not have a material impact on the Company’s financial position, results of operations or cash flows.

The Company’s financial instruments with market risk exposure are borrowings under its Credit Agreements that total $12.1 million at December 31, 2003. Based on this balance, a change of one percent in the interest rate would cause a change in interest expense of approximately $121,000, or $0.0 per share, on an annual basis. The Credit Agreement was not entered into for trading purposes and carries interest at a pre-agreed upon percentage point spread from either the prime interest rate or LIBOR interest rate.

The financial statements required by this Item 8 are incorporated under Item 14 in Part III of this Annual Report on Form 10-K.

None.

The Company’s management, including the Company’s principal executive officer and principal financial officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Annual Report on Form 10-K. Based upon that evaluation, the Company’s principal executive officer and principal financial officer have concluded that the disclosure controls and procedures were effective as of the end of the period covered by this Annual Report on Form 10-K. However, some of the information used for internal and external reporting by the Company and management is derived from

27

Table of Contents

data input by decentralized employees at the dental centers. The decentralization of input and system controls may affect the accuracy of this data. Management is aware of this risk and is taking steps to reduce this risk by improving the Company’s dental practice management system. However, such improvement may require a new practice management system, which management is presently evaluating but may take several years to implement and could present additional risk associated with systems conversions.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

28

Table of Contents

PART III

The following sets forth information as to the current directors and executive officers of the Company, including their ages, present principal occupations, other business experience during the last five years, memberships on committees of the Board of Directors and directorships in other publicly-held companies.

Board of Directors

Frank A. Baynham became a director of the Company in October 2002. Mr. Baynham has been in senior management for Luxottica Retail since April 1987 and is currently Executive Vice President, Stores. Luxottica is a multinational distributor of designer eyewear and owns LensCrafters and Sunglass Hut. From 1981 to 1987, Mr. Baynham held management positions with Proctor & Gamble. Mr. Baynham has been designated as a director of the Company pursuant to the Stockholders Agreement. Mr. Baynham received a B.A. from Murray State University.

Ira Glazer became a director of the Company in August 2002. Mr. Glazer is the Chief Executive Officer of the Wire Rope Corporation of America, Inc., a privately owned manufacturer of wire, wire rope and related products. Mr. Glazer was appointed as the Chief Restructuring Officer of Wire Rope when it filed for bankruptcy protection under Chapter 11 in May 2002. From 1999 until 2003, Mr. Glazer was a managing director of Getzler & Co., Inc., a New York based turnaround specialist. In his capacity as an employee of Getzler & Co., he served as acting Chief Executive Officer of the Company from February 2001 until June 2001. As a private consultant prior to 1999, he served as President of Knitwaves, Inc., a privately owned manufacturer of children’s knitwear, from May 1998 until February 1999. Knitwaves filed bankruptcy in November 1998. From 1986 until September 1997, Mr. Glazer served as Chief Financial Officer and Chief Operating Officer of Maidenform Worldwide, Inc., a private manufacturer of intimate apparel. Maidenform filed bankruptcy in August 1998. Before joining Maidenform, Mr. Glazer spent ten years with Chase Manhattan Bank, where he was a Vice President and Division Executive in middle market

29

Table of Contents

lending. Mr. Glazer has been designated as a director of the Company pursuant to the Stockholders Agreement. Mr. Glazer received a B.B.A. from Pace University.

Edward L. Kuntz became a director of the Company in August 2002. Mr. Kuntz has served as the Chairman of the Board and Chief Executive Officer of Kindred Healthcare, Inc., a publicly held provider of long-term healthcare services, since January 1999. Mr. Kuntz served as the Chief Operating Officer and a director of Kindred Healthcare from November 1998 to January 1999. He also served as President of Kindred Healthcare from November 1998 until January 2002. Mr. Kuntz was Chairman and Chief Executive Officer of Living Centers of America, Inc., a publicly held provider of long-term healthcare, from 1992 to 1997. After leaving Living Centers of America, Inc., he served as an advisor and consultant to a number of healthcare services and investment companies and was affiliated with Austin Ventures, a venture capital firm. In addition, Mr. Kuntz served as Associate General Counsel from 1978 until 1985, and as Executive Vice President from 1985 until the formation of Living Centers of America, Inc. in 1992, of ARA Living Centers. Mr. Kuntz has been designated as a director of the Company by Sentinel pursuant to the Stockholders Agreement. Mr. Kuntz received a J.D. and a B.A. from Temple University.

David S. Lobel was elected Chairman of the Board of Directors in July 2003. Mr. Lobel has been Managing Partner of Sentinel, a private equity investment firm he founded in 1995. From 1981 through 1995, Mr. Lobel was associated with First Century Partners (“First Century”), a venture capital affiliate of Smith Barney, where he served as a general partner of funds managed by First Century from 1983 to 1995. Before joining First Century, Mr. Lobel was a consultant at Bain & Company, a management consulting firm, from 1979 to 1981. He currently is Chairman of Alemite Corporation, an industrial lubrication equipment producer, Cottman Transmission Holdings, LLC, an automotive transmission repair company, Floral Plant Growers, LLC, a grower of floriculture products and Romacorp, Inc., an owner and franchisor of Tony Roma’s restaurants, and is a Director of Buffets, Inc., an operator of buffet-style restaurants, Growing Family, Inc., an in-hospital infant photography services company and Spinrite Limited Partnership, a leading manufacturer of yarn for the craft industry. He received an M.B.A. and an M.S. from Stanford University. Mr. Lobel has been designated as a director of the Company by Sentinel pursuant to the Stockholders Agreement.

Paul F. Murphy has been a Principal at Sentinel since July 2000. Prior to that, Mr. Murphy was a Director at Dilmun Investments, Inc., the U.S. private equity affiliate of Bahrain International Bank E.C., from 1997 to 2000. Prior to working at Dilmun, Mr. Murphy was a Vice President in the Financial Buyers Group at NationsBanc Capital Markets, Inc. from 1996 to 1997. Prior to joining NationsBanc, Mr. Murphy was an Associate in the Merchant Banking Group of Chase Manhattan Bank from 1994 to 1996. Mr. Murphy holds an M.B.A. from Georgetown University and a B.S. from the United States Military Academy at West Point. He served on active duty for five years as an Artillery officer in the United States Army where he attained the rank of Captain. Mr. Murphy has been designated as a director of the Company by Sentinel pursuant to the Stockholders Agreement.

Executive Officers

The Board elects executive officers annually at its first meeting following the annual meeting of stockholders. Information concerning the executive officers other than Mr. Usdan is set forth below.

John M. Slack was appointed Interim Chief Executive Officer in June 2003. Mr. Slack joined the Company in December 1995 as Vice President and Chief Financial Officer and was appointed Senior Vice President and Chief Administrative Officer in January 2002. From November 1994 through November 1995, he served as Vice President and Chief Financial Officer of Team, Inc., a publicly held environmental services company. From 1985 through August 1994, Mr. Slack was Vice President and Chief Financial Officer of Serv-Tech, Inc., a publicly held industrial services company. Mr. Slack received a B.S. in international economics from Georgetown University in 1969.

Joseph P. Keane joined the Company as Senior Vice President and Chief Financial Officer in January 2002. During 2000 and 2001, Mr. Keane was Chief Financial Officer of Galaxy.com, LLC, a vertical internet directory owned 50/50 by a subsidiary of Fox Entertainment Group and private investors. From

30

Table of Contents

1997 to 2000, Mr. Keane held the positions of Deputy Commissioner of the Tennessee Department of Insurance and also worked as the Director of Internal Audit for the State of Tennessee. From 1995 to 1997, Mr. Keane worked for Columbia/HCA as an analyst involved in government relations, mergers and acquisitions. Mr. Keane received a Bachelor of Business Administration degree from East Tennessee University and he is a certified public accountant.

Tim S. Tiffin became Vice President and Chief Information Officer (“CIO”) in September 2000. From 1998 to 2000, Mr. Tiffin served as Senior Vice President-Operations and CIO for First National Net, Inc. an international mortgage field services company. From 1995 to 1998 Mr. Tiffin was CIO of Frontier Engineering, Inc. a Department of Defense contractor with global operations.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934 requires the Company’s directors, officers and persons holding more than ten percent of a registered class of the Company’s equity securities to file with the SEC and any stock exchange or automated quotation system on which the Common Stock may then be listed or quoted (i) initial reports of ownership, (ii) reports of changes in ownership and (iii) annual reports of ownership of Common Stock and other equity securities of the Company. Such directors, officers and ten-percent stockholders are also required to furnish the Company with copies of all such filed reports.

Based solely upon review of the copies of such reports furnished to the Company and written representations that no other reports were required during 2003, the Company believes that all of the Company’s executive officers and directors complied with Section 16(a) reporting requirements during 2003, except as follows: Mr. Glazer filed one report late; Mr. Baynham filed one report late; Mr. Kuntz filed one report late; Mr. Slack filed one report late; Mr. Keane filed one report late and Mr. Tiffin filed two reports late.

Information Concerning the Operation of the Board of Directors

The Company’s business is managed under the direction of the Board of Directors. The Board of Directors meets on a quarterly basis to review significant developments affecting the Company and to act on matters requiring Board approval. The Board of Directors may also hold special meetings when an important matter requires Board action between regularly scheduled meetings. During 2003, the Board of Directors met formally 4 times. All directors attended at least 75% of the total number of meetings of the Board of Directors.

In order to facilitate the various functions of the Board of Directors, the Board of Directors has created an Executive Committee, an Audit Committee, and a Compensation Committee. Committee members are not remunerated in addition to their annual Board retainer. The Stockholders Agreement provides that two Sentinel Directors and one non-Sentinel Director, who shall be specified by the holders of a majority of the Sentinel Shares or the holders of a majority of the non-Sentinel Shares, respectively, shall be appointed to the Executive Committee, Compensation Committee and Audit Committee of the Board of Directors, each of which shall have no more than three members.

Executive Committee. The Executive committee has been delegated, to the fullest extent allowed by law, the authority of the Board of Directors that has not otherwise been delegated to another committee of the Board of Directors. The Executive Committee was formed on June 16, 2003, and consists of Mr. Lobel and Mr. Murphy. Following his hiring, the new Chief Executive Officer will also become a member of the Executive Committee.

Audit Committee. The Audit Committee makes recommendations to the Board of Directors concerning the engagement of independent public accountants, monitors the Company’s internal accounting controls, reviews quarterly and annual financial information, and reviews the independence, services and fees of the independent auditors. The Board of Directors adopted an Audit Committee Charter in 2000, a copy of which has been filed with the SEC. From October 14, 2002 to June 16, 2003, the Audit Committee consisted of Ira Glazer, Paul Kreie and Edward L. Kuntz. Since June 16, 2003, the Audit Committee has consisted of Ira Glazer and Paul Murphy. The Board of Directors has determined that Ira Glazer is qualified to be the Audit Committee Financial Expert. Based on the definition of independence in Sections 303.01(b)(2)(a) and (3) of

31

Table of Contents

the New York Stock Exchange’s listing standards, all of the Company’s current Audit Committee members are independent. The Audit Committee held 4 meetings during 2003, and all members of the Audit Committee attended the meetings.

Compensation Committee. The Compensation Committee periodically determines the amount and form of compensation and benefits payable to all principal officers and certain other management personnel. This committee also administers the 2002 Plan. From October 14, 2002 to June 16, 2003, the Compensation Committee consisted of Frank A. Baynham, Paul Kreie, and Edward L. Kuntz. Since June 16, 2003, the Compensation Committee has consisted of Mr. Baynham, Mr. Kuntz and Mr. Lobel. The Compensation Committee held 2 meetings during 2003, and all members of the Compensation Committee attended all meetings.

Code of Ethics

The Company has adopted a Code of Ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer or controller. This Code of Ethics is attached to this Annual Report on Form 10-K as Exhibit A.

Directors’ Compensation

During 2003, each non-employee director, excluding the Sentinel directors, were paid an annual retainer of $7,500, a fee of $1,500 for each Board of Directors meeting attended in person and $500 for each telephonic Board of Directors meeting in which the director participated. The Company paid aggregate fees of $41,500 to non-employee directors in connection with Board of Directors’ and committee meetings in 2003. The Company does not pay director fees to directors who also are the Company’s employees. No member of the Board of Directors was paid compensation during 2003 for his service as a director other than pursuant to the standard compensation arrangement described above. On March 3, 2003, each non-employee director was granted 461,809 options under the 2002 Plan, exercisable at $.10 per share.

Summary Compensation Table

The following table provides certain summary information concerning compensation earned by each person who served as the Company’s Chief Executive Officer during 2003 and each of the other executive officers of the Company (the “Named Executive Officers”) whose compensation exceeded $100,000 during the year ended December 31, 2003.

32

Table of Contents

Employment Agreements

John M. Slack. On July 19, 2002 the Company entered into a three-year employment agreement with John M. Slack. Following the initial three-year term, the employment agreement is automatically renewed for successive one year terms unless terminated by the Company or Mr. Slack. This agreement was amended effective June 16, 2003, following his assumption of the duties of Interim Chief Executive Officer.

The employment agreement provides for a base annual salary of $15,417 per month, subject to increase at the sole discretion of the Compensation Committee. During the period that Mr. Slack serves as Interim Chief Executive Officer, he will be paid a bonus of $5,000 per month. Mr. Slack is eligible for an annual bonus at the discretion and based on the criteria approved by the Compensation Committee. Mr. Slack is entitled to reimbursement of expenses, and to participate in all benefit, incentive, insurance, disability and other similar plans provided by the Company. Mr. Slack is entitled to life insurance in an amount equal to the greater of (1) fifty percent of Mr. Slack’s annual salary and (2) the amount to which Mr. Slack is entitled pursuant to the Company’s policy for its executive employees.

The Company may terminate Mr. Slack’s agreement for “cause.” Cause is defined in the employment agreement to include the failure to provide services, fraud or embezzlement, committing any act with the intent to injure the Company, conviction of a felony, misappropriation of Company property, personal misconduct that has materially injured the Company, or willfully violating laws or regulations relating to the Company’s business. If Mr. Slack is terminated without cause or terminates the agreement for good reason, the Company must pay Mr. Slack a severance amount equal to one year’s salary, and must continue to provide, at the Company’s cost, coverage under its group health plan for the applicable COBRA coverage period. Good reason is defined in the agreement as assigning Mr. Slack duties materially inconsistent with his position, a 5% reduction in Mr. Slack’s salary, a failure by the Company to continue to provide any material benefit, incentive, insurance, disability or similar plan, requiring Mr. Slack to relocate or materially breaching the agreement.

Joseph P. Keane. On July 19, 2002 the Company entered into a three-year employment agreement with Joseph P. Keane. This employment agreement was amended on August 19, 2003. Following the initial three-year term, the employment agreement is automatically renewed for successive one year terms unless terminated by Mr. Keane or the Company. The employment agreement provides for a base annual salary of $15,417 per month, subject to increase at the sole discretion of the Compensation Committee. Mr. Keane is eligible for an annual bonus at the discretion and based on the criteria approved by the Compensation Committee. Mr. Keane is entitled to reimbursement of expenses, and to participate in all benefit, incentive, insurance, disability and other similar plans provided by the Company.

The Company may terminate Mr. Keane’s agreement for “cause.” Cause is defined in the employment agreement to include the failure to provide services, fraud or embezzlement, committing any act with the intent to injure the Company, conviction of a felony, misappropriation of Company property, personal misconduct that has materially injured the Company, or willfully violating laws or regulations relating to the

33

Table of Contents

Company’s business. If Mr. Keane is terminated without cause or terminates the agreement for good reason, the Company must pay Mr. Keane a severance amount equal to one year’s salary, and must continue to provide, at the Company’s cost, coverage under its group health plan for the applicable COBRA coverage period; provided, however, that if Mr. Keane is terminated by the Company without cause or he terminates his employment prior to the earlier of April 30, 2004 or the date 90 days after the Company hires a new Chief Executive Officer, the Company must pay him a severance amount equal to $260,000 plus certain other benefits. Good reason is defined in the agreement as assigning Mr. Keane duties materially inconsistent with his position, a 5% reduction in Mr. Keane’s salary, a failure by the Company to continue to provide any material benefit, incentive, insurance, disability or similar plan, requiring Mr. Keane to relocate or materially breaching the agreement.

Tim S. Tiffin. On July 19, 2002, the Company entered into a three-year employment agreement with Tim S. Tiffin. Following the initial three-year term, the employment agreement is automatically renewed for successive one year terms unless terminated by Mr. Tiffin or the Company. The employment agreement provides for a base annual salary of $15,417 per month, subject to increase at the sole discretion of the Compensation Committee. Mr. Tiffin is eligible for an annual bonus at the discretion and based on the criteria approved by the Compensation Committee. Mr. Tiffin is entitled to reimbursement of expenses, and to participate in all benefit, incentive, insurance, disability and other similar plans provided by the Company.

The Company may terminate Mr. Tiffin’s agreement for “cause.” Cause is defined in the employment agreement to include the failure to provide services, fraud or embezzlement, committing any act with the intent to injure the Company, conviction of a felony, misappropriation of Company property, personal misconduct that has materially injured the Company, or willfully violating laws or regulations relating to the Company’s business. If Mr. Tiffin is terminated without cause or terminates the agreement for good reason, the Company must pay Mr. Tiffin a severance amount equal to one year’s salary, and must continue to provide, at the Company’s cost, coverage under its group health plan for the applicable COBRA coverage period. Good reason is defined in the agreement as assigning Mr. Tiffin duties materially inconsistent with his position, a 5% reduction in Mr. Tiffin’s salary, a failure by the Company to continue to provide any material benefit, incentive, insurance, disability or similar plan, requiring Mr. Tiffin to relocate or materially breaching the agreement.

Stock Option Grants in 2003

The following table reflects certain information regarding stock options granted to the named executive officers during 2003.

34

Table of Contents

Aggregate Option Exercises in 2003 and Year-End 2003 Option Values

The following table reflects certain information concerning the number of unexercised options held by the Named Executive Officers and the value of such officers’ unexercised options as of December 31, 2003. The Named Executive Officers exercised no options during the year ended December 31, 2003.

Compensation Committee Interlocks and Insider Participation

In 2003, the members of the Compensation Committee were David S. Lobel, Frank A. Baynham and Edward L. Kuntz. Mr. Lobel is a party to certain transactions with the Company. See “Certain Relationships and Related Transactions.”

Principal Stockholders

The following table sets forth information as of the record date with respect to beneficial ownership of the Company’s Common Stock, Series A-1 Stock, Series A-2 Stock and Series B Stock by: (i) each director, (ii) each Named Executive Officer, (iii) all executive officers and directors of the Company as a group, and (iv) each person known to the Company who beneficially owns 5% or more of the outstanding shares of its voting securities. Unless otherwise indicated, each of the stockholders listed below has sole voting and investment power with respect to the shares beneficially owned. The business address of each person named below is 3701 Kirby Drive, Suite 550, Houston, Texas 77098, unless otherwise indicated. The percentage of each class of voting stock owned is based on 8,265,323 shares of Common Stock, 195,838 Shares of Series A-1 Stock, no shares of Series A-2 Stock and 79,190 shares of Series B Stock outstanding on the Record Date. On the Record Date, warrants to purchase 10,984 shares of Series A-2 Stock were outstanding. Each share of Series A-1 Stock and Series A-2 Stock is currently convertible into 182.68 shares of common stock and each share of Series B Stock is currently convertible into 2,083.89 shares of common stock.

35

Table of Contents