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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
(mark one)

 
For the fiscal year ended September 30, 2010
 
or
 
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from _______________ to _______________
 
Commission file number 000-26285
 
CNS RESPONSE, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
87-0419387
(State or other jurisdiction
(I.R.S. Employer
of incorporation or organization)
Identification No.)
 
85 Enterprise, Suite 410
Aliso Viejo, CA 92656
(Address of Principal Executive Offices)(Zip Code)
 
(714) 545-3288
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
None
 
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $0.001 par value
 
(Title of Class)
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes    ¨     No     x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes    ¨     No     x
 
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 whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes    ¨     No     ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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 a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer      ¨
Accelerated filer ¨
Non-accelerated filer     ¨   (Do not check if smaller reporting company)
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)
Yes     ¨     No     x
 
The aggregate market value of the registrant's common stock held by non-affiliates of the registrant on March 31, 2010, the last business day of the registrant's most recently completed second fiscal quarter was $64,427,500 (based on the closing sales price of the registrant's common stock on that date).

At December 16, 2010, the registrant had 56,023,921 shares of Common Stock, $0.001 par value, issued and outstanding.

 
 

 

 
2009 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

PART I
 
3
ITEM 1.
Business
4
ITEM 1A.
Risk Factors
12
ITEM 1B.
Unresolved Staff Comments
22
ITEM 2.
Properties
23
ITEM 3.
Legal Proceedings
23
ITEM 4.
(Removed and Reserved)
23
PART II
 
24
ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
24
ITEM 6.
Selected Financial Data
28
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
28
ITEM 7A.
Quantitative and Qualitative Disclosures about Market Risk
37
ITEM 8.
Financial Statements and Supplementary Data
38
ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
62
ITEM 9A. 
Controls and Procedures
63
ITEM 9B.
Other Information
64
PART III
 
65
ITEM 10.
Directors, Executive Officers and Corporate Governance
65
ITEM 11.
Executive Compensation
69
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
77
ITEM 13.
Certain Relationships and Related Transactions, and Director Independence
79
ITEM 14.
Principal Accounting Fees and Services
86
PART IV
 
86
ITEM 15.
Exhibits, Financial Statement Schedules
86
 
 
2

 

 
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
 
This 2010 Annual Report on Form 10-K, including the sections entitled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business,” contains “forward-looking statements” that include information relating to future events, future financial performance, strategies, expectations, competitive environment, regulation and availability of resources.  These forward-looking statements include, without limitation, statements regarding: proposed new products or services; our statements concerning litigation or other matters; statements concerning projections, predictions, expectations, estimates or forecasts for our business, financial and operating results and future economic performance; statements of management’s goals and objectives; trends affecting our financial condition, results of operations or future prospects; our financing plans or growth strategies; and other similar expressions concerning matters that are not historical facts.  Words such as “may,” “will,” “should,” “could,” “would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes” and “estimates,” and similar expressions, as well as statements in future tense, identify forward-looking statements.
 
Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, that performance or those results will be achieved. Forward-looking statements are based on information available at the time they are made and/or management’s good faith belief as of that time with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements. Important factors that could cause these differences include, but are not limited to:
 
 
·
our inability to raise additional funds to support operations and capital expenditures;
 
 
·
our inability to achieve greater and broader market acceptance of our products and services in existing and new market segments;
 
 
·
our inability to successfully compete against existing and future competitors;
 
 
·
our inability to manage and maintain the growth of our business;
 
 
·
our inability to protect our intellectual property rights; and
 
 
·
other factors discussed under the headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.”
 
Forward-looking statements speak only as of the date they are made. You should not put undue reliance on any forward-looking statements. We assume no obligation to update forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except to the extent required by applicable securities laws.  If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.

 
3

 
 
ITEM 1.
Business
 
With respect to this discussion, the terms “we” “us” “our” “CNS” and the “Company” refer to CNS Response, Inc., a Delaware corporation and its wholly-owned subsidiaries CNS Response, Inc., a California corporation (“CNS California”), Colorado CNS Response, Inc., a Colorado corporation (“CNS Colorado”) and Neuro-Therapy Clinic, Inc., a Colorado professional medical corporation and a wholly-owned subsidiary of CNS Colorado (“NTC”).

Background

CNS Response, Inc. was incorporated in Delaware on March 16, 1987, under the name Age Research, Inc.   Prior to January 16, 2007, CNS Response, Inc. (then called Strativation, Inc.) existed as a “shell company” with nominal assets whose sole business was to identify, evaluate and investigate various companies to acquire or with which to merge.  On January 16, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with CNS Response, Inc., a California corporation formed on January 11, 2000 (“CNS California”), and CNS Merger Corporation, a California corporation and our wholly-owned subsidiary (“MergerCo”) pursuant to which we agreed to acquire CNS California in a merger transaction wherein MergerCo would merge with and into CNS California, with CNS California being the surviving corporation (the “Merger”). On March 7, 2007, the Merger closed, CNS California became our wholly-owned subsidiary, and on the same date we changed our corporate name from Strativation, Inc. to CNS Response, Inc.

Our address is 85 Enterprise, Suite 410, Aliso Viejo, CA 92672 and we maintain a website at www.CNSResponse.com. The reference to our web address does not constitute incorporation by reference of the information contained at this site  
 
Overview

CNS Response is a web-based neuroinformatic company with two distinct business segments. Our primary business is Neurometric Information Services (formerly called Laboratory Information Services) operated by CNS California, which is focused on neurometric analysis, research, development and commercialization of a patented system that provides data to psychiatrists and other physicians/prescribers to enable them to make more informed decisions when treating  patients with behavioral (psychiatric and/or addictive) disorders. Our secondary business is Clinical Services business which is a full service psychiatric clinic operated by NTC.

Financial information with respect to our two segments is provided in Note 9 to our consolidated financial statements appearing elsewhere in this annual report on Form 10-K.

Neurometric Information Services
 
Traditionally, prescription of medication for the treatment of behavioral disorders (such as depression, bipolar disorders, eating disorders, addiction, anxiety disorders, ADHD and schizophrenia) has been primarily based on symptomatic factors, while the underlying physiology and pathology of the disorder is rarely able to be analyzed, often resulting in multiple ineffective, costly, and often lengthy, courses of treatment before effective medications are identified.  Some patients never find effective medications.
 
We believe that our technology offers an improvement upon traditional methods for determining a course of medication for patients suffering from non-psychotic behavioral disorders because our technology is designed to correlate the success of courses of medication, with the neurophysiological characteristics of a particular patient. Our technology provides medical professionals with medication sensitivity data for a subject patient based upon the identification and correlation of treatment outcome information from other patients with similar neurophysiologic characteristics.   This treatment outcome information is contained in a proprietary outcomes database that consists of over 17,000 medication trials for patients with psychiatric or addictive problems (the “CNS Database ”).  For each patient in the CNS Database, we have compiled electroencephalographic (“EEG ”) scans, symptoms and outcomes often across multiple treatments from multiple psychiatrists and physicians.  This patented technology, called “Referenced-EEG®” or “rEEG®” represents an innovative approach to identifying effective medications for patients suffering from debilitating behavioral disorders.

With rEEG®, physicians order a digital EEG for a patient, which is then evaluated with reference to the CNS Database.  By providing this reference correlation, an attending physician can choose a treatment strategy with the knowledge of how other patients having similar brain function have previously responded to a myriad of treatment alternatives.  Analysis of this complete data set yielded a platform of 74 neurometric variables that have shown utility in characterizing patient response to diverse medications.  This platform then allows a new patient to be characterized, based on these 74 neurometrics, and the database to be queried to understand the statistical probability of how patients with similar brain patterns have previously responded to the medications currently in the database. This technology allows us to create and provide simple reports (“ rEEG Reports ”) to the prescriber that summarizes historical treatment success of specific medications for those patients with similar brain patterns.   It provides neither a diagnosis nor specific treatment, but like all lab results, provides objective, evidenced-based information to help the prescriber in their decision-making.
 
 
4

 

Our Neurometric Information Services business is focused on increasing the demand for our rEEG Reports. We believe the key factors that will drive broader adoption of our rEEG Reports will be acceptance by healthcare providers and patients of their benefit, demonstration of the cost-effectiveness of using our technology, reimbursement by third-party payers, expansion of our sales force and increased marketing efforts.
 
In addition to its utility in providing psychiatrists and other physicians/prescribers with medication sensitivity guidance, rEEG provides us with significant opportunities in the area of pharmaceutical development.  rEEG, in combination with the information contained in the CNS Database, has the potential to be able to identify novel uses for neuropsychiatric medications currently on the market and in late stages of clinical development, as well as aid in the identification of neurophysiologic characteristics of clinical subjects that may be successfully treated with neuropsychiatric medications in the clinical testing stage. We intend to enter into relationships with established drug and biotechnology companies to further explore these opportunities, although no relationships are currently contemplated.  The development of pathophysiological markers as the new method for identifying the correct patient population to research is being encouraged by both The National Institute of Mental Health (NIMH) and The Food and Drug Administration (FDA).
 
Clinical Services
 
In January 2008, we acquired our largest customer, NTC, located in Colorado. Upon the completion of the transaction, NTC became our wholly-owned subsidiary. At the time, NTC operated one of the largest psychiatric medication management practices in the state of Colorado, under contract with multiple national health plans.  Daniel A. Hoffman, M.D. is the medical director at NTC, and, after the acquisition, became our Chief Medical Officer and more recently, our President.
 
NTC, having performed a significant number of rEEGs, serves as an important resource in our product development, the expansion of our CNS Database, production system development and implementation, along with the integration of our rEEG services into a medical practice.  Through NTC, we also expect to successfully develop marketing and patient acquisition strategies for our Neurometric Information Services business. Specifically, NTC is learning how to best communicate the advantages of rEEG to patients and referring physicians in the local market. We will share this knowledge and develop communication programs which can be generalized to physicians using our services throughout the country, which we believe will help drive market acceptance of our services.  In addition, we plan to use NTC to train practitioners across the country in the uses of rEEG technology.  
 
We view our Clinical Services business as secondary to our Neurometric Information Services business, and we have no current plans to significantly expand this business.
 
Neurometric Information Services
 
The Challenge and the Opportunity
 
The 1990’s were known as “the Decade of the Brain,” a period in which basic neuroscience yielded major advances in drug discovery and neurotherapy.  Several trends have emerged which may propel significant adoption of these advances over the next decade: 

 
·
More than $29 billion in spending has been dedicated to the compulsory utilization of electronic health records and other IT services under the “HITECH” portion of the American Recovery and Reinvestment Act (ARRA), with most of that spending to occur between 2011-2013.  Currently, less than 20% of healthcare providers utilize electronic records, yet all providers will be expected to have adopted such systems by 2015 (or face economic penalties under Medicare/Medicaid).  This extraordinary growth in the use of medical informatics tools creates a significant and expanding market for CNS Response.

 
·
Similarly, Comparative Effectiveness Research has been made a key feature of the Obama health plan. The cost to treat Americans under care for depression and other mental illnesses rose by nearly two-thirds from $35 billion to $58 billion in the last 10 years, according to a recent report from the Agency for Healthcare Research and Quality.  Finding more cost-effective treatment modalities in mental disorders will be critical to successful health care reform;

 
·
The Mental Health Parity Act (Parity Act) requires payers, beginning in 2010, to pay for behavioral medications and treatments using the same standards for evidence and coverage as they currently use for medical/surgical treatments;

 
·
According to a recent RAND report, 275,000 returning military personnel from the Iraq and Afghanistan theatres suffer from Major Depression, Post Traumatic Stress Disorder (PTSD), traumatic brain injury; and

 
·
Consumers have emerged as active decision makers in behavioral treatment, driven by over $4.8 billion in annual Pharma direct-to-consumer advertising and the internet.  At the same time, media costs for reaching those consumers are at historic lows.
 
 
5

 

Today, there are over 100 prescription drugs available to patients suffering from a behavioral disorder, representing one of the largest and fastest-growing drug classes.  Unfortunately, psychotropic drugs often do not work, or lose their effect over time, and over 17 million Americans who have failed two or more medication treatments are now considered “treatment resistant”.  For these patients, the conventional “trial and error” method of prescribing psychotropic drugs has resulted in low efficacy, high relapse and treatment discontinuation rates, significant patient suffering and billions in additional cost to payers.
 
We believe we are the first company to create a neurometric database that correlates a patient’s response to major drug classes and specific medications with their individual brain physiology.  We developed this tool to improve pharmacotherapy outcomes, particularly in treatment resistant patients, a particularly expensive patient population with profound unmet clinical needs.  Our rEEG technology has been used by physicians to guide prescribing in behavioral disorders such as depression, anxiety, anorexia, OCD, bipolar, ADHD, addiction and others.
 
rEEG® was developed by a pathologist/psychiatrist who recognized that correlation of a patient’s unique brain patterns to known long-term medication outcomes in similar patients might significantly improve therapeutic performance.  This approach — commonly referred to as Personalized Medicine, and exemplified by companies such as Genomic Health (GHDX) — is in the process of transforming both clinical practice and the pharmaceutical industry.  CNS Response brings this science to behavioral medicine, where the unmet clinical need is well-documented, expensive, and growing.
 
The rEEG® Method
 
rEEG® Reports are offered as a service, much like a reference lab, in which standard electroencephalogram (EEG) readings are referenced to a database to suggest patient-specific probabilities of response to different medications.  EEG recording devices are widely available, inexpensive to lease, and are available in most cities by independent mobile EEG providers.

The service works as follows:

 
·
Patients are directed by an attending physician to a local rEEG® provider, who performs a standard digital EEG.
 
·
EEG data file is uploaded over the web to our central analytical database.
 
·
We analyze the data against the CNS Database for patients with similar brain patterns.
 
·
We provide a report describing the probability of patient success with different medication options (much like an antibiotic sensitivity report commonly used in medicine).
 
·
The rEEG® Report is sent back to the attending physician, usually by the next business day.

Treatment Decisions Made by Licensed Professionals
 
With the exception of our subsidiary, the Neuro-Therapy Clinic based in Denver, CO, we do not currently operate our own healthcare facilities, employ our own treating physicians or provide medical advice or treatment for patients.  Physicians who contract for our rEEG Reports own their own facilities or professional licenses, and control and are responsible for the clinical activities provided on their premises.  Patients receive medical care in accordance with orders from their attending physicians or providers.  Physicians who contract for rEEG Reports are responsible for exercising their independent medical judgment in determining the specific application of the information contained in the rEEG Reports and the appropriate course of care for each patient.  Following the prescription of any medication, Physicians are presumed to administer and provide continuing care treatment.
 
Estimated Market for rEEG Reports
 
Currently, the wholesale (direct to physician) price for standard rEEG testing is $400 per test, and the retail (payer and consumer) price is approximately $800.  Thus far, payments have typically been from psychiatrists whose patients pay privately for the rEEG® Report.  The National Institute of Mental Health (NIMH) estimates that only 12.7% of patients get minimally effective treatment, with over 17 million Americans now classified as “treatment resistant”, meaning that they have failed to find relief after trying two or more medications.
 
We therefore estimate the potential market for our rEEG Reports at $1.7 billion annually, based on an addressable market of 17 million Treatment Resistant patients, with only 12.5% of patients seeking care and complying with treatment.  
 
Path to Adoption
 
Several firms have successfully commercialized products that predict medication response, including Genomic Health’s OncotypeDx which predicts response to chemotherapy, and Roche/Affymetrix Cytochrome P450 test which shows how each patient is likely to metabolize a given antidepressant.  We are following the paths to adoption used by these successful firms by focusing on growth in three stages:
 
 
6

 

(1)            Private pay market.
 
Consumers and private-pay psychiatrists drive over 33% of the market for psychiatric visits, and a significant proportion of all licensed psychiatrists now describe themselves as private pay only.  We believe consumers who have experienced treatment failure will seek out our network of physicians once they become aware of the successful outcomes demonstrated by our clinical trial.
 
During 2008, the recruiting for our Depression Efficacy Trial (the Depression Efficacy Trial is further described under the heading Neurometric Services Accomplishments below) generated many important lessons about integrated marketing for our rEEG® service.  By using a media mix of web, radio and TV, interested patients were delivered into the trial at an average cost of $40-$68 per contact.  We will continue to pursue integrated consumer marketing as a means to introduce interested patients to our rEEG® provider network.
 
To drive growth in private pay, consumer-driven rEEG testing, we plan to do the following:

 
·
Grow our focused physician network:  We currently have 52 active practicing physicians utilizing rEEG in their practices, defined as having paid for testing within the last 12 months.  Over the same period 31 new physicians were trained.  Physicians who become “power users” (which we define as physicians who conduct several tests per month) report significantly better results than casual users of rEEG technology, and have certain economies of scale in using the test in their practices.  Similar to the adoption of LASIK technology in consumer-driven ophthalmology, successful practices using rEEG have reported that as their word-of-mouth referrals increase, their procedure billings increase, and their average patient visits decrease (as patients improve).  Accordingly, their patient turnover may increase over time, requiring additional marketing efforts to grow their practice volume.

We plan to focus on supporting these power users through direct marketing, clinical practice support (patient intake, scheduling, washout support and reporting), and technical support.  This focused network approach has been successful in other specialties (for example, in organ transplant networks and in disease management) because it is easier to sell to payers, facilitates data collection, and is more cost-effective in delivering care even at higher provider margins.

 
·
Increase unit pricing:  Currently, the wholesale (direct-to-physician) price for standard rEEG testing is $400 per test, and the retail (payer and consumer) price is approximately $800.   We anticipate that our pricing will be increased over time with greater acceptance of the test as a standard of care, rewarding power users for committed volume and affording improvement in test margins overall.

 
·
Utilize our neurometric information service:  In 2008, we purchased the psychiatric clinic in Denver, co-founded by our Chief Medical Officer, Daniel Hoffman, MD.  The clinic currently serves as a platform for perfecting rEEG workflow, information systems, product development and research.  We also test local marketing strategies in Denver which can then be generalized to other rEEG® network clinics.  The Denver clinic may ultimately become a national Center of Excellence for neuropsychiatry, where insurers may direct certain treatment-resistant patients.

 
·
Scalable platform for delivery:  During 2009 and 2010, significant development effort was focused on production systems and lab infrastructure to accommodate potential growth in the production volume of our rEEG Reports.  Our current production application is able to accommodate up to 100 tests per week without additional manpower.  In addition to providing scalable capacity, the production system provides for online delivery of tests and delivery of test data to physicians’ desktops or iPAD.  Currently, we are investing in projects to reduce or eliminate the remaining manual processes in test production: including the “artifacting” of EEG data and the Neurologist review of each case.  It is estimated that these processes will, over time, be replaced with validated algorithms, exception-based reviews and/or post-facto sampling for quality assurance.

 (2)           Payer economic trials.
 
Health plans currently spend over $30 billion on psychotropic medications each year according to the Substance Abuse and Mental Health Services Administration (SAMHSA), and most are aware that these agents only work on about 30% of patients who take them.  The lack of medication adherence and poor treatment outcomes in behavioral health has been a longstanding issue for payers, but they have lacked a targeted, cost-efficient approach to solve the problem.
 
Presently, rEEG is not a reimbursable procedure for most health care payers.  Initially, payer response to most new technologies is a reflexive denial of coverage, regardless of the superiority of evidence or economics.  Over time, however, certain payers may adopt technologies which confer a clear marketing or underwriting advantage, or which protect them from legal claims for reimbursement under new legislation (e.g. Parity).  Because of this, it is possible that with sufficient marketing efforts, we may shift payer “fear of adoption” to “fear of not adopting” and increase the number of payers that approve our rEEG Reports as a reimbursable expense.
 
 
7

 

We intend to prove that our rEEG Reports are a compelling value for payers through independent research, budget impact models, and payer pilots (economic trials):

 
·
Evidence for payers:  We will share well-designed research on rEEG® efficacy, showing the weight of superior evidence in controlled and real-world clinical trials and case series.

 
·
Parity:  In 2010, the Mental Health Parity Act (Parity Act) will change all payers’ coverage criteria, requiring equal coverage for behavioral and medical therapies, using the same coverage criteria and evidence.  Milliman Global Actuarial Services estimates a 1-3% increase in overall health costs resulting from a significant increase in behavioral health expenditures driven by the Parity Act.  Of particular interest to us, however, is the specific language in the Parity Act which requires that coverage of a scope-of-service for one type of diagnosis (for example: a Neurologist performing a diagnostic EEG for Epilepsy) be applied equally as the use of an EEG by a Psychiatrist for medication management.

 
·
Budget Impact Model:  A Budget Impact Model for rEEG® has been developed by Analysis Group Economics based on the published research of Kessler, Russell and others covering the cost of treatment failure in mental disorders.  Modeling the economic impact of rEEG® in a health plan with five million members, we estimate that full utilization of rEEG® in treatment-resistant depression, anxiety, bipolar and ADHD could save $8,500 per treatment resistant member for a savings of $45 million per year.

 
·
Economic Trials: Economic Trials are intended to demonstrate the comparative effectiveness of rEEG versus prevailing Trial & Error medication management through pilot programs within a payer’s own population.  Although no payer is currently reimbursing physicians for the use of rEEG technology, we are currently negotiating pilot programs for reimbursement coverage with several of the nation’s largest payers, representing over 80 million covered lives.
 
(3) 
Full payer coverage.
 
Full reimbursement of referenced-EEG is likely to follow successful direct-to-consumer adoption of the rEEG test, along with continued release of confirmatory rEEG research in peer-reviewed publications.  Following the example of the firms discussed above, it appears possible to accelerate the effect of these initiatives in the following ways: 

 
·
Patient Advocacy:  We believe that some components of the rEEG test may be billable to payers under the Mental Health Parity Act.  Historically, patients of our physician network providers, and those in our own clinic in Colorado, have paid out of pocket for rEEG testing and then sought reimbursement from their insurance carrier.  Although these providers frequently furnish information to support these claims, the success of their prosecution by patients is unclear.

Accordingly, we intend to follow the example of firms such as Genomic Health, which developed Patient Advocacy services where patient claims were documented and tracked, and the company helped organize the advocacy of each claim with third party payers.  Using this approach, Genomic Health was able to win a retrospective reversal of claim denials for its test from Medicare (the Centers for Medicare and Medicaid Services) in 2006.

 
·
Guideline development:  We intend to continue internal and externally-sponsored clinical research to prove the efficacy of our technology to professional associations, such as the American Psychiatric Association.  We believe that with strong clinical results, professional associations may endorse rEEG in their treatment guidelines, which may drive full payer coverage.

We also believe that the inclusion of historical and new rEEG research in Comparative Effectiveness studies conducted under the Agency for Healthcare Research and Quality (AHRQ) would be a significant milestone.  As a consequence of this recent focus on cost-effective treatment, an unprecedented level of funding has been made available under the Economic Recovery Act, the budgets for NIH and AHRQ, and earmarked budgets for Defense and the Veterans Association (VA).  We intend to pursue research opportunities with several external sponsors of research, including: 

 
·
the National Institutes of Mental Health, focusing on the cost-effectiveness of rEEG as a more deployable version of brain imaging to guide prescribing;

 
·
the Department of Defense and the Veterans Administration, to address the potential for rEEG in treating returning soldiers with PTSD and Major Depression; and

 
·
the Centers for Medicare and Medicaid Services (CMS), as a mechanism for improving quality and cost performance in programs that spend billions on psychotropic medications.
 
 
8

 

Neurometric Services Accomplishments
 
Over the last few years, we have been primarily focused on proving the efficacy of rEEG-guided treatments through multiple clinical trials.  The largest of these — the Depression Efficacy Trial — was a multi-center, randomized, parallel controlled trial completed in 2009 at 12 medical centers, including Harvard, Stanford, Cornell, UCI and Rush.  The study began in late 2007 and was completed in September 2009, screening 465 potential subjects with Treatment Resistant Depression and ultimately randomizing 114 participants to a 12-week course of treatment utilizing rEEG in the experimental group and a modified STAR*D algorithm in the control group (STAR*D, or Sequenced Alternatives to Relieve Depression, was a large, seven-year study sponsored by the National Institute of Mental Health and completed in 2006).  Primary clinical outcome measures included the Quick Inventory of Depression Symptomology (QIDS) and the Quality of Life Enjoyment and Satisfaction Questionnaire (QLESQ).  Top-line results were consistent with previous clinical trials of rEEG:

 
·
The study found that rEEG significantly outperformed the modified STAR*D treatment algorithm from the beginning.  The difference, or separation, between rEEG and the STAR*D control group was 50 and 100 percent for the study’s two primary endpoints.  By contrast, separation between a new treatment and a control group often averages less than 10 percent in antidepressant studies.  Interestingly, separation was achieved early (in week 2) and was durable, continuing to grow through week 12.

 
·
The control group in this case, STAR*D, was a particularly tough comparator, representing a level of evidence-based depression care that is available to only 10% of the US population, according to one of the study’s authors.

 
·
Statistical significance (p < .05) was achieved on all primary and most secondary endpoints.

In the course of undertaking the study, we also gained insights into marketing of the rEEG technology, highlighting aspects of marketing which proved to be more successful than others.  Furthermore, we also developed a foundation for commercialization of the rEEG technology with insurance companies, and signed a payer group, Cal Optima (a Southern California health plan for Medicare/Medicaid enrollees), to run a pilot study with us.  A second large insurer is in the process of negotiating a pilot study.  Additionally, over the course of the last few years, much time has been spent securing sufficient financing to continue our operations and to ensure that the clinical trial was completed.
 
Going forward, we plan to continue expanding the CNS Database with the addition of more pharmaceuticals and their respective outcomes.  Additionally, we plan on improving the functionality and clinical utility of our rEEG Reports, in order to improve adoption and compress the training period necessary for physicians to become proficient with the report.  To this end we have integrated an iPAD application as the user interface.  Finally, we plan to increase and refine our marketing efforts to consumers and psychiatrists, and expand our effort to obtain regular insurance reimbursement for rEEG-guided therapies.

Use of rEEG Technology in Pharmaceutical Development
 
In addition to its utility in providing psychiatrists and other physicians with medication sensitivity guidance, rEEG provides us with significant opportunities in the area of pharmaceutical development.  In the future, we aim to use our propriety data and processes to advance central nervous system (CNS) pharmaceutical development and economics, in one or more of the following ways: 
 
 
·
Enrichment:  Selecting patients for clinical trial who not only have the symptoms of interest, but are shown by rEEG® screening to likely respond to the developer’s drug.  An oft-cited example is the antidepressant Prozac, which failed several clinical trials before it achieved success in two separate trials.  The ability to design trials in which exclusion criteria identify and exclude patients who are clearly resistant, as determined by rEEG, has the potential to sharpen patient focus and productivity in clinical trials of psychotropic medications.

 
·
Repositioning:  rEEG® may suggest new applications/indications of existing medications.  For example, Selective Serotonin Reuptake Inhibitors Antidepressants (SSRI’s) are now commonly given by primary care physicians for depression and other complaints, but often produce unwanted side effects or inadequate results.  The ability to define individual neurometrics for patients, who respond better to tricyclics (TCA’s), or combinations of TCA’s and stimulants, offers the potential for new indications for existing compounds.

 
·
Salvage:  Resuscitation of medications that failed phase II or III studies.   One example of this opportunity is Sanofi-Aventis’ unsuccessful PMA filing for Rimonabant, a promising anti-obesity/cardio-metabolic compound which was denied approval in the U.S. due to central nervous system side-effects in their clinical trial populations.  Being able to screen out trial participants with resistance to a certain medication is an application for rEEG, and could create “theranostic” products (where an indication for use is combined with rEEG) for compounds which have failed to receive broader approval.
 
 
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·
New Combinations:  Unwanted adverse effects occur with medications in fields from cancer to hepatitis. The ability to improve these medications, in combination with psychotropics, may improve safety, compliance, and sometimes, patient outcomes.

 
·
Decision Support:  Improved understanding supports improved decision making at all levels of pharmaceutical development.

Competition
 
Comparable Companies  
 
Although there are no companies offering a service directly comparable to rEEG, the following companies might be noted as pursuing similar strategies: 
 
 
·
GENOMIC HEALTH, Inc. is a life science company focused on the development and commercialization of genomic-based clinical laboratory services for cancer that allow physicians and patients to make individualized treatment decisions.

 
·
ASPECT MEDICAL SYSTEMS, INC. (now part of Covidien) is developing a specific EEG measurement system that indicates a patient's likely response to some antidepressant medications.

 
·
BRAIN RESOURCE COMPANY, is an Australian Clinical Research Organization (CRO) and neurosciences company focused on personalized medicine solutions for patients, clinicians, pharmaceutical trials and discovery research.

We believe that we have a competitive advantage with respect to the behavioral analytics firms such as Aspect Medical or Brain Resource Company as we offer more comprehensive testing (e.g. to cover the full range of CNS medications, not just certain antidepressants in the case of Aspect Medical) and have conducted studies to validate the efficacy of our service.  We also believe that we offer greater clinical utility (ease of use, rapid results) in day-to-day clinical practice than our competitors.

Intellectual Property
 
rEEG Patents

We have four issued U.S. Patents which we believe provide us with the right to exclude others from using our rEEG technology.  In addition, we believe these patents cover the analytical methodology we use with any form of neurophysiology measurement including SPECT (Single Photon Emission Computed Tomography), fMRI (Functional Magnetic Resonance Imaging), PET (Positron Emission Tomography), CAT (Computerized Axial Tomography), and MEG (Magnetoencephalography)).  We do not currently have data on the utility of such alternate measurements, but we believe they may, in the future, prove to be useful to guide therapy in a manner similar to rEEG.  We have also filed patent applications for our technology in various foreign jurisdictions, and have issued patents in Australia and Israel.

During 2009 and 2010 the Company was awarded additional patents for use of rEEG technology in drug discovery, including clinical trial and drug efficacy studies.  In addition, the company successfully defended its patents by requesting reexamination of a patent issued to Aspect Medical (now Covidien), resulting in a reduction and narrowing of claims awarded under the previously issued Aspect patents.

rEEG Trademarks
 
“Referenced-EEG” and “rEEG” are registered trademarks of CNS California in the United States.  We will continue to expand our brand names and our proprietary trademarks worldwide as our operations expand.
 
CNS Database
 
The CNS Database consists of over 17,000 medication trials across over 2,000 patients who had psychiatric or addictive problems. The CNS Database is maintained in two parts:
 
1.           The QEEG Database
 
The QEEG Database includes EEG recordings and neurometric data derived from analysis of these recordings.  This data is collectively known as the QEEG Data. QEEG or “Quantitative EEG” is a standard measure that adds modern computer and statistical analyses to traditional EEG studies.  The Company utilizes two separate QEEG databases which provide statistical and normative information in the rEEG process.
 
 
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2.           The Clinical Outcomes Database
 
The Clinical Outcomes Database consists of physician provided assessments of the clinical long-term outcomes (average of 405 days) of patients and their associated medications. The clinical outcomes of patients are recorded using an industry-standard outcome rating scale, the Clinical Global Impression Global Improvement scale (“CGI-I”).  The CGI-I requires a clinician to rate how much the patient's illness has improved or worsened relative to a baseline state. A patient's illness is compared to change over time and rated as: very much improved, much improved, minimally improved, no change, minimally worse, much worse, or very much worse.
 
The format of the data is standardized and that standard is enforced at the time of capture by a software application.  Outcome data is input into the database by the treating physician or in some cases, their office staff.  Each Physician has access to his/her own patient data through the software tool that captures clinical outcome data.
 
We consider the information contained in the CNS Database to be a valuable trade secret and are diligent about protecting such information.  The CNS Database is stored on a secure server and only a limited number of employees have access to it.

Research and Development
 
Going forward, we plan to continue to enhance, refine and improve the accuracy of our CNS Database and rEEG through expansion of the number of medications covered by our rEEG Reports, expansion of our neurometrics, refinement of our report generating system, and by reducing the time to turnaround a report to the physician.  Research and development expenses during the fiscal years ended September 30, 2010 and 2009 were $1,120,500 and $1,924,100, respectively.
 
Government Regulation
 
The FDA informed us that it believes our rEEG service constitutes a medical device which is subject to regulation by the FDA,  requiring pre-market approval or 510(k) clearance by the FDA pursuant to the Federal Food, Drug and Cosmetic Act (the “Act”) before our service can be marketed or sold. 

In early 2010 we submitted an application to obtain 510(k) clearance for our rEEG service, without waiving our right to continue to take the position that our services do not constitute a medical device.  We sought review of our rEEG service, based upon its equivalence to predicate devices that already have FDA clearance, which appeared to represent a sound mechanism in order to reduce regulatory risks.

On July 27, 2010 we received a letter (the “NSE Letter”) from the FDA stating that they determined that our rEEG service was not substantially equivalent to the predicate devices that had previously been granted 510(k) clearance and that, among other options, we could be required to file an approved premarket approval application (PMA) before our rEEG service could be marketed legally, unless it was otherwise reclassified.

We currently plan to continue marketing our rEEG service as a non-device web-based neurometric information service, while continuing to discuss alternative approaches with the FDA.  Alternative approaches, which are not mutually exclusive, may consist of (1) filing a request for reconsideration of the NSE letter and/or (2) submitting a new 510(k) with revised claims for rEEG and/or additional information about the predicate devices.  If we continue to market our rEEG service and the FDA determines that we should be subject to FDA regulation, it could seek enforcement action against the Company based upon its position that our rEEG service is a medical device.

In addition to the foregoing, federal and state laws and regulations relating to the sale of our Neurometric Information Services are subject to future changes, as are administrative interpretations of regulatory agencies. In the event that federal and state laws and regulations change, we may need to incur additional costs to seek government approvals for the sale of our Neurometric Information Services.
 
In the future, we may seek approval for medications or combinations of medications for new indications, either with corporate partners, or potentially, on our own. The development and commercialization of medications for new indications is subject to extensive regulation by the U.S. Federal government, principally through the FDA and other federal, state and governmental authorities elsewhere. Prior to marketing any central nervous system medication, and in many cases prior to being able to successfully partner a central nervous system medication, we will have to conduct extensive clinical trials at our own expense to determine safety and efficacy of the indication that we are pursuing.

Employees
 
As of September 30, 2010, we had approximately 15 full-time and 7 part-time employees, and 3 independent contractors.  We offer all full-time employees medical insurance, dental insurance and paid vacation.  We believe that our relations with our employees are good.  None of our employees belong to a union.
 
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ITEM 1A.
Risk Factors 
 
INVESTING IN CNS RESPONSE, INC. INVOLVES A HIGH DEGREE OF RISK.  YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION CONTAINED IN THIS REPORT BEFORE PURCHASING OUR COMMON STOCK. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING US. ADDITIONAL RISKS AND UNCERTAINTIES THAT WE ARE UNAWARE OF, OR THAT WE CURRENTLY DEEM IMMATERIAL, ALSO MAY BECOME IMPORTANT FACTORS THAT AFFECT US. IF ANY OF THE FOLLOWING RISKS OCCUR, OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY AFFECTED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE SOME OR ALL OF THE MONEY YOU PAID TO PURCHASE OUR COMMON STOCK.
 
Risks Related to Our Company
 
We need immediate additional funding to support our operations and capital expenditures, which may not be available to us and which lack of availability could have a material adverse effect on our business.  The Company’s continued operating losses and limited capital raise substantial doubt about its ability to continue as a going concern.
 
We have not generated significant revenues or become profitable, may never do so, and may not generate sufficient working capital to cover costs of operations.  Our continued operating losses and limited capital raise substantial doubt about our ability to continue as a going concern.  Until we can generate a sufficient amount of revenues to finance our operations and capital expenditures, we have to finance our cash needs primarily through public or private equity offerings, debt financings, borrowings or strategic collaborations. As of September 30, 2010, we had approximately $62,000 in cash and cash equivalents at hand.  While we received approximately $2.0 million from the sale of promissory notes and warrants in October and November, 2010, we still need additional funds immediately to continue our operations and will need substantial additional funds before we can increase demand for our rEEG services.  We are currently exploring additional sources of capital; however, we do not know whether additional funding will be available on acceptable terms, or at all, especially given the economic conditions that currently prevail.  In addition, any additional equity funding may result in significant dilution to existing stockholders, and, if we incur additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, thus limiting funds available for our business activities.  If adequate funds are not available, it would have a material adverse effect on our business, financial condition and/or results of operations, and could ultimately cause us to have to cease operations.  Our financial statements include a an opinion of our auditors that the Company’s continued operating losses and limited capital raise substantial doubt about its ability to continue as a going concern.
 
Our liabilities exceed our assets; we have a working capital deficit.  Our convertible notes, which are payable during 2011, are secured by all of our assets.

As of September 30, 2010 we had liabilities of $4.4 million and assets of only $0.2 million.  We had a working capital deficit of $4.2 million.  Since September 30, 2010, we raised $2 million by selling secured convertible notes and warrants, we still have a negative net worth.  Furthermore, as of December 15, 2010, we have outstanding convertible notes having a principal amount of $3,023,938, which is repayable beginning October 1, through November 11, 2011.  These notes are secured by substantially all of the assets of the Company.  We currently have no resources to repay such notes and we will be required to either raise additional funds or seek conversion of these notes to avoid a default.  If we default, the holders of the notes will be entitled to take all of our assets, in satisfaction of the obligation we have to them, thereby leaving no value for the holders of common stock.

We have a history of operating losses.
 
We are a company with a limited operating history. Since our inception, we have incurred significant operating losses. As of September 30, 2010, our accumulated deficit was approximately $33.4 million. Our future capital requirements will depend on many factors, such as the risk factors described in this section, including our ability to maintain our existing cost structure and to execute our business and strategic plans as currently conceived.  Even if we achieve profitability, we may be unable to maintain or increase profitability on a quarterly or annual basis.
 
If our rEEG reports do not gain widespread market acceptance, we will not sell adequate services to maintain our operations.
 
We have developed a methodology that aids psychiatrists and other physicians in selecting appropriate and effective medications for patients with certain behavioral or addictive disorders based on physiological traits of the patient’s brain and information contained in a proprietary database that has been developed over the last twenty years.  We began selling reports, referred to as rEEG   Reports, based on our methodology in 2000.  To date, we have not received widespread market acceptance of the usefulness of our rEEG Reports in helping psychiatrists and physicians inform their treatment strategies for patients suffering from behavioral and/or addictive disorders and we currently rely on a limited number of employees to market and promote our rEEG Reports. To grow our business, we will need to develop and introduce new sales and marketing programs and clinical education programs to promote the use of our rEEG Reports by psychiatrists and physicians and hire additional employees for this purpose. If we do not implement these new sales and marketing and education programs in a timely and successful manner, we may not be able to achieve the level of market awareness and sales required to expand our business, which could also negatively impact our stock price.

 
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Our rEEG Reports may not be as effective as we believe them to be, which could limit or prevent us from growing our revenues.
 
Our belief in the efficacy of our rEEG technology is based on a limited number of studies.  Such results may not be statistically significant, and may not be indicative of the long-term future efficacy of the information we provide. Controlled scientific studies, including those that have been announced and that are planned for the future, may yield results that are unfavorable or demonstrate that our services, including our rEEG Reports, are not clinically useful. While we have not experienced such problems to date, if the initially indicated results cannot be successfully replicated or maintained over time, utilization of services based on our rEEG technology, including the delivery of our rEEG Reports, may not increase as we anticipate, which would harm our operating results and stock price.  In addition, if we fail to upgrade our CNS Database to account for new medications that are now available on the market, psychiatrists and other physicians may be less inclined to utilize our services if they believe that our reports only provide information about older treatment options, which would further harm our operating results and stock price.
 
The United States Food & Drug Administration (FDA) believes that our rEEG service constitutes a medical device, which is subject to regulation by the FDA.  As we continue to market our rEEG service, there is risk that the FDA will seek enforcement action against us and has informed us that our marketing of our rEEG services without prior approval or re-classification by the FDA constitutes a violation of the Federal Food , Drug and Cosmetic Act.
 
Since April of 2008, we have been in a dialogue with the FDA regarding its position that our rEEG service constitutes a medical device which is subject to regulation by the FDA.  On April 10, 2008 we received correspondence from the FDA in which the FDA indicated it believed, based in part on the combination of certain marketing statements it read on our website, together with the delivery of our rEEG Reports, that we were selling a software product to aid in diagnosis, which constituted a “medical device” requiring pre-market approval or 510(k) clearance by the FDA pursuant to the Federal Food, Drug and Cosmetic Act (the “Act”).  We responded to the FDA on April 24, 2008 indicating that we believed it had incorrectly understood our product offering, and clarified that our rEEG services are not diagnostic and thus for this as well as other reasons, do not constitute a medical device.  On December 14, 2008, the FDA again contacted us and indicated that, based upon its review of our description of our intended use of the rEEG Reports on our website, it continued to maintain that our rEEG service met its definition of medical devices. In response to the FDA communications, we made a number of changes to our website and other marketing documents to reflect that rEEG is a service to aid in medication selection and is not an aid to diagnosis.  On September 4, 2009, through our regulatory counsel, we responded to the December 14, 2008 FDA letter explaining our position in more detail.

During the intervening period of time, based upon conversations with FDA, we chose to submit an application to obtain 510(k) clearance for our rEEG service, without waiving our right to continue to take the position that our services do not constitute a medical device.  We sought review of our rEEG service based upon its equivalence to predicate devices that already have FDA clearance which appeared to represent a sound mechanism to reduce regulatory risks.

On July 27, 2010 we received a letter (the “NSE Letter”) from the FDA stating that they determined that our rEEG service was not substantially equivalent to the predicate devices that had previously been granted 510(k) clearance and that among other options we could be required to file an approved premarket approval application (PMA) before it can be marketed legally, unless it is otherwise reclassified.

We currently plan to continue marketing as a non-device web-based neurometric information service, while continuing to discuss alternative approaches with the FDA.  Alternative approaches, which are not mutually exclusive, may consist of (1) filing a request for reconsideration of the NSE letter and/or (2) submitting a new 510(k) with revised claims for rEEG and/or additional information about the predicate devices.  If we continue to market our rEEG service and the FDA determines that we should be subject to FDA regulation, it could seek enforcement action against the Company based upon its position that our rEEG service is a medical device.
 
If government and third-party payers fail to provide coverage and adequate payment rates for treatments that are guided by our rEEG Reports, our revenue and prospects for profitability will be harmed.
 
Our future revenue growth will depend in part upon the availability of reimbursement from third-party payers for psychiatrists and physicians who use our rEEG Reports to guide the treatment of their patients. Such third-party payers include government health programs such as Medicare and Medicaid, managed care providers, private health insurers and other organizations. These third-party payers are increasingly attempting to contain healthcare costs by demanding price discounts or rebates and limiting both coverage on which procedures they will pay for and the amounts that they will pay for new procedures. As a result, they may not cover or provide adequate payment for treatments that are guided by our rEEG Reports, which will discourage psychiatrists and physicians from utilizing the information services we provide.  We may need to conduct studies in addition to those we have already announced to demonstrate the cost-effectiveness of treatments that are guided by our products and services to such payers’ satisfaction. Such studies might require us to commit a significant amount of management time and financial and other resources. Adequate third-party reimbursement might not be available to enable us to realize an appropriate return on investment in research and product development, and the lack of such reimbursement could have a material adverse effect on our operations and could adversely affect our revenues and earnings.
 
 
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Regulations are constantly changing, and in the future our business may be subject to additional regulations that increase our compliance costs.
 
Federal, state and foreign laws and regulations relating to the sale of our rEEG Reports are subject to future changes, as are administrative interpretations of regulatory agencies. If we fail to comply with applicable federal, state or foreign laws or regulations, we could be subject to enforcement actions, including injunctions preventing us from conducting our business, withdrawal of clearances or approvals and civil and criminal penalties.  In the event that federal, state, and foreign laws and regulations change, we may need to incur additional costs to seek government approvals, in addition to the clearance we are currently seeking from the FDA (discussed above), in order to sell market our rEEG service.  There is no guarantee that we will be able to obtain such approvals in a timely manner or at all, and as a result, our business would be significantly harmed.
  
Our Clinical Services Business generates the majority of our revenue, and adverse developments in this business could negatively impact our operating results.
 
Our Clinical Services business, which we view as ancillary to our core Neurometric Information Services business, currently generates the majority of our revenue and is operated by our wholly-owned subsidiary, NTC.  In the event that NTC is unable to sustain the current demand for its services because, for instance, the company is unable to maintain favorable and continuing relations with its clients and referring psychiatrists and physicians or Daniel Hoffman, the Medical Director at NTC and our Chief Medical Officer and President, is no longer associated with NTC, our revenues could significantly decline, which could adversely impact our operating results and our ability to implement our growth strategy.
 
Our operating results may fluctuate significantly and our stock price could decline or fluctuate if our results do not meet the expectation of analysts or investors.
 
Management expects that we will experience substantial variations in our operating results from quarter to quarter. We believe that the factors which influence this variability of quarterly results include:

 
·
the use of and demand for rEEG Reports and other products and/or services that we may offer in the future that are based on our patented methodology;

 
·
the effectiveness of new marketing and sales programs;

 
·
turnover among our employees;

 
·
changes in management;

 
·
the introduction of products or services that are viewed in the marketplace as substitutes for the services we provide;

 
·
communications published by industry organizations or other professional entities in the psychiatric and physician community that are unfavorable to our business;

 
·
the introduction of regulations which impose additional costs on or impede our business; and

 
·
the timing and amount of our expenses, particularly expenses associated with the marketing and promotion of our services, the training of physicians and psychiatrists in the use of our rEEG Reports, and research and development.

As a result of fluctuations in our revenue and operating expenses that may occur, management believes that period-to-period comparisons of our results of operations are not a good indication of our future performance. It is possible that in some future quarter or quarters, our operating results will be below the expectations of securities analysts or investors. In that case, our common stock price could fluctuate significantly or decline.
 
 
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If we do not maintain and expand our relationships in the psychiatric and physician community, our growth will be limited and our business could be harmed.  If psychiatrists and other physicians do not recommend and endorse our products and services, we may be unable to increase our sales, and in such instances our profitability would be harmed.
 
Our relationships with psychiatrists and physicians are critical to the growth of our Neurometric Information Services business.  We believe that these relationships are based on the quality and ease of use of our rEEG Reports, our commitment to the behavioral health market, our marketing efforts, and our presence at tradeshows.  Any actual or perceived diminution in our reputation or the quality of our rEEG Reports, or our failure or inability to maintain our commitment to the behavioral health market and our other marketing and product promotion efforts could damage our current relationships, or prevent us from forming new relationships, with psychiatrists and other physicians and cause our growth to be limited and our business to be harmed.
 
To sell our rEEG Reports, psychiatric professionals must recommend and endorse them.  We may not obtain the necessary recommendations or endorsements from this community. Acceptance of our rEEG Reports depends on educating psychiatrists and physicians as to the benefits, clinical efficacy, ease of use, revenue opportunity, and cost-effectiveness of our rEEG Reports and on training the medical community to properly understand and utilize our rEEG Reports.  If we are not successful in obtaining the recommendations or endorsements of psychiatrists and other physicians for our rEEG Reports, we may be unable to increase our sales and profitability.
 
Negative publicity or unfavorable media coverage could damage our reputation and harm our operations.
 
In the event that the marketplace perceives our rEEG Reports as not offering the benefits which we believe they offer, we may receive significant negative publicity.  This publicity may result in litigation and increased regulation and governmental review.  If we were to receive such negative publicity or unfavorable media attention, whether warranted or unwarranted, our ability to market our rEEG Reports would be adversely affected, pharmaceutical companies may be reluctant to pursue strategic initiatives with us relating to the development of new products and services based on our rEEG technology, we may be required to change our products and services and become subject to increased regulatory burdens, and we may be required to pay large judgments or fines and incur significant legal expenses.  Any combination of these factors could further increase our cost of doing business and adversely affect our financial position, results of operations and cash flows.
 
If we do not successfully generate additional products and services from our patented methodology and proprietary database, or if such products and services are developed but not successfully commercialized, then we could lose revenue opportunities.
 
Our primary business is the sale of rEEG Reports to psychiatrists and physicians based on our rEEG methodology and proprietary database.  In the future, we may utilize our patented methodology and proprietary database to produce pharmaceutical advancements and developments.  For instance, we may use our patented methodology and proprietary database to identify new medications that are promising in the treatment of behavioral health disorders, identify new uses of medications which have been previously approved, and identify new patient populations that are responsive to medications in clinical trials that have previously failed to show efficacy in United States Food & Drug Administration (FDA) approved clinical trials.  The development of new pharmaceutical applications that are based on our patented methodology and proprietary database will be costly, since we will be subject to additional regulations, including the need to conduct expensive and time consuming clinical trials.

In addition, to successfully monetize our pharmaceutical opportunity, we will need to enter into strategic alliances with biotechnology or pharmaceutical companies that have the ability to bring to market a medication, an ability which we currently do not have.  We maintain no pharmaceutical manufacturing, marketing or sales organization, nor do we plan to build one in the foreseeable future.  Therefore, we are reliant upon approaching and successfully negotiating attractive terms with a partner who has these capabilities.  No guarantee can be made that we can do this on attractive terms or at all.  If we are unable to find strategic partners for our pharmaceutical opportunity, our revenues may not grow as quickly as we desire, which could lower our stock price.
 
Our industry is highly competitive, and we may not be able to compete successfully, which could result in price reductions and decreased demand for our products.
 
The healthcare business in general, and the behavioral health treatment business in particular, are highly competitive. In the event that we are unable to convince physicians, psychiatrists and patients of the efficacy of our products and services, individuals seeking treatment for behavioral health disorders may seek alternative treatment methods, which could negatively impact our sales and profitability.
 
In the event that we pursue our pharmaceutical opportunities, we or any development partners that we partner with will likely need to conduct clinical trials.  If such clinical trials are delayed or unsuccessful, it could have an adverse effect on our business.
 
We have no experience conducting clinical trials of psychiatric medications and in the event we conduct clinical trials, we will rely on outside parties, including academic investigators, outside consultants and contract research organizations to conduct these trials on our behalf.  We will rely on these parties to assist in the recruitment of sites for participation in clinical trials, to maintain positive relations with these sites, and to ensure that these sites conduct the trials in accordance with the protocol and our instructions.  If these parties renege on their obligations to us, our clinical trials may be delayed or unsuccessful.

 
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In the event we conduct clinical trials, we cannot predict whether we will encounter problems that will cause us or regulatory authorities to delay or suspend our clinical trials or delay the analysis of data from our completed or ongoing clinical trials. In addition, we cannot assure you that we will be successful in reaching the endpoints in these trials, or if we do, that the FDA or other regulatory agencies will accept the results.
 
Any of the following could delay the completion of clinical trials, or result in a failure of these trials to support our business, which would have an adverse effect on our business:

 
·
delays or the inability to obtain required approvals from institutional review boards or other governing entities at clinical sites selected for participation in our clinical trials;

 
·
delays in enrolling patients and volunteers into clinical trials;

 
·
lower than anticipated retention rates of patients and volunteers in clinical trials;

 
·
negative results from clinical trials for any of our potential products; and

 
·
failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.

If we determine that the costs associated with attaining regulatory approval of a product exceed the potential financial benefits or if the projected development timeline is inconsistent with our determination of when we need to get the product to market, we may chose to stop a clinical trial and/or development of a product.

We may fail to successfully manage and maintain the growth of our business, which could adversely affect our results of operations.
 
As we continue expanding our commercial operations, this expansion could place significant strain on our management, operational, and financial resources.  To manage future growth, we will need to continue to hire, train, and manage additional employees, particularly a specially trained sales force to market our rEEG Reports.
 
In addition, we have maintained a small financial and accounting staff, and our reporting obligations as a public company, as well as our need to comply with the requirements of the Sarbanes-Oxley Act of 2002, and the rules and regulations of the SEC will continue to place significant demands on our financial and accounting staff, on our financial, accounting and information systems and on our internal controls. As we grow, we will need to add additional accounting staff and continue to improve our financial, accounting and information systems and internal controls in order to fulfill our reporting responsibilities and to support expected growth in our business. Our current and planned personnel, systems, procedures and controls may not be adequate to support our anticipated growth or management may not be able to effectively hire, train, retain, motivate and manage required personnel. Our failure to manage growth effectively could limit our ability to achieve our marketing and commercialization goals or to satisfy our reporting and other obligations as a public company.
 
We may not be able to adequately protect our intellectual property, which is the core of our business.
 
We consider the protection of our intellectual property to be important to our business prospects.  We currently have four issued U.S. patents, as well as issued patents in Australia and Israel, and we have filed separate patent applications in multiple foreign jurisdictions.
 
In the future, if we fail to file patent applications in a timely manner, or in the event we elect not to file a patent application because of the costs associated with patent prosecution, we may lose patent protection that we may have otherwise obtained. The loss of any proprietary rights which are obtainable under patent laws may result in the loss of a competitive advantage over present or potential competitors, with a resulting decrease in revenues and profitability for us.
 
With respect to the applications we have filed, there is no guarantee that the applications will result in issued patents, and further, any patents that do issue may be too narrow in scope to adequately protect our intellectual property and provide us with a competitive advantage.  Competitors and others may design around aspects of our technology, or alternatively may independently develop similar or more advanced technologies that fall outside the scope of our claimed subject matter but that can be used in the treatment of behavioral health disorders.
 
In addition, even if we are issued additional patents covering our products, we cannot predict with certainty whether or not we will be able to enforce our proprietary rights, and whether our patents will provide us with adequate protection against competitors.  We may be forced to engage in costly and time consuming litigation or reexamination proceedings to protect our intellectual property rights, and our opponents in such proceedings may have and be willing to expend, substantially greater resources than we are able to.  In addition, the results of such proceedings may result in our patents being invalidated or reduced in scope.  These developments could cause a decrease in our operating income and reduce our available cash flow, which could harm our business and cause our stock price to decline.
 
 
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We also utilize processes and technology that constitute trade secrets, such as our CNS Database, and we must implement appropriate levels of security for those trade secrets to secure the protection of applicable laws, which we may not do effectively.  In addition, the laws of many foreign countries do not protect proprietary rights as fully as the laws of the United States.
 
While we have not had any significant issues to date, the loss of any of our trade secrets or proprietary rights which may be protected under the foregoing intellectual property safeguards may result in the loss of our competitive advantage over present and potential competitors.
 
Confidentiality agreements with employees, licensees and others may not adequately prevent disclosure of trade secrets and other proprietary information.
 
In order to protect our proprietary technology and processes, we rely in part on confidentiality provisions in our agreements with employees, licensees, treating physicians and psychiatrists and others. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information.  Moreover, policing compliance with our confidentiality agreements and non-disclosure agreements, and detecting unauthorized use of our technology is difficult, and we may be unable to determine whether piracy of our technology has occurred.  In addition, others may independently discover our trade secrets and proprietary information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
 
The liability of our directors and officers is limited.
 
The applicable provisions of the Delaware General Corporate Law and our Certificate of Incorporation limit the liability of our directors to the Company and our stockholders for monetary damages for breaches of their fiduciary duties, with certain exceptions, and for other specified acts or omissions of such persons. In addition, the applicable provisions of the Delaware General Corporate Law and of our Certificate of Incorporation and Bylaws, as well as indemnification agreements we have entered into with our directors, officers and certain other individuals, provide for indemnification of such persons under certain circumstances.  In the event we are required to indemnify any of our directors or any other person, our financial strength may be harmed, which may in turn lower our stock price.
 
If we do not retain our senior management and other key employees, we may not be able to successfully implement our business strategy.
 
Our future success depends on the ability, experience and performance of our senior management and our key professional personnel.  Our success therefore depends to a significant extent on retaining the services of George Carpenter, our Chief Executive Officer, our senior product development and clinical managers, and others.  Because of their ability and experience, if we lose one or more of the members of our senior management or other key employees, our ability to successfully implement our business strategy could be seriously harmed.  While we believe our relationships with our executives are good and do not anticipate any of them leaving in the near future, the loss of the services of any of our senior management could have a material adverse effect on our ability to manage our business.  We do not carry key man life insurance on any of our key employees.
 
If we do not attract and retain skilled personnel, we may not be able to expand our business.
 
Our products and services are based on a complex database of information.  Accordingly, we require skilled medical, scientific and administrative personnel to sell and support our products and services. Our future success will depend largely on our ability to continue to hire, train, retain and motivate additional skilled personnel, particularly sales representatives who are responsible for customer education and training and customer support.  In the future, if we pursue our pharmaceutical opportunities, we will also likely need to hire personnel with experience in clinical testing and matters relating to obtaining regulatory approvals.  If we are not able to attract and retain skilled personnel, we will not be able to continue our development and commercialization activities.

In the future we could be subject to personal injury claims, which could result in substantial liabilities that may exceed our insurance coverage.
 
All significant medical treatments and procedures, including treatment that is facilitated through the use of our rEEG Reports, involve the risk of serious injury or death. While we have not been the subject of any personal injury claims for patients treated by providers using our rEEG Reports, our business entails an inherent risk of claims for personal injuries, which are subject to the attendant risk of substantial damage awards. We cannot control whether individual physicians and psychiatrists will properly select patients, apply the appropriate standard of care, or conform to our procedures in determining how to treat their patients. A significant source of potential liability is negligence or alleged negligence by physicians treating patients with the aid of the rEEG Reports that we provide. There can be no assurance that a future claim or claims will not be successful or, including the cost of legal defense, will not exceed the limits of available insurance coverage.
 
 
17

 

We currently have general liability and medical professional liability insurance coverage for up to $5 million per year for personal injury claims. We may not be able to maintain adequate liability insurance, in accordance with standard industry practice, with appropriate coverage based on the nature and risks of our business, at acceptable costs and on favorable terms. Insurance carriers are often reluctant to provide liability insurance for new healthcare services companies and products due to the limited claims history for such companies and products. In addition, based on current insurance markets, we expect that liability insurance will be more difficult to obtain and that premiums will increase over time and as the volume of patients treated by physicians that are guided by our rEEG Reports increases.  In the event of litigation, regardless of its merit or eventual outcome, or an award against us during a time when we have no available insurance or insufficient insurance, we may sustain significant losses of our operating capital which may substantially reduce stockholder equity in the company.
 
We are subject to evolving and expensive corporate governance regulations and requirements. Our failure to adequately adhere to these requirements or the failure or circumvention of our controls and procedures could seriously harm our business.
 
Because we are a publicly traded company we are subject to certain federal, state and other rules and regulations, including applicable requirements of the Sarbanes-Oxley Act of 2002. Compliance with these evolving regulations is costly and requires a significant diversion of management time and attention, particularly with regard to our disclosure controls and procedures and our internal control over financial reporting.  Although we have reviewed our disclosure and internal controls and procedures in order to determine whether they are effective, our controls and procedures may not be able to prevent errors or frauds in the future. Faulty judgments, simple errors or mistakes, or the failure of our personnel to adhere to established controls and procedures may make it difficult for us to ensure that the objectives of the control system are met. A failure of our controls and procedures to detect other than inconsequential errors or fraud could seriously harm our business and results of operations.
 
Our senior management’s limited recent experience managing a publicly traded company may divert management’s attention from operations and harm our business.
 
Our management team has relatively limited recent experience managing a publicly traded company and complying with federal securities laws, including compliance with recently adopted disclosure requirements on a timely basis.  Our management will be required to design and implement appropriate programs and policies in responding to increased legal, regulatory compliance and reporting requirements, and any failure to do so could lead to the imposition of fines and penalties and harm our business.

Risks Related To Our Industry
 
The healthcare industry in which we operate is subject to substantial regulation by state and federal authorities, which could hinder, delay or prevent us from commercializing our products and services.
 
Healthcare companies are subject to extensive and complex federal, state and local laws, regulations and judicial decisions governing various matters such as the licensing and certification of facilities and personnel, the conduct of operations, billing policies and practices, policies and practices with regard to patient privacy and confidentiality, and prohibitions on payments for the referral of business and self-referrals. There are federal and state laws, regulations and judicial decisions that govern patient referrals, physician financial relationships, submission of healthcare claims and inducement to beneficiaries of federal healthcare programs. Many states prohibit business corporations from practicing medicine, employing or maintaining control over physicians who practice medicine, or engaging in certain business practices, such as splitting fees with healthcare providers. Many healthcare laws and regulations applicable to our business are complex, applied broadly and subject to interpretation by courts and government agencies. Our failure, or the failure of physicians and psychiatrists to whom we sell our rEEG Reports, to comply with these healthcare laws and regulations could create liability for us and negatively impact our business.
 
In addition, the FDA regulates development, testing, labeling, manufacturing, marketing, promotion, distribution, record-keeping and reporting requirements for prescription drugs. Compliance with laws and regulations enforced by the FDA and other regulatory agencies may be required in relation to future products or services developed or used by us, in addition to the regulatory process and dialogue in which we are now engaged with the FDA (please see the risk factor above for further information). Failure to comply with applicable laws and regulations may result in various adverse consequences, including withdrawal of our products and services from the market, or the imposition of civil or criminal sanctions.
 
We believe that this industry will continue to be subject to increasing regulation, political and legal action and pricing pressures, the scope and effect of which we cannot predict. Legislation is continuously being proposed, enacted and interpreted at the federal, state and local levels to regulate healthcare delivery and relationships between and among participants in the healthcare industry. Any such changes could prevent us from marketing some or all of our products and services for a period of time or permanently.
 
 
18

 

We may be subject to regulatory and investigative proceedings, which may find that our policies and procedures do not fully comply with complex and changing healthcare regulations.
 
While we have established policies and procedures that we believe will be sufficient to ensure that we operate in substantial compliance with applicable laws, regulations and requirements, the criteria are often vague and subject to change and interpretation. We may become the subject of regulatory or other investigations or proceedings, and our interpretations of applicable laws and regulations may be challenged. The defense of any such challenge could result in substantial cost and a diversion of management’s time and attention. Thus, any such challenge could have a material adverse effect on our business, regardless of whether it ultimately is successful. If we fail to comply with any applicable laws, or a determination is made that we have failed to comply with these laws, our financial condition and results of operations could be adversely affected.
 
Failure to comply with the Federal Trade Commission Act or similar state laws could result in sanctions or limit the claims we can make.
 
The Company’s promotional activities and materials, including advertising to consumers and physicians, and materials provided to third parties for their use in promoting our products and services, are regulated by the Federal Trade Commission (FTC) under the FTC Act, which prohibits unfair and deceptive acts and practices, including claims which are false, misleading or inadequately substantiated. The FTC typically requires competent and reliable scientific tests or studies to substantiate express or implied claims that a product or service is effective. If the FTC were to interpret our promotional materials as making express or implied claims that our products and services are effective for the treatment of mental illness, it may find that we do not have adequate substantiation for such claims. Failure to comply with the FTC Act or similar laws enforced by state attorneys general and other state and local officials could result in administrative or judicial orders limiting or eliminating the claims we can make about our products and services, and other sanctions including fines.

Our business practices may be found to constitute illegal fee-splitting or corporate practice of medicine, which may lead to penalties and adversely affect our business.
 
Many states, including California, in which our principal executive offices are located, have laws that prohibit business corporations, such as us, from practicing medicine, exercising control over medical judgments or decisions of physicians, or engaging in certain arrangements, such as employment or fee-splitting, with physicians. Courts, regulatory authorities or other parties, including physicians, may assert that we are engaged in the unlawful corporate practice of medicine through our ownership of the Neuro-Therapy Clinic or by providing administrative and ancillary services in connection with our rEEG Reports. These parties may also assert that selling our rEEG Reports for a portion of the patient fees constitutes improper fee-splitting.  If asserted, such claims could subject us to civil and criminal penalties and substantial legal costs, could result in our contracts being found legally invalid and unenforceable, in whole or in part, or could result in us being required to restructure our contractual arrangements, all with potentially adverse consequences to our business and our stockholders.
 
Our business practices may be found to violate anti-kickback, self-referral or false claims laws, which may lead to penalties and adversely affect our business.
 
The healthcare industry is subject to extensive federal and state regulation with respect to financial relationships and “kickbacks” involving healthcare providers, physician self-referral arrangements, filing of false claims and other fraud and abuse issues. Federal anti-kickback laws and regulations prohibit certain offers, payments or receipts of remuneration in return for (i) referring patients covered by Medicare, Medicaid or other federal health care program, or (ii) purchasing, leasing, ordering or arranging for or recommending any service, good, item or facility for which payment may be made by a federal health care program. In addition, federal physician self-referral legislation, commonly known as the Stark law, generally prohibits a physician from ordering certain services reimbursable by Medicare, Medicaid or other federal healthcare program from any entity with which the physician has a financial relationship. In addition, many states have similar laws, some of which are not limited to services reimbursed by federal healthcare programs. Other federal and state laws govern the submission of claims for reimbursement, or false claims laws. One of the most prominent of these laws is the federal False Claims Act, and violations of other laws, such as the anti-kickback laws or the FDA prohibitions against promotion of off-label uses of medications, may also be prosecuted as violations of the False Claims Act.
 
While we believe we have structured our relationships to comply with all applicable requirements, federal or state authorities may claim that our fee arrangements, agreements and relationships with contractors and physicians violate these anti-kickback, self-referral or false claims laws and regulations. These laws are broadly worded and have been broadly interpreted by courts. It is often difficult to predict how these laws will be applied, and they potentially subject many typical business arrangements to government investigation and prosecution, which can be costly and time consuming. Violations of these laws are punishable by monetary fines, civil and criminal penalties, exclusion from participation in government-sponsored health care programs and forfeiture of amounts collected in violation of such laws. Some states also have similar anti-kickback and self-referral laws, imposing substantial penalties for violations. If our business practices are found to violate any of these provisions, we may be unable to continue with our relationships or implement our business plans, which would have an adverse effect on our business and results of operations.
 
 
19

 

We may be subject to healthcare anti-fraud initiatives, which may lead to penalties and adversely affect our business.
 
State and federal governments are devoting increased attention and resources to anti-fraud initiatives against healthcare providers, taking an expansive definition of fraud that includes receiving fees in connection with a healthcare business that is found to violate any of the complex regulations described above. While to our knowledge we have not been the subject of any anti-fraud investigations, if such a claim were made defending our business practices could be time consuming and expensive, and an adverse finding could result in substantial penalties or require us to restructure our operations, which we may not be able to do successfully.
 
Our use and disclosure of patient information is subject to privacy and security regulations, which may result in increased costs.
 
In conducting research or providing administrative services to healthcare providers in connection with the use of our rEEG Reports, as well as in our Clinical Services business, we may collect, use, maintain and transmit patient information in ways that will be subject to many of the numerous state, federal and international laws and regulations governing the collection, dissemination, use and confidentiality of patient-identifiable health information, including the federal Health Insurance Portability and Accountability Act (HIPAA) and related rules. The three rules that were promulgated pursuant to HIPAA that could most significantly affect our business are the Standards for Electronic Transactions, or Transactions Rule; the Standards for Privacy of Individually Identifiable Health Information, or Privacy Rule; and the Health Insurance Reform: Security Standards, or Security Rule.  HIPAA applies to covered entities, which include most healthcare facilities and health plans that may contract for the use of our services. The HIPAA rules require covered entities to bind contractors like us to compliance with certain burdensome HIPAA rule requirements.
 
The HIPAA Transactions Rule establishes format and data content standards for eight of the most common healthcare transactions. If we perform billing and collection services on behalf of psychiatrists and physicians, we may be engaging in one of more of these standard transactions and will be required to conduct those transactions in compliance with the required standards. The HIPAA Privacy Rule restricts the use and disclosure of patient information, requires entities to safeguard that information and to provide certain rights to individuals with respect to that information. The HIPAA Security Rule establishes elaborate requirements for safeguarding patient information transmitted or stored electronically. We may be required to make costly system purchases and modifications to comply with the HIPAA rule requirements that are imposed on us and our failure to comply may result in liability and adversely affect our business.
 
Numerous other federal and state laws protect the confidentiality of personal and patient information. These laws in many cases are not preempted by the HIPAA rules and may be subject to varying interpretations by courts and government agencies, creating complex compliance issues for us and the psychiatrists and physicians who purchase our services, and potentially exposing us to additional expense, adverse publicity and liability.
 
Risks Relating To Investment In Our Common Stock
 
We have a limited trading volume and shares eligible for future sale by our current stockholders may adversely affect our stock price.
 
Bid and ask prices for shares of our Common Stock are quoted on NASDAQ’s Over-the-Counter Bulletin Board under the symbol CNSO.OB. There is currently no broadly followed, established trading market for our Common Stock and an established trading market for our shares of Common Stock may never develop or be maintained. Active trading markets generally result in lower price volatility and more efficient execution of buy and sell orders. The absence of an active trading market increases price volatility and reduces the liquidity of our Common Stock. As long as this condition continues, the sale of a significant number of shares of Common Stock at any particular time could be difficult to achieve at the market prices prevailing immediately before such shares are offered. Also, as a result of this lack of trading activity, the quoted price for our Common Stock on the Over-the-Counter Bulletin Board is not necessarily a reliable indicator of its fair market value. If we cease to be quoted, holders would find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our Common Stock, and the market value of our Common Stock would likely decline.

If and when a larger trading market for our Common Stock develops, the market price of our Common Stock is likely to be highly volatile and subject to wide fluctuations, and you may be unable to resell your shares at or above the price at which you acquired them.  
 
The market price of our Common Stock is likely to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our control, including:

 
·
quarterly variations in our revenues and operating expenses;

 
·
developments in the financial markets and worldwide or regional economies;

 
·
announcements of innovations or new products or services by us or our competitors;
 
 
20

 

 
·
announcements by the government relating to regulations that govern our industry;

 
·
significant sales of our Common Stock or other securities in the open market;

 
·
variations in interest rates;

 
·
changes in the market valuations of other comparable companies; and

 
·
changes in accounting principles.

In the past, stockholders have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities.  If a stockholder were to file any such class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business to respond to the litigation, which could harm our business.
 
Future sales of our Common Stock in the public market could cause our stock price to fall.
 
Of our 56,023,921 shares of common stock outstanding, 47,095,675 shares are restricted securities, as that term is defined under the Securities Act of 1933, as amended.  In addition, as at December 15, 2010, 10,375,190 shares may be issued upon the conversion of our convertible notes, 24,904,308 shares upon the exercise of our warrants and 15,670,973 shares upon the exercise of stock options. We have filed a registration statement covering the resale of 65,879,838 shares and 18,409,015 shares of underlying warrants. The sale of shares of our common stock pursuant to Rule 144 of the Securities Act of 1933, as amended, or otherwise, could depress the market price of our Common Stock.  A reduced market price for our Common Stock could make it more difficult to raise funds through future offering of Common Stock.
 
The sale of securities by us in any equity or debt financing could result in dilution to our existing stockholders and have a material adverse effect on our earnings.
 
Any sale of Common Stock by us in a future private placement or public offering could result in dilution to our existing stockholders as a direct result of our issuance of additional shares of our capital stock.  In addition, our business strategy may include expansion through internal growth, by acquiring complementary businesses, by acquiring or licensing additional products and services, or by establishing strategic relationships with targeted customers and suppliers. In order to do so, or to finance the cost of our other activities, we may issue additional equity securities that could dilute our stockholders' stock ownership. We may also assume additional debt and incur impairment losses related to goodwill and other tangible assets if we acquire another company and this could negatively impact our earnings and results of operations.
 
The trading of our Common Stock on the Over-the-Counter Bulletin Board and the potential designation of our Common Stock as a “penny stock” could impact the trading market for our Common Stock.
 
Our securities, as traded on the Over-the-Counter Bulletin Board, may be subject to SEC rules that impose special sales practice requirements on broker-dealers who sell these securities to persons other than established customers or accredited investors.  For the purposes of the rule, the phrase “accredited investors” means, in general terms, institutions with assets in excess of $5,000,000, or individuals having a net worth in excess of $1,000,000 or having an annual income that exceeds $200,000 (or that, when combined with a spouse’s income, exceeds $300,000).  For transactions covered by the rule, the broker-dealer must make a special suitability determination for the purchaser and receive the purchaser’s written agreement to the transaction before the sale.  Consequently, the rule may affect the ability of broker-dealers to sell our securities and also may affect the ability of purchasers to sell their securities in any market that might develop therefor.
 
In addition, the SEC has adopted a number of rules to regulate “penny stock” that restrict transactions involving these securities.  Such rules include Rules 3a51-1, 15g-1, 15g-2, 15g-3, 15g-4, 15g-5, 15g-6, 15g-7, and 15g-9 under the Securities and Exchange Act of 1934, as amended. These rules may have the effect of reducing the liquidity of penny stocks.  “Penny stocks” generally are equity securities with a price of less than $5.00 per share (other than securities registered on certain national securities exchanges or quoted on the NASDAQ Stock Market if current price and volume information with respect to transactions in such securities is provided by the exchange or system).  Because our securities may constitute “penny stock” within the meaning of the rules, the rules would apply to us and to our securities.  Our stockholders may therefore find it more difficult to sell their securities.
 
Stockholders should be aware that, according to SEC, the market for penny stocks has suffered in recent years from patterns of fraud and abuse.  Such patterns include (i) control of the market for the security by one or a few broker-dealers that are often related to the promoter or issuer; (ii) manipulation of prices through prearranged matching of purchases and sales and false and misleading press releases; (iii) “boiler room” practices involving high-pressure sales tactics and unrealistic price projections by inexperienced sales persons; (iv) excessive and undisclosed bid-ask differentials and markups by selling broker-dealers; and (v) the wholesale dumping of the same securities by promoters and broker-dealers after prices have been manipulated to a desired level, resulting in investor losses.  Our management is aware of the abuses that have occurred historically in the penny stock market.  Although we do not expect to be in a position to dictate the behavior of the market or of broker-dealers who participate in the market, management will strive within the confines of practical limitations to prevent the described patterns from being established with respect to our securities.
 
 
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We have not paid dividends in the past and do not expect to pay dividends for the foreseeable future, and any return on investment may be limited to potential future appreciation on the value of our Common Stock.
 
We currently intend to retain any future earnings to support the development and expansion of our business and do not anticipate paying cash dividends in the foreseeable future.  Our payment of any future dividends will be at the discretion of our Board of Directors after taking into account various factors, including without limitation, our financial condition, operating results, cash needs, growth plans and the terms of any credit agreements that we may be a party to at the time.  To the extent we do not pay dividends, our stock may be less valuable because a return on investment will only occur if and to the extent our stock price appreciates, which may never occur.  In addition, investors must rely on sales of their Common Stock after price appreciation as the only way to realize their investment, and if the price of our stock does not appreciate, then there will be no return on investment.  Investors seeking cash dividends should not purchase our Common Stock.
 
Our officers, directors and principal stockholders can exert significant influence over us and may make decisions that are not in the best interests of all stockholders.
 
Our officers, directors and principal stockholders (greater than 5% stockholders) collectively control approximately 44% of our issued and outstanding Common Stock. As a result, these stockholders are able to affect the outcome of, or exert significant influence over, all matters requiring stockholder approval, including the election and removal of directors and any change in control. In particular, this concentration of ownership of our Common Stock could have the effect of delaying or preventing a change of control of us or otherwise discouraging or preventing a potential acquirer from attempting to obtain control of us. This, in turn, could have a negative effect on the market price of our Common Stock. It could also prevent our stockholders from realizing a premium over the market prices for their shares of Common Stock. Moreover, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders, and accordingly, they could cause us to enter into transactions or agreements that we would not otherwise consider.

Transactions engaged in by our largest stockholders, our directors or executives involving our common stock may have an adverse effect on the price of our stock.
 
Our officers, directors and principal stockholders (greater than 5% stockholders) collectively control approximately 44% of our issued and outstanding Common Stock. Subsequent sales of our shares by these stockholders could have the effect of lowering our stock price. The perceived risk associated with the possible sale of a large number of shares by these stockholders, or the adoption of significant short positions by hedge funds or other significant investors, could cause some of our stockholders to sell their stock, thus causing the price of our stock to decline. In addition, actual or anticipated downward pressure on our stock price due to actual or anticipated sales of stock by our directors or officers could cause other institutions or individuals to engage in short sales of our Common Stock, which may further cause the price of our stock to decline.
 
From time to time our directors and executive officers may sell shares of our common stock on the open market. These sales will be publicly disclosed in filings made with the SEC. In the future, our directors and executive officers may sell a significant number of shares for a variety of reasons unrelated to the performance of our business. Our stockholders may perceive these sales as a reflection on management's view of the business and result in some stockholders selling their shares of our common stock. These sales could cause the price of our stock to drop.
 
Anti-takeover provisions may limit the ability of another party to acquire us, which could cause our stock price to decline.
 
Delaware law contains provisions that could discourage, delay or prevent a third party from acquiring us, even if doing so may be beneficial to our stockholders, which could cause our stock price to decline. In addition, these provisions could limit the price investors would be willing to pay in the future for shares of our Common Stock.

ITEM 1B.           Unresolved Staff Comments
 
Not applicable.

 
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ITEM 2.              Properties

The Company leases its headquarters and Neurometric Information Services space, located at 85 Enterprise, Suite 410, Aliso Viejo, CA 92656, under an operating lease which commenced on February 1, 2010 and terminates on January 30, 2013. The 2,023 square foot facility has an average cost for the lease term of $3,600 per month.
 
The Company leases space for its Clinical Services operations, located at 7800 East Orchard Road, Suite 340, Greenwood Village, Co 80111, under an operating lease.  A 37 month extension to the original 2005 lease was negotiated commencing April 1, 2010 and terminating April 30, 2013. The 3,542 square foot facility has an average cost for the lease term of $5,100 per month.
 
 We believe that our current space is adequate for our needs and that suitable additional or substitute space will be available to accommodate the foreseeable expansion of our operations.

ITEM 3.              Legal Proceedings
 
From time to time, we may be involved in litigation relating to claims arising out of our operations in the ordinary course of business. Other than as set forth below, we are not currently party to any legal proceedings, the adverse outcome of which, in our management’s opinion, individually or in the aggregate, would have a material adverse effect on our results of operations or financial position.
 
ITEM 4.              (Removed and Reserved.)
 
 
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ITEM 5.              Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Common Stock
 
Our common stock is currently trading on the OTC Bulletin Board under the symbol CNSO.OB. The following table sets forth, for the periods indicated, the high and low bid information for Common Stock as determined from sporadic quotations on the OTC Bulletin Board. The following quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
 
   
High
   
Low
 
             
Year Ended September 30, 2009
           
First Quarter
 
$
1.01
   
$
0.10
 
Second Quarter
 
$
0.90
   
$
0.05
 
Third Quarter
 
$
0.69
   
$
0.15
 
Fourth Quarter
 
$
0.72
   
$
0.20
 
                 
Year Ended September 30, 2010
               
First Quarter
 
$
1.20
   
$
0.50
 
Second Quarter
 
$
1.20
   
$
0.52
 
Third Quarter
 
$
1.15
   
$
0.40
 
Fourth Quarter
 
$
0.95
   
$
0.05
 
 
On December 16, 2010, the closing sales price of our common stock as reported on the OTC Bulletin Board was $0.40 per share.  As of December 16, 2010, there were 364 record holders of our common stock.  The number of holders of record is based on the actual number of holders registered on the books of our transfer agent and does not reflect holders of shares in “street name” or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depository trust companies.
 
Dividend Rights
 
We have not paid or declared cash distributions or dividends on our common stock and we do not intend to pay cash dividends on our common stock in the foreseeable future.  We currently intend to retain all earnings, if and when generated, to finance our operations.  The declaration of cash dividends in the future will be determined by the board of directors based upon our earnings, financial condition, capital requirements and other relevant factors.

Securities Authorized for Issuance Under Equity Compensation Plans

The required disclosure on our equity compensation plan is incorporated herein by reference to “Item 13. Certain Relationships and Related Transactions, and Director Independence - Securities Authorized for Issuance Under Equity Compensation Plans.”

Recent Sales of Unregistered Securities—Private Placement Transactions


On August 26, 2009, we received gross proceeds of approximately $2,043,000 in the first closing of our private placement transaction with six accredited investors.  Pursuant to Subscription Agreements entered into with the investors, we sold approximately 38 Investment Units at $54,000 per Investment Unit.  Each “Investment Unit” consists of 180,000 shares of our common stock and a five year non-callable warrant to purchase 90,000 shares of our common stock at an exercise price of $0.30 per share.  After commissions and expenses, we received net proceeds of approximately $1,792,300 upon the first closing of our private placement.  On December 24, 2009, we had a second closing of our private placement in which we received additional gross proceeds of approximately $2,996,000 from 24 accredited investors.  At the second closing, we sold approximately 55 Investment Units on the same terms and conditions as the Investment Units sold at the first closing.  After commissions and expenses, we received net proceeds of approximately $2,650,400 in connection with this second closing of our private placement.  On December 31, 2009, we had a third closing of our private placement in which we received additional gross proceeds of approximately $432,000 from five accredited investors.  At the third closing, we sold eight Investment Units on the same terms and conditions as the Investment Units sold at the first closing. After commissions and expenses, we received net proceeds of approximately $380,200 in connection with this third closing of our private placement.  On January 4, 2010, the Company completed its fourth and final closing of its private placement, resulting in additional gross proceeds to the Company of $108,000 from two accredited investors.  At this fourth closing, we sold two Investment Units on the same terms and conditions as the Investment Units sold at the first closing. After commissions and expenses, we received net proceeds of approximately $95,000 in connection with this final closing of our private placement.   These private placement transactions are described in further detail in “Liquidity and Capital Resources” below and Note 3 to the audited consolidated financial statements.
 
 
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Prior to our private placement, we raised aggregate proceeds of $1,700,000 in fiscal year 2009 through the issuance of secured convertible promissory notes on each of March 30, May 14, and June 12, 2009.  Upon the first closing of our private placement on August 26, 2009, these notes were converted into shares of our common stock, as more fully described in Note 3 of the audited consolidated financial statements.

2010 Private Placement Transactions

During 2010 we entered into a series of Bridge Note and Warrant Purchase Agreements as described in detail below.  On September 26, 2010, the Company’s Board approved an approximate aggregate offering amount of $3 million by January 31, 2011, including for the exchange of Bridge Notes and Deerwood Notes and interest on those notes.  The fund raising efforts were successful and new notes in the aggregate principal amount of approximately $3 million were issued by November 12, 2010.

Bridge Notes and Warrants

On June 3, 2010, we entered into a Bridge Note and Warrant Purchase Agreement with John Pappajohn to purchase two secured promissory notes (each, a “Bridge Note”) in the aggregate principal amount of $500,000, with each Bridge Note in the principal amount of $250,000 maturing on December 2, 2010.  On June 3, 2010, Mr. Pappajohn loaned the Company $250,000 in exchange for the first Bridge Note (there were no warrants issued in connection with this first note) and on July 25, 2010, Mr. Pappajohn loaned us $250,000 in exchange for the second Bridge Note.  In connection with his purchase of the second Bridge Note, Mr. Pappajohn received a warrant to purchase up to 250,000 shares of our common stock.  The exercise price of the warrant (subject to anti-dilution adjustments, including for issuances of securities at prices below the then-effective exercise price) was $0.50 per share.

Pursuant to a separate agreement that we entered into with Mr. Pappajohn on July 25, 2010, we granted him a right to convert his Bridge Notes into shares of our common stock at a conversion price of $0.50.  The conversion price was subject to customary anti-dilution adjustments, but would never be less than $0.30. Each Bridge Note accrued interest at a rate of 9% per annum. 

Deerwood Notes and Warrants

On July 5, 2010 and August 20, 2010, we issued unsecured promissory notes (each, a “Deerwood Note”) in the aggregate principal amount of $500,000 to Deerwood Partners LLC and Deerwood Holdings LLC, with each investor purchasing two notes in the aggregate principal amount of $250,000.  Our director George Kallins and his spouse are the managing members of these investors.  The Deerwood Notes mature on December 15, 2010.  We received $250,000 in gross proceeds from the issuance of the first two notes on July 5, 2010 and another $250,000 in gross proceeds from the issuance of the second two notes on August 20, 2010.   In connection with the August 20, 2010 transaction, each of the two investors also received a warrant to purchase up to 75,000 shares of our common stock at an exercise price (subject to anti-dilution adjustments, including for issuances of securities at prices below the then-effective exercise price) of $0.56 per share.
 
SAIL Venture Partners L.P. (“SAIL”), of which our director David Jones is a managing partner, issued unconditional guaranties to each of the Deerwood investors, guaranteeing the prompt and complete payment when due of all principal, interest and other amounts under each Deerwood Note.  The obligations under each guaranty were independent of our obligations under the Deerwood Notes and separate actions could be brought against the guarantor.  We entered into an oral agreement to indemnify SAIL and grant to SAIL a security interest in our assets in connection with the guaranties. In addition, on August 20, 2010, we granted SAIL warrants to purchase up to an aggregate of 100,000 shares of common stock at an exercise price (subject to anti-dilution adjustments, including for issuances of securities at prices below the then-effective exercise price) of $0.56 per share.
 
Each Deerwood Note accrued interest at a rate of 9% per annum and was convertible into shares of our common stock at a conversion price of $0.50.  The conversion price was subject to customary anti-dilution adjustments, but would never be less than $0.30.

October Notes and Warrants
 
On October 1, 2010, we entered into a Note and Warrant Purchase Agreement (the “Purchase Agreement”) with John Pappajohn and SAIL as investors, pursuant to which we issued to the investors secured convertible promissory notes (the “October Notes”) in the aggregate principal amount of $1,011,688 and warrants to purchase up to 1,686,144 shares of common stock. The Company received $500,000 in gross proceeds from the issuance to these investors of October Notes in the aggregate principal amount of $500,000 and related warrants to purchase up to 833,332 shares.  We also issued October Notes in the aggregate principal amount of $511,688, and related warrants to purchase up to 852,812 shares, to Mr. Pappajohn in exchange for the cancellation of the two Bridge Notes originally issued to him on June 3, 2010 and July 25, 2010 in the aggregate principal amount of $500,000 (and accrued and unpaid interest on those notes) and a warrant to purchase up to 250,000 shares originally issued to him on July 25, 2010. The transaction closed on October 1, 2010.
 
 
25

 
 
On October 7 and October 12, 2010, a third and fourth accredited investor, respectively, executed the Purchase Agreement. In connection therewith, we issued October Notes in the aggregate principal amount of $600,000 and warrants to purchase up to 999,999 shares of common stock of the Company, to such investors on those dates.  We received $588,000 in net proceeds from these investors, after paying $12,000 to the placement agent as described below. Monarch Capital Group LLC (“Monarch”) acted as non-exclusive placement agent with respect to the October 12 placement of October Notes in the aggregate principal amount of $100,000 and related warrants, pursuant to an engagement agreement, dated September 30, 2010, between us and Monarch. Under the engagement agreement, in return for its services as non-exclusive placement agent, Monarch was entitled to receive (a) a cash fee equal to 10% of the gross proceeds raised from the sale of October Notes to investors introduced to the Company by Monarch; (b) a cash expense allowance equal to 2% of the gross proceeds raised from the sale of October Notes to such investors; and (c) five-year warrants (the “Placement Agent Warrants”) to purchase common stock of the Company equal to 10% of the shares issuable upon conversion of October Notes issued to such investors.  In connection with the October 12, 2010 closing, Monarch received a cash fee of $10,000 and a cash expense allowance of $2,000 and, on October 25, 2010, received Placement Agent Warrants to purchase 33,333 shares of the Company’s common stock at an exercise price of $0.33 per share.
 
On October 21, 2010 and October 28, a fifth and sixth accredited investor executed the Purchase Agreement. In connection therewith, we issued October Notes in the aggregate principal amount of $250,000 and warrants to purchase up to 416,666 shares of common stock to such investors on that date. We received approximately $250,000 in net proceeds from the issuance to these investors.
 
On November 3, 2010, three affiliated entities, identified below, executed the Purchase Agreement.  In connection therewith, we issued October Notes in the aggregate principal amount of $762,250 and warrants to purchase up to 1,270,414 shares of common stock, as follows:  (a) We received $250,000 in gross proceeds from the issuance to BGN Acquisition Ltd., LP, an entity controlled by our director George Kallins, of October Notes in the aggregate principal amount of $250,000 and related warrants to purchase up to 416,666 shares.  (b)  We also issued October Notes in the aggregate principal amount of $512,250, and related warrants to purchase up to 512,250 shares, to Deerwood Holdings LLC and Deerwood Partners LLC, two entities controlled by Mr. Kallins, in exchange for the cancellation of the Deerwood Notes originally issued on July 5, 2010 and August 20, 2010 in the aggregate principal amount of $500,000 (and accrued and unpaid interest on those notes) and warrants to purchase an aggregate of up to 150,000 shares originally issued on August 20, 2010.  The related guaranties and oral indemnification and security agreement that had been entered into in connection with the Deerwood Notes were likewise terminated.   SAIL, of which our director David Jones is a managing partner, issued unconditional guaranties to each of the Deerwood investors, guaranteeing the prompt and complete payment when due of all principal, interest and other amounts under the October Notes issued to such investors.  The obligations under each guaranty are independent of our obligations under the October Notes and separate actions may be brought against the guarantor.  In connection with its serving as guarantor, we granted SAIL warrants to purchase up to an aggregate of 341,498 shares of common stock.  The warrants to purchase 100,000 shares of common stock previously granted to SAIL on August 20, 2010 were canceled.
 
On November 12, a tenth accredited investor executed the Purchase Agreement.  In connection therewith, the Company issued Notes in the aggregate principal amount of $400,000 and Warrants to purchase up to 666,666 shares of common stock of the Company, to the investor on such date.   The Company received $352,000 in net proceeds from the investor.   Monarch acted as non-exclusive placement agent with respect to the placement of the Note in the aggregate principal amount of $400,000 and related Warrants, pursuant to the abovementioned engagement agreement, dated September 30, 2010.  In connection with the November 12, 2010 closing, Monarch received a cash fee of $40,000 and a cash expense allowance of $8,000 and will receive a Placement Agent Warrant to purchase 133,333 shares of the Company’s common stock at an exercise price of $0.33 per share.

The Purchase Agreement provides for the issuance and sale of October Notes, for cash or in exchange for outstanding convertible notes, in the aggregate principal amount of up to $3,000,000 plus an amount corresponding to accrued and unpaid interest on any exchanged notes, and warrants to purchase a number of shares corresponding to 50% of the number of shares issuable on conversion of the October Notes.  The agreement provides for multiple closings, but mandates that no closings may occur after January 31, 2011.  The Purchase Agreement also provides that the Company and the holders of the October Notes will enter into a registration rights agreement covering the registration of the resale of the shares underlying the October Notes and the related warrants.
 
The October Notes mature one year from the date of issuance (subject to earlier conversion or prepayment), earn interest equal to 9% per year with interest payable at maturity, and are convertible into shares of common stock of the Company at a conversion price of $0.30. The conversion price is subject to adjustment upon (1) the subdivision or combination of, or stock dividends paid on, the common stock; (2) the issuance of cash dividends and distributions on the common stock; (3) the distribution of other capital stock, indebtedness or other non-cash assets; and (4) the completion of a financing at a price below the conversion price then in effect.  The October Notes are furthermore convertible, at the option of the holder, into securities to be issued in subsequent financings at the lower of the then-applicable conversion price or price per share payable by purchasers of such securities.  The October Notes can be declared due and payable upon an event of default, defined in the October Notes to occur, among other things, if the Company fails to pay principal and interest when due, in the case of voluntary or involuntary bankruptcy or if the Company fails to perform any covenant or agreement as required by the October Note.
 
Our obligations under the terms of the October Notes are secured by a security interest in the tangible and intangible assets of the Company, pursuant to a Security Agreement, dated as of October 1, 2010, by and between us and John Pappajohn, as administrative agent for the holders of the October Notes.  The agreement and corresponding security interest terminate if and when holders of a majority of the aggregate principal amount of October Notes issued have converted their October Notes into shares of common stock.
 
 
26

 

The warrants related to the October Notes expire seven years from the date of issuance and are exercisable for shares of common stock of the Company at an exercise price of $0.30.  Exercise price and number of shares issuable upon exercise are subject to adjustment (1) upon the subdivision or combination of, or stock dividends paid on, the common stock; (2) in case of any reclassification, capital reorganization or change in capital stock and (3) upon the completion of a financing at a price below the exercise price then in effect. Any provision of the October Notes or related warrants can be amended, waived or modified upon the written consent of the Company and holders of a majority of the aggregate principal amount of such notes outstanding.  Any such consent will affect all October Notes or warrants, as the case may be, and will be binding on all holders thereof.
 
The Placement Agent Warrants have an exercise price equal to 110% of the conversion price of the Notes and an exercise period of five years.  The terms of the Placement Agent Warrants, except for the exercise price and period, are identical to the terms of the warrants related to the October Notes.
 
For a table showing the differences in terms between the October Notes (and related warrants), on the one hand, and the exchanged Bridge Notes and Deerwood Notes (and related warrants), on the other hand, please refer to “Item 13 - Certain Relationships and Related Transactions, and Director Independence - Differences between October Notes and Bridge Notes/Deerwood Notes.”
 
In issuing the securities described in this section without registration under the Securities Act, the Company relied upon the exemption from registration contained in Section 4(2) of the Securities Act and in Regulation D promulgated thereunder, as the securities  were issued to accredited investors, without a view to distribution, and were not issued through any general solicitation or advertisement.

 
27

 
 
ITEM 6.
Selected Financial Data.
 
 Not applicable.

ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes provided under Part II, Item 8 of this annual report on Form 10-K.  This discussion summarizes the significant factors affecting the consolidated operating results, financial condition and liquidity and cash flows of CNS Response, Inc. for the fiscal years ended September 30, 2010 and 2009.  Except for historical information, the matters discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management as of the date hereof based on information currently available to our management. Use of words such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “should,” “forecasts,” “goal,” “likely” or similar expressions, indicate a forward-looking statement. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions. Actual results may differ materially from the forward-looking statements we make. See “Risk Factors” elsewhere in this annual report on Form 10-K for a discussion of certain risks associated with our business.  We disclaim any obligation to update forward-looking statements for any reason.
 
Overview 

We are a web-based neuroinformatic analysis company with two distinct business segments. Our primary business is the Neurometric Information Services (formerly called Laboratory Information Services) business operated by CNS California, which is focused on neurometric analysis, research, development and the commercialization of a patented system that provides data to psychiatrists and other physicians to enable them to make more informed, patient-specific decisions when treating individual patients with behavioral (psychiatric and/or addictive) disorders.  Our secondary Clinical Services business, operated by our wholly-owned subsidiary, Neuro-Therapy Clinic (“NTC”), is a full service psychiatric clinic.
 
Neurometric Information Services
 
Traditionally, prescription of medication for the treatment of behavioral disorders (such as depression, bipolar disorders, eating disorders, addiction, anxiety disorders, ADHD and schizophrenia) has been primarily based on symptomatic factors, while the underlying physiology and pathology of the disorder can rarely be analyzed, which often results in multiple ineffective, costly, and often lengthy, courses of treatment before the effective medications are identified.  Some patients never find effective medications.
 
We believe that our technology offers an improvement upon traditional methods for determining a course of medication for patients suffering from non-psychotic behavioral disorders because our technology is designed to correlate the success of courses of medication with the neurophysiological characteristics of a particular patient. Our technology provides medical professionals with medication sensitivity data for a subject patient based upon the identification and correlation of treatment outcome information from other patients with similar neurophysiologic characteristics.   This treatment outcome information is contained in a proprietary outcomes database which consists of over 17,000 medication trials for patients with psychiatric or addictive problems (the “ CNS Database ”).  For each patient in the CNS Database, we have compiled electroencephalographic (“ EEG ”) scans, symptoms and outcomes often across multiple treatments from multiple psychiatrists and physicians.  This patented technology, called “Referenced-EEG®” or “rEEG®”, represents an innovative approach to identifying effective medications for patients suffering from debilitating behavioral disorders.
 
With rEEG®, physicians order a digital EEG for a patient, which is then evaluated with reference to the CNS Database.  By providing this reference correlation, an attending physician can better determine a treatment strategy with the knowledge of how other patients having similar brain function have previously responded to a myriad of different treatment alternatives.  Analysis of this complete data set yielded a platform of 74 neurometric variables that have shown utility in characterizing patient response to diverse medications.  This platform then allows a new patient to be characterized, based on these 74 neurometric variables, and the database to be queried to understand the statistical probability of how patients with similar brain patterns have previously responded to the medications currently in the database. This technology allows us to create and provide simple reports (“ rEEG Reports ”) to the prescriber that summarizes historical treatment success of specific medications for those patients with similar neurometric brain patterns.   It provides neither a diagnosis nor a specific treatment, but like all lab results, provides objective, evidenced-based information to help the prescriber in their decision-making.
 
Our Neurometric Information Services business is focused on increasing the demand for our rEEG Reports. We believe the key factors that will drive broader adoption of our rEEG Reports will be the acceptance by healthcare providers and patients of their benefit, the demonstration of the cost-effectiveness of using our technology, the reimbursement by third-party payers, the expansion of our sales force and increased marketing efforts.
 
 
28

 

In addition to its utility in providing psychiatrists and other physicians/prescribers with medication sensitivity guidance, rEEG provides us with significant opportunities in the area of pharmaceutical development.  rEEG, in combination with the information contained in the CNS Database, has the potential to enable the identification of novel uses for neuropsychiatric medications currently on the market and in late stages of clinical development, as well as in aiding the identification of neurophysiologic characteristics of clinical subjects that may be successfully treated with neuropsychiatric medications in the clinical testing stage. We intend to enter into relationships with established drug and biotechnology companies to further explore these opportunities, although no relationships are currently contemplated.  The development of pathophysiological markers as the new method for identifying the correct patient population to research is being encouraged by both The National Institute of Mental Health (NIMH) and The Food and Drug Administration (FDA).
 
Clinical Services
 
In January 2008, we acquired our then largest customer, the Neuro-Therapy Clinic, Inc.  Upon the completion of the transaction, NTC became a wholly-owned subsidiary of ours. NTC operates one of the larger psychiatric medication management practices in the state of Colorado, with six full time and seven part time employees including psychiatrists and clinical nurse specialists with prescribing privileges.  Daniel A. Hoffman, M.D. is the medical director at NTC, and, after the acquisition, became our Chief Medical Officer and more recently, our President.
 
NTC, having performed a significant number of rEEG’s, serves as an important resource in our product development, the expansion of our CNS Database, production system development and implementation, along with the integration of our rEEG services into a medical practice.  Through NTC, we also expect to develop marketing and patient acquisition strategies for our Neurometric Information Services business. Specifically, NTC is learning how to best communicate the advantages of rEEG to patients and referring physicians in the local market.  We will share this knowledge and developed communication programs learned through NTC with other physicians using our services, which we believe will help drive market acceptance of our services.  In addition, we plan to use NTC to train practitioners across the country in the uses of rEEG technology.
 
We view our Clinical Services business as secondary to our Neurometric Information Services business, and we have no current plans to expand this business.
 
Business operations
 
Since our inception, we have generated significant net losses. As of September 30, 2010, we had an accumulated deficit of approximately $33.4 million, and as of September 30, 2009, our accumulated deficit was approximately $25.2 million.  We incurred operating losses of $6.5 million and $6.7 million for the fiscal years ended September 30, 2010 and 2009, respectively and incurred net losses of $8.2 million and $8.5 million for those respective periods.  We expect our net losses to continue for at least the next couple of years. We anticipate that a substantial portion of our capital resources and efforts will be focused on the scale-up of our commercial organization, research and product development and other general corporate purposes, including the payment of legal fees incurred as a result of our litigation.  Research and development projects include the completion of more clinical trials which are necessary to further validate the efficacy of our products and services relating to our rEEG technology across different types of behavioral disorders; the enhancement of the CNS Database and rEEG process, and to a lesser extent, the identification of new medications that are often combinations of approved drugs.  We anticipate that future research and development projects will be funded by grants or third-party sponsorship.

As of September 30, 2010, our current liabilities of approximately $4.4 million exceeded our current assets of approximately $0.20 million by approximately $4.2 million and our net losses will continue for the foreseeable future.  As part of the $4.4 million of current liabilities we have $1.0 million of secured convertible debt which is discounted to $0.  Since September 30, 2010, we have raised an additional $2.0 million from the issuance of secured convertible debt; however, we will need immediate additional funding to continue our operations plus substantial additional funding before we can increase the demand for our rEEG services.  We are currently exploring additional sources of capital; however, we do not know whether additional funding will be available on acceptable terms, or at all, especially given the economic conditions that currently prevail.  Furthermore, any additional equity funding may result in significant dilution to existing stockholders, and, if we incur additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, thus limiting the funds available for our business activities.  If adequate funds are not available, we may be required to delay or curtail significantly our development and commercialization activities.  This would have a material adverse effect on our business, financial condition and/or results of operations and could ultimately cause us to have to cease operations.

The Private Placement Transactions
 
From June 3, through to November 12, 2010, we raised $3.0 million through the sale of secured convertible notes and warrants.  Of such amount $1.75 million was purchased by members of our Board of Directors or their affiliate companies. See Note 3 of the audited financial statements, “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Recent Sales of Unregistered Securities” and “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
 
 
29

 

Financial Operations Overview
 
Revenues
 
Our Neurometric Information Services revenues are derived from the sale of rEEG Reports to physicians. Physicians are generally billed upon delivery of a rEEG Report.  The list prices of our rEEG Reports to physicians range from $200 to $800 with $400 being the most frequent charge.
 
Clinical Services revenue is generated as a result of providing services to patients on an outpatient basis. Patient service revenue is recorded at our established billing rates less contractual adjustments. Generally, collection in full is not expected on our established billing rates. Contractual adjustments are recorded to state our patient service revenue at the amount we expect to collect for the services provided based on amounts due from third-party payors at contractually determined rates.
 
Cost of Revenues
 
Cost of revenues are for Neurometric Information Services and represent the cost of direct labor, the costs associated with external processing, analysis and consulting review necessary to render an individualized test result and any miscellaneous support expenses.  Costs associated with performing our tests are expensed as the tests are performed.  We continually evaluate the feasibility of hiring our own personnel to perform most of the processing and analysis necessary to render a rEEG Report.
 
Cost of revenues for Clinical Services are not broken out separately but are included in general and administrative expenses.
 
Research and Development
 
Research and development expenses are associated with our Neurometric Information Services and primarily represent costs incurred to design and conduct clinical studies, to recruit patients into the studies, to improve rEEG processing, to add data to the CNS Database, to improve analytical techniques and advance application of the methodology. We charge all research and development expenses to operations as they are incurred.
 
 Sales and Marketing
 
 For our Neurometric Information Services, our selling and marketing expenses consist primarily of personnel, media, support and travel costs to inform user organizations and consumers of our products and services.  Additional marketing expenses are the costs of educating physicians, laboratory personnel, other healthcare professionals regarding our products and services.
 
For our Clinical Services, selling and marketing costs relate to advertising to attract patients to the clinic.
 
General and Administrative
 
Our general and administrative expenses consist primarily of personnel, occupancy, legal, consulting and administrative and support costs for both our Neurometric Information Services and Clinical Services businesses.
 
Critical Accounting Policies and Significant Judgments and Estimates
 
This discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could therefore differ materially from those estimates under different assumptions or conditions.
 
 
30

 

Our significant accounting policies are described in Note 2 to our consolidated financial statements included elsewhere in this report. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements.
 
Revenue Recognition
 
We have generated limited revenues since our inception. Revenues for our Neurometric Service product are recognized when a rEEG Report is delivered to a Client-Physician.  For our Clinical Services, revenues are recognized when the services are performed.
 
Stock-based Compensation Expense
 
Stock-based compensation expense, which is a non-cash charge, results from stock option grants.  Compensation cost is measured at the grant date based on the calculated fair value of the award.  We recognize stock-based compensation expense on a straight-line basis over the vesting period of the underlying option. The amount of stock-based compensation expense expected to be amortized in future periods may decrease if unvested options are subsequently cancelled or may increase if future option grants are made.

Derivative accounting for convertible debt and warrants

  The Company analyzes all financial instruments with features of both liabilities and equity under ASC-480-10 and ASC 815-10 whereby the Company determines the fair market carrying value of a financial instrument using the Black-Scholes model and revalues the fair market value on a quarterly basis.  Any changes in carrying value flow through as other income (expense) in the income statement.

 

 
   
Year ended September 30,
 
   
2010
   
2009
 
             
Revenues
   
100
%
   
100
%
Cost of revenues
   
21
     
19
 
Gross profit
   
79
     
81
 
Research and development
   
176
     
305
 
Sales and marketing
   
136
     
131
 
General and administrative expenses
   
785
     
555
 
Goodwill impairment
   
0
     
46
 
Operating loss
   
(1,018
)
   
(956
)
Other income (expense), net
   
(262
)
   
(261
Net income (loss)
   
(1,280
)%
   
(1217
)%
  
 
 
Year ended September 30,
   
Percent
 
 
2010
 
2009
   
Change
 
               
Neurometric Service Revenues
$ 136,100   $ 120,400       13 %
Clinical Service Revenues
  502,400     579,700       (13 )%
Total Revenues
$ 638,500   $ 700,100       (9 )%

 
 
31

 

 
   
Year ended September 30,
   
Percent
 
   
2009
   
2008
   
Change
 
                   
Cost of Neurometric Information Services revenues
  $ 135,100     $ 131,600       3 %
 
Cost of Neurometric Information Services revenues consists of payroll, consulting, and other miscellaneous costs.  Consulting costs primarily represent external costs associated with the processing and analysis of rEEG Reports and range between $75 and $100 per rEEG Report.  For the year ended September 30, 2010, cost of revenues of $135,100 consist primarily of direct labor and benefit costs of $102,100, which includes stock-based compensation, and consulting fees of $32,700.  For the year ended September 30, 2009, cost of revenues of $131,600 consisted primarily of direct labor and benefit costs of $99,600, including stock-based compensation, and consulting fees of $29,200.  We expect costs of revenues will increase as an absolute number as more rEEG Reports are processed. However, we expect the cost of revenues to decrease as a percentage of revenues as we improve our operating efficiency and increase the automation of certain processes.
 
 
   
Year ended September 30,
   
Percent
 
   
2010
   
2009
   
Change
 
                   
Neurometric Information Services research and development
  $ 1,120,500     $ 1,924,100       (42 )%
Research and development expenses consist of payroll costs (including stock-based compensation costs), consulting fees, clinical study costs, patient marketing and recruitment costs and other miscellaneous costs.  Research and development costs for the year ended September 30, 2010, included the following: payroll and benefit costs (including stock based compensation) of $848,300, consultant costs of $201,700 and other miscellaneous costs of $70,500 which include travel, database and support costs.  There were negligible clinical study patient costs or patient marketing and recruitment costs incurred for the year ended September 30, 2010.  For the comparable period for 2009, research and development costs included: payroll and benefit costs (including stock based compensation) of $792,100, consultant costs of $105,700 and other miscellaneous costs of $76,200 which included travel, database and support costs.  Additionally, as the clinical study was in full progress during the 2009 period, research and development costs included clinical study patient costs of $789,300 and patient marketing and recruitment costs of $161,100.

Comparing the year ended September 30, 2010 with the corresponding period in 2009, clinical study patient costs and patient marketing and recruitment costs were eliminated in the 2010 period as the study was completed in September 2009.  Consequently, the focus of the research and development department moved from conducting the clinical study to analyzing the data and drafting scientific papers for publications; the department also generated several applications for research grants for future funding.  Additionally, the focus moved to enhancing the rEEG production system and the preparation of the 510(k) application with the FDA.  With this shift in focus, consulting fees increased by $96,100: in total $50,200 was spent on research and $151,500 was spent on product enhancements in the year ended September 30, 2010.  Of the $151,500, $76,100 was spent on consulting resources assisting with the filing of our 510(k) application with the FDA, while the balance, $75,400, was spent on programming resources to improve our database and the rEEG process.  Payroll and benefits increased by $56,200 in the 2010 period primarily due to the reassignment of a staff member between departments and due to the increase in stock-based compensation.

 
 
Year ended September 30,
   
Percent
 
 
2010
 
2009
   
Change
 
Sales and Marketing
             
Neurometric Information Services
$ 853,100   $ 908,500       (6 )%
Clinical Services
  17,800     7,300       144 %
Total Sales and Marketing
$ 870,900   $ 915,800       (5 )%
 
 
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Comparing the year ended September 30, 2010, with the same period in 2009; payroll and benefits decreased by $27,900 in the 2010 period as a result a reduction in staff and the reassignment of staff to another department.  However, in July 2010 we recruited an Executive Vice President and Chief Marketing Officer to lead our marketing efforts and pursue contracts with key organizations.  Advertising and marketing expenses decreased by $88,500 as advertising was curtailed while the Company awaited resolution to its 510(k) application with the FDA.  Consequently, in the year ended September 30, 2010, marketing efforts were largely limited to planning and provider network development, whereas for the 2009 period the Company was actively executing its advertising and marketing plans.  Conference and travel expenses increased by $27,900 in the 2010 period as the Company conducted its first user-group conference in January 2010 and conducted multiple visits to potential clients. 

The Clinical Services sales and marketing expenses consists of advertising to attract patients to the clinic. During the year ended September 30, 2010, Clinical Services also invested in re-launching its updated website and in the development of a new marketing strategy, which accounted for much of the increase in expenditure.  We anticipate a moderate increase in marketing expenditure to attract new patients to the clinic as the capacity to treat new patients has increased with the addition of our newly recruited psychiatrist.
 
 
   
Year ended September 30,
   
Percent
 
   
2010
   
2009
   
Change
 
General and administrative
                 
Neurometric Information Services
  $ 4,262,900     $ 3,430,900       24 %
Clinical Services
    754,100       669,600       13 %
Total General and administrative
  $ 5,017,000     $ 4,100,500       22 %
 
General and administrative expenses for our Neurometric Information Services business are largely comprised of payroll and benefit costs, including stock based compensation, legal, patent costs, other professional and consulting fees, general administrative and occupancy costs, conference and travel and miscellaneous costs.  For the year ended September 30, 2010, General and Administrative costs included the following: salaries and benefit costs of $1,203,200; legal fees of $1,738,400; other professional and consulting fees of $727,700; general administrative and occupancy costs of $234,600; patent costs of $77,300; marketing and investor relations expenses of $96,400 and conference and travel expenses of $103,300.  For the same period in 2009, General and Administrative costs included the following: salaries and benefit costs of $792,700; legal fees of $1,361,200; other professional and consulting fees of $521,000; general administrative and occupancy costs of $263,000; patent costs of $213,100; marketing and investor relations expenses of $86,500 and conference and travel expenses of $69,800.  Additionally, other one-time miscellaneous charges of $99,700 were booked for the 2009 period, which were the result of a revised IRS assessment on 2006 payroll taxes and Delaware Franchise Tax assessments for calendar years 2007 and 2008.

With respect to our Neurometric Information Services business, in the year ended September 30, 2010, compared to the same period in 2009, payroll and benefit expenses increased by a net $410,500, of which $410,000 was due to an increase in stock-based compensation due to the accounting for vested option grants given to employees, directors, advisors and consultants in March and July of 2010.  The balance of the change, $101,300 was due to the change of staff mix with the former CEO, Mr. Brandt, leaving the Company in April 2009 and the former President, Mr. Carpenter, becoming the CEO.  Additionally, the Chief Financial Officer (CFO), who was previously engaged as a consultant, joined the staff in mid February 2010.   Professional and consulting fees increased by a net $206,600 which was partly due to the mix of consulting services used in fiscal 2010: these fees included $284,000 associated with financial advisory services used to obtain funding, $121,000 for accounting services, $62,500 used for public relations services and $41,000 was used for consultants associated with the Brandt litigation.  Legal fees increased by a net $376,400 which was made up of a $567,600 increase in litigation fees in defending against actions brought by Mr. Brandt, which was partly offset by a reduction of $191,200 in non-litigation related legal expenses.  In total $1,700,700 was directly incurred in the course of the litigation, of which $566,600 was incurred in fiscal 2009 and $1,134,100 in fiscal 2010.  All matters between Mr. Brandt and us have either been dismissed or adjudicated in our favor.  General administrative and occupancy costs increased by $51,500, in part due to increases in computer and telecommunications costs.  Patent costs declined by $135,800 due to the timing of patent applications as expenses were primarily associated with patent maintenance.  Marketing and Investor relations expenses increased by $9,900 due to attendance and presentations at more investor conferences with a view to raising capital.  Conference and travel costs increased by $36,600 as a result of increased travel associated with raising capital and the litigation activities.  
 
 
33

 

General and administrative expenses for our Clinical Services business includes all costs associated with operating NTC.  This includes payroll costs, medical supplies, occupancy costs and other general and administrative costs.  These costs increased by $59,550 to $754,100 in the year ending September 30, 2010 from $669,600 in the fiscal year 2009.  This increase is largely due to the recruiting fees, moving costs, sign-on bonus and salary of our new psychiatrist who joined NTC in August 2010.  Other contributing cost increases for NTC were due to Clinical Services staff, who had worked on the clinical study, no longer being reimbursed by the Neurometric Information Services for their time spent on the study.  These increases in cost for NTC were partially offset by a reduction in rent as a less expensive lease extension was negotiated with a reduction in sub-leased space as a cost saving measure.
 
Goodwill impairment charges
 
During the fiscal year 2009, we conducted a goodwill impairment test and determined that all of the goodwill related to the NTC acquisition was impaired. Accordingly, we recorded a goodwill impairment charge of $320,200 for the year ended September 30, 2009.
 
 
   
Year ended September 30,
   
Percent
 
   
2010
   
2009
   
Change
 
                   
Neurometric Information Services (Expense), net
  $ (1,668,100 )   $ (1,822,700 )     (8 )%
Clinical Services (Expense)
    (100 )     (200 )     50 %
Total interest income (expense)
  $ (1,668,200 )   $ (1,822,900 )     (8 )%
* not meaningful                         
 
 
Firstly, we incurred a non-cash loss on the extinguishment of debt of $1,094,300, which was due to the fact that the Bridge Notes issued to John Pappajohn on June 3 and July 25, 2010 and the Deerwood Notes issued to the Deerwood investors on July 5 and August 20, 2010 were subsequently replaced by October Notes (please see Note 3 to the Financial Statements).  The modifications of the terms were accounted for as a debt extinguishment, whereby the difference in the carrying value of the original notes (i.e., the Bridge Notes and Deerwood Notes) and the carrying value of the replacement notes (i.e., the related October Notes) were recognized as losses within the period. Although the replacement notes were issued after the close of the fiscal year ended September 30, 2010, i.e., on October 1, 2010 (in the case of John Pappajohn) and November 3, 2010 (in the case of the Deerwood investors), we considered the replacement notes to be outstanding and effective for the fiscal year ended September 30, 2010 and accordingly recorded the resultant loss on extinguishment of debt for the year ended September 30, 2010.
 
Secondly, we incurred interest expenses of $360,500, which is comprised of a non-cash charge of $258,900 associated with the value of the beneficial conversion feature of the Bridge Notes and Deerwood Notes, which were expensed to interest.  Additionally, we incurred a non-cash charge of $77,000 related to the amortization of warrant discount associated with the warrants issued along with the Bridge Notes and Deerwood Notes and a further interest charge of $19,700, which had accrued on the notes themselves.  Actual interest paid net of interest earned was only $4,900.
 
Lastly, we incurred a financing premium of $213,400.  This comprised a non-cash charge of $193,400 associated with the warrants issued to SAIL in connection with the guaranties provided by SAIL in connection with the Deerwood Notes (please see Note 3 to the Financial Statements).  An additional $20,000 was paid for due diligence work to an entity in anticipation of obtaining financing; no financing ensued as the terms were ultimately considered to be potentially too dilutive to our shareholders.
 
For fiscal 2009, Neurometric Information Services incurred a $90,000 financing premium that was paid in connection with the bridge note issued to Mr. Pappajohn on June 12, 2009 and a $20,900 non-cash interest charge on the bridge notes issued to Mr. Brandt and Sail Venture Partners.  Additionally, a $1,058,000 non-cash charge associated with the valuation of bridge warrants and a $642,000 non-cash charge associated with the value of the beneficial conversion feature of the bridge notes which was expensed interest upon conversion of the bridge notes.  Furthermore, interest paid net of interest earned was $3,800.  
 
34

 

 
   
Year ended September 30,
   
Percent
 
   
2010
   
2009
   
Change
 
                   
Neurometric Information Services net loss
  $ (7,904,400 )   $ (8,451,300 )         (6 )%
Clinical Services net loss
    (269,600 )     (70,900 )         280 %
Total Net Loss
  $ (8,174,000 )   $ (8,522,200 )         (4 )%
 
The decrease in net loss for our Neurometric Information Services business of approximately $547 thousand for the year ended September 30, 2010 compared to the prior fiscal year is primarily due to reductions in our Research and Development expenditures of $804 thousand as the clinical trial had ended in fiscal 2009; the reduction of Sales and Marketing costs of $55 thousand; the non-recurrence of the $320 thousand goodwill write-down of NTC in fiscal 2009; the reduction of Other Expenses of $155 thousand due to accounting for non-cash items including the beneficial conversion features of notes and the expensing of warrant discounts.  These decreases were partially offset by an increase in General and Administration expenses of $832 thousand, which was largely due to the increase in the Brandt litigation expenses and the increase in accounting for stock option compensation.      
 
The increase in the net loss for our Clinical Services business of approximately $199 thousand was the result of having insufficient psychiatric/prescriber resources to see a sufficient volume of new patients for the clinic to be profitable.  This situation was exacerbated by the upfront costs of recruiting and hiring the needed additional psychiatrist who joined Clinical Services in August 2010, before she could have a significant impact in increasing the clinic’s revenue.   
 
 
 
As of September 30, 2010, we had approximately $62,000 in cash and cash equivalents and a working capital deficit of approximately $4.2 million compared to approximately $0.99 million in cash and cash equivalents and a working capital balance of approximately $1.1 million at September 30, 2009.  The working capital deficit as of September 30, 2010 includes the $1.0 million of secured convertible promissory notes (Bridge Notes and Deerwood Notes) outstanding as of that date.
 
Operating Capital and Capital Expenditure Requirements
 
Our continued operating losses and limited capital raise substantial doubt about our ability to continue as a going concern, and we need to raise substantial additional funds in the next 12 months in order to continue to conduct our business.  Until we can generate a sufficient amount of revenues to finance our cash requirements, which we may never do, we expect to finance future cash needs primarily through public or private equity offerings, debt financings, borrowings or strategic collaborations.

We need additional funds immediately to continue our operations and will need substantial additional funds before we can increase demand for our rEEG services.  We are currently exploring additional sources of capital; however, we do not know whether additional funding will be available on acceptable terms, or at all, especially given the economic conditions that currently prevail.  In addition, any additional equity funding may result in significant dilution to existing stockholders, and, if we incur additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, thus limiting funds available for our business activities.  We expect to continue to incur operating losses in the future and to make capital expenditures to expand our research and development programs (including upgrading our CNS Database) and to scale up our commercial operations and marketing efforts.   If adequate funds are not available, it would have a material adverse effect on our business, financial condition and/or results of operations, and could ultimately cause us to have to cease operations.
 
Sources of Liquidity
 
Since our inception substantially all of our operations have been financed primarily from equity and debt financings.  Through September 30, 2010, we had received proceeds of approximately $13.7 million from the sale of stock, $7.7 million from the issuance of convertible promissory notes and $220,000 from the issuance of common stock to employees in connection with expenses paid by such employees on behalf of the Company.
 
From June 3, 2010 through to November 12, 2010, we raised $3.0 million through the sale of secured convertible notes and warrants.  Of such amount, $1.75 million was purchased by members of our Board of Directors or their affiliate companies. See Note 3 of the financial statements,  “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” and “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
 
 
35

 

 
 
 
Net cash proceeds from financing activities for the fiscal year ended September 30, 2010 were approximately $3.0 million, net of offering costs, raised on December 24 and 31, 2009 and January 4, 2009 in connection with the second, third and fourth closings respectively of our private placement transaction; $1.0 million raised in bridge financing transactions, and $100,000 as an advance from Mr. Pappajohn prior to these funds becoming part of a secured promissory note on October 1, 2010.  These proceeds were partly offset by the repayment of $94,100 on a promissory note issued to Daniel Hoffman in connection with our acquisition of NTC.

 For the fiscal year ended September 30, 2009 proceeds from financing activities were approximately $1.8 million, net of offering costs, raised on August 26, 2009, in connection with the first closing of our private placement transaction; $1.7 million raised in bridge financing transactions (which ultimately converted into equity as further described in Note 3 of the financial statements), and $295,500 due to the exercise of options and warrants.  These proceeds were partly offset by the repayment of a convertible promissory note, with accrued interest, totaling $92,600 and the repayment of $86,700 on a promissory note issued to Daniel Hoffman in connection with our acquisition of NTC.
 

As of September 30, 2010, we have a contractual obligation to pay the remaining balance on a promissory note of $24,700 issued in connection with our acquisition of NTC, which bears interest at a rate of 8% per annum.  Our combined lease obligations are $ 274,400; our remaining lease obligation on our Aliso Viejo office, which expires of January 30, 2013, is $112,100 in total: being $46,500, $49,000 and 16,600 for fiscal years 2011, 2012 and 2013 respectively, with an average monthly rental of $3,600 over the entire lease period.  Our remaining lease obligation on our Greenwood Village, CO, clinic office, which expires of April 30, 2013, is $162,300 in total:$58,200, $65,400 and $38,700 for fiscal years 2011, 2012 and 2013 respectively, with an average monthly rental of $5,100 over the entire lease period.  As of September 30, 2009, the balance outstanding on the aforementioned promissory note was $118,600; our obligations for leased space were immaterial as the leases were expired or were close to expiring.  Please see Note 10 to our Consolidated Financial Statements included elsewhere in this report for further details.
 
   
Payments due by period
             
Contractual Obligations
 
Total
   
Less than 1 year
   
1 to 3 years
   
3-5 years
   
More than 5 years
 
                               
Long-Term Debt Obligations
    24,700       24,799       -       -       -  
Capital Lease Obligations
    5,600       2,200       3,400       -       -  
Operating Lease Obligations
    274,500       104,700       169,800       -       -  
Total
    304,800       131,600       173,200       -       -  

Derivative Liability

Current liabilities include $2.1 million of derivative liability. This amount includes:

 
1.
$0.9 million, which represents the fair value liability associated with the warrants issued in conjunction with the October Notes.

 
2.
$1.2 million, which represent the fair value liability associated with the conversion option of the October Notes.
 
(Please see “Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”.)

The carrying value of these derivative liabilities will be reassessed each quarter and any change in the carrying value will be booked to other income (expense) in the income statement.

 
We expect to continue to incur operating losses in the future and to make capital expenditures to expand our research and development programs (including upgrading our CNS Database) and to scale up our commercial operations and marketing efforts. We expect that our existing cash will be used to fund working capital and for capital expenditures and other general corporate purposes, including the repayment of debt incurred as a result of our litigation with Brandt. Although since September 30, 2010 we have raised gross proceeds of $2.0 million through the sale of convertible promissory notes, we anticipate that our cash on hand (including the proceeds from these promissory notes) and cash generated through our operations will not be sufficient to fund our operations the next 12 months.  In addition we will have to repay the outstanding notes plus interest.  We therefore anticipate raising additional funds in the near future.
 
 
36

 

The amount of capital we will need to conduct our operations and the time at which we will require such capital may vary significantly depending upon a number of factors, such as:

 
·
the amount and timing of costs we incur in connection with our research and product development activities, including enhancements to our CNS Database and costs we incur to further validate the efficacy of our rEEG technology;

 
·
the amount and timing of costs we incur in connection with the expansion of our commercial operations, including our selling and marketing efforts;

 
·
whether we incur additional consulting and legal fees in our efforts to obtain 510(k) clearance from the FDA.

 
·
if we expand our business by acquiring or investing in complimentary businesses.

 
 
 
 
 
ITEM 7A.           Quantitative and Qualitative Disclosures about Market Risk.
 
 Not applicable.

 
37

 

ITEM 8.              Financial Statements and Supplementary Data

   
Page
     
Report of Independent Registered Public Accounting Firm
  39
     
Consolidated Balance Sheets as of September 30, 2010 and 2009
 
40
     
Consolidated Statements of Operations for the Years Ended September 30, 2010 and 2009
 
41
     
Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the Years Ended September 30, 2010 and 2009
 
42
     
Consolidated Statements of Cash Flows for the Years Ended September 30, 2010 and 2009
 
43
     
Notes to Consolidated Financial Statements for the Years Ended  September 30, 2010 and 2009
 
44

 
38

 
 
To the Board of Directors
CNS Response, Inc.
85 Enterprise, Suite 410
Aliso Viejo, CA 92656

We have audited the accompanying consolidated balance sheets of CNS Response, Inc. (the “Company”) and its subsidiaries as of September 30, 2010 and 2009, and the related consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for each of the years in the two-year period ended September 30, 2010. CNS Response, Inc.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2010 and 2009, and the results of its operations and its cash flows for each of the years in the two-year period ended September 30, 2010 in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1 to the consolidated financial statements, the Company’s continued operating losses and limited capital raise substantial doubt about its ability to continue as a going concern.  Management’s plans in regard to this matter are also described in Note 1.  The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Cacciamatta Accountancy Corporation

Irvine, California
December 20, 2010

 
39

 
 
CNS RESPONSE, INC.

CONSOLIDATED BALANCE SHEETS AT SEPTEMBER 30, 2010 and 2009

   
As at September 30,
 
   
2010
   
2009
 
ASSETS
           
CURRENT ASSETS:
           
Cash
  $ 62,000     $ 988,100  
Accounts receivable (net of allowance for doubtful accounts of $10,400 and $11,700 in 2010 and 2009 respectively)
    48,900       61,700  
Prepaids and other
    84,900       89,500  
Total current assets
    195,800       1,139,300  
Furniture & equipment
    23,000       17,500  
Other assets
    18,700       4,100  
TOTAL ASSETS
  $ 237,500     $ 1,160,900  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
Accounts payable (including $60,800 and $7,000 to related parties in 2010 and 2009 respectively)
  $ 1,383,700     $ 1,285,600  
Accrued liabilities
    380,700       261,400  
Other payable – related party
    100,000       -  
Deferred compensation (including $81,200 and $81,200 to related parties in 2010 and 2009 respectively)
    263,600       220,100  
Accrued patient costs
    135,000       305,500  
Accrued consulting fees (including $27,000 and $18,000 to related parties in 2010 and 2009, respectively)
    86,600       72,100  
Derivative liability
    2,061,900       -  
Secured convertible promissory notes-related party (net of discounts $1,023,900 in 2010 and $0 in 2009)
    -       -  
Current portion of long-term debt
    26,900       95,900  
Total current liabilities
    4,438,400       2,240,600  
                 
LONG-TERM LIABILITIES
               
Note payable to officer
    -       24,800  
Capital lease
    3,400       5,600  
Total long-term liabilities
    3,400       30,400  
TOTAL LIABILITIES
    4,441,800       2,271,000  
COMMITMENTS AND CONTINGENCIES
    -       -  
                 
STOCKHOLDERS' EQUITY:
               
Common stock, $0.001 par value; authorized 750,000,000 shares; 56,023,921 and 41,781,129 shares outstanding as of September 30, 2010 and 2009
    56,000       41,800  
Additional paid-in capital
    29,109,600       24,044,000  
Accumulated deficit
    (33,369,900 )     (25,195,900 )
Total stockholders' equity
    (4,204,300 )     (1,110,100 )
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 237,500     $ 1,160,900  

See accompanying Notes to Consolidated Financial Statements
 
40

 
CNS RESPONSE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED
SEPTEMBER 30, 2010 AND 2009

   
YEARS ENDED
SEPTEMBER 30,
 
   
2010
   
2009
 
REVENUES
           
Neurometric Information Services
  $ 136,100     $ 120,400  
Clinical Services
    502,400       579,700  
      638,500       700,100  
OPERATING EXPENSES:
               
Cost of Neurometric Service revenues
    135,100       131,600  
Research and development
    1,120,500       1,924,100  
Sales and marketing
    870,900       915,800  
General and administrative
    5,017,000       4,100,500  
Goodwill impairment charges
    -       320,200  
                 
Total operating expenses
    7,143,500       7,392,200  
                 
OPERATING LOSS
    (6,505,000 )     (6,692,100 )
                 
OTHER INCOME (EXPENSE):
               
Interest income (expense), net
    (360,500 )     (1,732,900
Loss on extinguishment of debt
    (1,094,300 )     -  
Financing fees
    (213,400 )     (90,000 )
Total other income (expense)
    (1,668,200 )     (1,822,900
                 
LOSS BEFORE PROVISION FOR INCOME TAXES
    (8,173,200 )     (8,515,000 )
                 
PROVISION FOR INCOME TAXES
    800       7,200  
                 
NET LOSS
  $ (8,174,000 )   $ (8,522,200 )
                 
BASIC NET LOSS PER SHARE
  $ (0.16 )   $ (0.31 )
                 
DILUTED NET LOSS PER SHARE
  $ (0.16 )   $ (0.31 )
                 
WEIGHTED AVERAGE SHARES OUTSTANDING:
               
Basic
    52,277,119       27,778,171  
Diluted
    52,277,119       27,778,171  
 
See accompanying Notes to Consolidated Financial Statements 
 
41

CNS RESPONSE, INC.
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) FOR THE YEARS ENDED SEPTEMBER 30, 2010 AND 2009
  
               
Additional
             
   
Common Stock
   
Paid-in
   
Accumulated
       
   
Shares
   
Amount
   
Capital
   
Deficit
   
Total
 
Balance at October 1, 2008
   
25,299,547
   
$
25,300
   
$
17,701,300
   
$
(16,673,700
)
 
$
1,052,900
 
                                         
Stock- based compensation
   
-
     
-
     
850,500
     
-
     
850,500
 
Issuance of 3,433,333 bridge warrants
   
-
     
-
     
1,058,000
     
-
     
1,058,000
 
Exercise of 1,498,986 $0.01 warrants
   
1,498,986
     
1,500
     
13,500
     
-
     
15,000
 
Exercise of 2,124,740 $0.132 options
   
2,124,740
     
2,100
     
278,400
     
-
     
280,500
 
Issuance of stock in connection with the Maxim PIPE net of offering costs of $250,700
   
6,810,002
     
6,800
     
1,785,500
     
-
     
1,792,300
 
Value of beneficial conversion feature of bridge notes
   
-
     
-
     
642,000
     
-
     
642,000
 
Issuance of stock on conversion $1,720,900 of bridge notes and accrued interest
   
6,047,854
     
6,100
     
1,714,800
     
-
     
1,720,900
 
Warrants issued in association with the Maxim PIPE
   
-
     
-
     
1,607,000
     
-
     
1,607,000
 
Offering cost pertaining to the Maxim PIPE
   
-
     
-
     
(1,607,000
)
   
-
     
(1,607,000
)
Net loss for the year ended September 30, 2009
   
-
     
-
             
(8,522,200
)
   
(8,522,200
)
                                         
Balance at September 30, 2009
   
41,781,129
   
$
41,800
   
$
24,044,000
   
$
(25,195,900
)
 
$
(1,110,100
)
                                         
Stock- based compensation
   
-
     
-
     
1,302,100
     
-
     
1,302,100
 
Issuance of stock in connection with the Maxim PIPE net of offering costs of $540,600
   
11,786,666
     
11,800
     
2,983,600
     
-
     
2,995,400
 
Warrants issued in association with the Maxim PIPE
   
-
     
-
     
7,615,100
     
-
     
7,615,100
 
Offering cost pertaining to the Maxim PIPE
   
-
     
-
     
(7,615,100
   
-
     
(7,615,100
Value of warrants surrendered for cashless exercise
   
-
     
-
     
(415,800
   
-
     
(415,800
)
Stock issued for cashless exercise
   
2,456,126
     
2,400
     
413,400
     
-
     
415,800
 
Warrants issued for consulting services
   
-
     
-
     
199,000
     
-
     
199,000
 
Value of beneficial conversion feature of bridge notes
   
-
     
-
     
430,700
     
-
     
430,700
 
Issuance of bridge warrants
                   
152,600
             
152,600
 
Net loss for the year ended September 30, 2010
   
-
     
-
     
     
(8,174,000
)
   
(8,174,000
)
                                         
Balance at September 30, 2010
   
56,023,921
   
$
56,000
   
$
29,109,600
   
$
(33,369,900
)
 
$
(4,204,300
)

See accompanying Notes to Consolidated Financial Statements
 
42

 
CNS RESPONSE, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR YEARS ENDED
SEPTEMBER 30, 2010 AND 2009

   
YEAR ENDED SEPTEMBER 30,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net loss
  $ (8,174,000 )   $ (8,522,200 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation & amortization
    9,400       9,100  
Amortization of discount on bridge notes issued
    335,900       1,058,000  
Value of beneficial conversion feature of bridge notes
    -       642,000  
Stock based compensation
    1,302,100       850,500  
Extinguishment of debt
    1,094,300       -  
Issuance of warrants for consulting services
    199,000       -  
Issuance of warrants for financing services
    193,400       -  
                 
Non-cash interest expense
    21,600       20,900  
Goodwill impairment
    -       320,200  
Write-off of doubtful accounts
    12,950       22,700  
Changes in operating assets and liabilities:
               
Accounts receivable
    (150     13,800  
Prepaids and other
    4,600       99,900  
Accounts payable and accrued liabilities
    231,900       1,003,800  
Deferred compensation and others
    43,500       (40,300 )
Accrued patient costs
    (170,500 )     (92,000 )
Security Deposit on new lease
    (14,600 )     -  
Net cash used in operating activities
    (4,910,600 )     (4,613,600 )
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Acquisition of Furniture & Equipment
    (14,900 )     (2,000 )
Net cash used in investing activities
    (14,900 )     (2,000 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Repayment of  convertible debt with accrued interest
    -       (92,600 )
Repayment of  debt
    (94,100 )     (86,700 )
Repayment of lease payable
    (1,900 )     (1,800 )
Proceeds from the sale of common stock, net of offering costs
    2,995,400       1,792,300  
Proceeds from bridge notes
    1,000,000       1,700,000  
Proceeds from related party loan
    100,000       -  
Proceeds from exercise of warrants and options
    -       295,500  
Net cash provided by financing activities
    3,999,400       3,606,700  
NET DECREASE IN CASH
    (926,100 )     (1,008,900 )
CASH- BEGINNING OF YEAR
    988,100       1,997,000  
CASH- END OF YEAR
  $ 62,000     $ 988,100  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Cash  paid during the period for:
               
Interest
  $ 7,900     $ 64,100  
Income taxes
  $ 800     $ 7,200  
Fair value of note payable to officer issued for acquisition
  $ 24,700     $ 118,600  
Fair value of equipment acquired through lease
  $ 6,600     $ 7,600  
Conversion of bridge notes and related accrued interest into common stock
  $ -     $ 1,720,900  
 
See accompanying Notes to Consolidated Financial Statements
 
43

 

CNS RESPONSE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2010 AND 2009
 
NATURE OF OPERATIONS
 
Organization and Nature of Operations

CNS Response, Inc. (the “Company”) was incorporated in Delaware on March 16, 1987, under the name Age Research, Inc.   Prior to January 16, 2007, CNS Response, Inc. (then called Strativation, Inc.) existed as a “shell company” with nominal assets whose sole business was to identify, evaluate and investigate various companies to acquire or with which to merge.  On January 16, 2007, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with CNS Response, Inc., a California corporation formed on January 11, 2000 (“CNS California”), and CNS Merger Corporation, a California corporation and the Company’s  wholly-owned subsidiary (“MergerCo”) pursuant to which the Company agreed to acquire CNS California in a merger transaction wherein MergerCo would merge with and into CNS California, with CNS California being the surviving corporation (the “Merger”). On March 7, 2007, the Merger closed, CNS California became a wholly-owned subsidiary of the Company, and on the same date the corporate name was changed from Strativation, Inc. to CNS Response, Inc.  
 
The Company is a web-based neuroinformatic company that utilizes a patented system that provides data to psychiatrists and other physicians/prescribers to enable them to make a more informed decision when treating a specific patient with mental, behavioral and/or addictive disorders.  The Company also intends to identify, develop and commercialize new indications of approved drugs and drug candidates for this patient population.
 
In addition, as a result of its acquisition of Neuro-Therapy Clinic, Inc. (“NTC”) on January 15, 2008, the Company provides behavioral health care services.  NTC is a center for highly-advanced testing and treatment of neuropsychiatric problems, including learning, attentional and behavioral challenges, mild head injuries, as well as depression, anxiety, bipolar and all other common psychiatric disorders. Through this acquisition, the Company expects to advance neurophysiology data collection, beta-test planned technological advances in rEEG, advance physician training in rEEG and investigate practice development strategies associated with rEEG.
 
Going Concern Uncertainty
 
The Company has a limited operating history and its operations are subject to certain problems, expenses, difficulties, delays, complications, risks and uncertainties frequently encountered in the operation of a new business. These risks include the failure to develop or supply technology or services to meet the demands of the marketplace, the ability to obtain adequate financing on a timely basis, the failure to attract and retain qualified personnel, competition within the industry, government regulation and the general strength of regional and national economies.
 
To date, the Company has financed its cash requirements primarily from debt and equity financings.  It will be necessary for the Company to raise additional funds.  The Company’s liquidity and capital requirements depend on several factors, including the rate of market acceptance of its services, the future profitability of the Company, the rate of growth of the Company’s business and other factors described elsewhere in this Annual Report.  The Company is currently exploring additional sources of capital but there can be no assurances that any financing arrangement will be available in amounts and terms acceptable to the Company.
 
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Consolidation
 
The consolidated financial statements include the accounts of CNS Response, Inc., an inactive parent company, and its wholly owned subsidiaries CNS California and NTC.  All significant intercompany transactions have been eliminated in consolidation.

Use of Estimates
 
The preparation of the consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expense, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, doubtful accounts, intangible assets, income taxes, valuation of equity instruments, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.
 
44

 
Cash
 
The Company deposits its cash with major financial institutions and may at times exceed federally insured limit of $250,000.  At September 30, 2010 cash did not exceed the federally insured limit.  The Company believes that the risk of loss is minimal. To date, the Company has not experienced any losses related to cash deposits with financial institutions.

Derivative Liabilities

The Company applies ASC Topic 815-40, “Derivatives and Hedging,” which provides a two-step model to determine whether a financial instrument or an embedded feature is indexed to an issuer’s own stock and thus able to qualify for the scope exception in ASC 815-10-15-74. This standard triggers liability accounting on all instruments and embedded features exercisable at strike prices based on future equity-linked instruments issued at a lower rate.  Using the criteria in ASC 815, the Company determines which instruments or embedded features that require liability accounting and records the fair values as a derivative liability. The changes in the values of the derivative liabilities are shown in the accompanying consolidated statements of operations as “gain (loss) on change in fair value of derivative liabilities.” 

On September 26, 2010, the Company’s board of directors approved a term sheet to modify the terms of six convertible notes outstanding at that date in order to induce additional investment in the form of convertible debt. The original convertible notes were due in December 2010 with accrued interest at 9%, convertible into common shares at $0.50 per share and had warrants exercisable at strike price between $0.50 and $0.56. The Company modified the terms of these notes to be due 12 months from the modification date with accrued interest at 9%, convertible into common shares at $0.30 per share, 50% warrant coverage exercisable at $0.30 per share and increased the principal for accrued interest through the modification date. Both the convertible note and warrants contained ratchet provisions, which under ASC 815 required bifurcation of the conversion feature and warrants for derivative liability treatment. As of September 30, 2010 the derivative liability was $2,061,900, which was comprised of the warrant liability of $889,100 and the debt conversion option liability of $1,172,800.

Fair Value of Financial Instruments
 
ASC 825-10 (formerly SFAS 107, “Disclosures about Fair Value of Financial Instruments”) defines financial instruments and requires disclosure of the fair value of financial instruments held by the Company. The Company considers the carrying amount of cash, accounts receivable, other receivables, accounts payable and accrued liabilities, to approximate their fair values because of the short period of time between the origination of such instruments and their expected realization.

The Company also analyzes all financial instruments with features of both liabilities and equity under ASC 480-10 (formerly SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”), ASC 815-10 (formerly SFAS No 133, “Accounting for Derivative Instruments and Hedging Activities”) and ASC 815-40 (formerly EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”).

The Company adopted ASC 820-10 (formerly SFAS 157, “Fair Value Measurements”) on January 1, 2008. ASC 820-10 defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosure requirements for fair value measures. The three levels are defined as follow:
 
 
·
Level 1   inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 
·
Level 2   inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.

 
·
Level 3   inputs to the valuation methodology are unobservable and significant to the fair value.
 
The Company’s warrant liability is carried at fair value totaling $889,100 and $0, as of September 30, 2010 and 2009, respectively.  The Company’s conversion option liability is carried at fair value totaling $1,172,800 and $0 as of September 30, 2010 and 2009, respectively.  The Company used Level 2 inputs for its valuation methodology for the warrant liability and conversion option liability as their fair values were determined by using the Black-Scholes option pricing model using the following assumptions:
 
45

 
   
September 30, 2010
 
Annual dividend yield
   
-
 
Expected life (years)
   
1.0-3.5
 
Risk-free interest rate
   
1.12%-1.27
%
Expected volatility
   
142%-274
%
 
   
Fair Value
   
Fair Value Measurements at