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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

 

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

 

¨ 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: 001-34171

 

 

GRAYMARK HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

 

OKLAHOMA   20-0180812

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

204 N. Robinson Avenue, Ste. 400

Oklahoma City, Oklahoma 73102

(Address of principal executive offices)

(405) 601-5300

(Registrant’s telephone number, including area code)

 

 

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

Common Stock, $0.0001 Par Value   The Nasdaq Stock Market LLC

Securities registered under Section 12(g) of the Exchange Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

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    x  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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).    x  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 a 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    x  No

As of June 30, 2011, the aggregate market value of Graymark Healthcare, Inc. common stock, par value $0.0001, held by non-affiliates (based upon the closing transaction price on The Nasdaq Stock Market) was approximately $8,521,000.

As of April 9, 2012, 15,070,634 shares of the registrant’s common stock, $0.0001 par value, were outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Definitive Proxy Statement to be filed within 120 days after December 31, 2011 for the Registrant’s Annual Shareholders’ Meeting are incorporated by reference into Part III of this Report on Form 10-K.

 

 

 


Table of Contents

GRAYMARK HEALTHCARE, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 2011

TABLE OF CONTENTS

 

Part I.

    

Item 1.

  Business      1   

Item 1A.

  Risk Factors      13   

Item 1B.

  Unresolved Staff Comments      27   

Item 2.

  Properties      27   

Item 3.

  Legal Proceedings      28   

Item 4.

  Mine Safety Disclosures      28   

Part II.

    

Item 5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      28   

Item 6.

  Selected Financial Data      30   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      30   

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk      49   

Item 8.

  Financial Statements and Supplementary Data      49   

Item 9.

  Changes In and Disagreements With Accountants on Accounting and Financial Disclosure      49   

Item 9A.

  Controls and Procedures      49   

Item 9B.

  Other Information      50   

Part III.

    

Item 10.

  Directors, Executive Officers and Corporate Governance      51   

Item 11.

  Executive Compensation      51   

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      52   

Item 13.

  Certain Relationships and Related Transactions, and Director Independence      52   

Item 14.

  Principal Accounting Fees and Services      52   

Part IV.

    

Item 15.

  Exhibits, Financial Statement Schedules      52   

SIGNATURES

     57   

 

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain statements under the captions “Item 1. Business,” “Item 1A. Risk Factors,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “expects,” “may,” “will,” or “should” or other variations thereon, or by discussions of strategies that involve risks and uncertainties. Our actual results or industry results may be materially different from any future results expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include general economic and business conditions; our ability to implement our business strategies; competition; availability of key personnel; increasing operating costs; unsuccessful promotional efforts; changes in brand awareness; acceptance of new product offerings; and changes in, or the failure to comply with, and government regulations.

Throughout this report the first personal plural pronoun in the nominative case form “we” and its objective case form “us”, its possessive and the intensive case forms “our” and “ourselves” and its reflexive form “ourselves” refer collectively to Graymark Healthcare, Inc. and its subsidiaries and “Sleep Management Solutions,” or “SMS,” refers to our sleep centers and related service and supply business, and “ApothecaryRx” refers to the discontinued operations of ApothecaryRx, LLC, our subsidiary that operated retail pharmacies through December 2010.

 

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PART I

Item 1. Business.

We are one of the largest providers of care management solutions to the sleep disorder market based on number of independent sleep care centers and hospital sleep diagnostic programs operated in the United States. We provide a comprehensive diagnosis and care management solution for patients suffering from sleep disorders.

Sleep Management Solutions Overview

Our Sleep Management Market Opportunity

We believe that the market for Sleep Management Solutions is large and growing with no clear market leader. A number of factors support the future growth of this market:

 

  Large and undiagnosed population of patients that suffer from sleep disorders. There are a substantial number of undiagnosed patients who could benefit from diagnosis and treatment of sleep disorders. There are an estimated 50 million Americans that suffer from chronic, long-term sleep disorders, according to the National Institutes of Health, or NIH. There are over 80 different sleep disorders, including obstructive sleep apnea, or OSA, insomnia, narcolepsy and restless legs syndrome. The primary focus of our business is OSA, which the National Sleep Foundation estimates occur in at least 18 million Americans. Moreover, according to the American College of Physicians, about 80% of persons with sleep apnea go undiagnosed.

 

  Increasing awareness of diagnosis and treatment options, particularly for OSA. We believe there is an increasing awareness among the U.S. population and physicians in particular about the health risks and the availability and benefits of treatment options for sleep disorders. Of significant importance, OSA can have serious effects on people’s health and personal lives. OSA is known to increase the risk for several serious health conditions, including obesity, high blood pressure, heart disease, stroke, diabetes, depression and sexual dysfunction. Additionally, OSA may result in excessive daytime sleepiness, memory loss, lack of concentration and irritability. OSA and its effects may increase the risk for automobile accidents and negatively affect work productivity and personal relationships. In addition, as physicians become aware of the links between OSA and other serious health conditions, physicians are increasingly referring patients for sleep studies.

 

  Growth in obesity rates. OSA is found in people of every age and body type, but is most commonly found in the middle-aged, obese population. Obesity is found in approximately 72 million adults in America and is a growing problem in the United States. By 2020, the number of obese Americans is expected to be approximately 103 million. Obesity exacerbates OSA by enlarging the upper airway soft tissue structures and narrowing the airway. Not only does obesity contribute to sleep disorders such as OSA, but sleep disorders can also contribute to obesity. We believe individuals suffering from OSA generally have less energy and ability to exercise or keep a strict diet. Medical studies have also shown that sleep disorders can impair metabolism and disrupt hormone levels, promoting weight gain.

 

  Large aging population. An aging U.S. population, led by approximately 78 million baby-boomers, is becoming increasingly at risk for OSA. As their soft palates enlarge, their pharyngeal fat pads increase in size and the shape of bony structures around the airway change.

We believe these factors present a significant business opportunity for us because we provide a complete continuum of care for those who suffer from OSA – from initial diagnosis to treatment with a continuous positive airway pressure, or CPAP, device to providing ongoing CPAP supplies and long-term follow-up care.

 

  The amount being spent on sleep disorder diagnosis and treatment is increasing. A 2010 Frost & Sullivan report estimated the U.S. sleep diagnostic market was $1.4 billion in 2008, and that it will grow to $3.4 billion by 2015 for a compound annual growth rate of 14.3%.

 

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  The sleep diagnostic market is highly fragmented. Our presence as one of the largest overall providers of sleep diagnostic services with 100 total diagnostic and therapy locations comprised of 22 independent sleep care centers and 78 hospital sleep diagnostic programs, out of a total we estimate includes 4,000 sleep clinics in the United States, illustrates the level of fragmentation in the market. Only a limited number of companies provide a comprehensive solution which includes initial diagnosis to treatment with a CPAP device and the provision of ongoing CPAP supplies and long-term follow-up care.

Our Sleep Management Solution

Our sleep management solution is driven by our clinical approach to managing sleep disorders. Our clinical model is led by our staff of medical directors who are board-certified physicians in sleep medicine, who oversee the entire life cycle of a sleep disorder from initial referral through continuing care management. Our approach to managing the care of our patients diagnosed with OSA is a key differentiator for us. Five key elements support our clinical approach:

 

  Referral: Our medical directors, who are board-certified physicians in sleep medicine, have forged strong relationships with referral sources, which include primary care physicians, as well as physicians from a wide variety of other specialties and dentists.

 

  Diagnosis: We own and operate sleep testing clinics that diagnose the full range of sleep disorders including OSA, insomnia, narcolepsy and restless legs syndrome.

 

  CPAP Device Supply: We sell CPAP devices, which are used to treat OSA.

 

  Re-Supply: We offer a re-supply program for our patients and other CPAP users to obtain the required components for their CPAP devices that must be replaced on a regular basis.

 

  Care Management: We provide continuing care to our patients led by our medical directors who are board-certified physicians in sleep medicine and their staff.

Our clinical approach increases the long-term compliance of our patients, and enables us to manage a patient’s sleep disorder care throughout the lifecycle of the disorder, thereby allowing us to generate a long-term, recurring revenue stream. We generate revenues via three primary sources: providing the diagnostic tests and related studies for sleep disorders through our sleep diagnostic centers, the sale of CPAP devices, and the ongoing re-supply of components of the CPAP device that need to be replaced. In addition, as a part of our ongoing care management program, we monitor the patient’s sleep disorder and as the patient’s medical condition changes, we are paid for additional diagnostic tests and studies.

In addition, we believe that our clinical approach to comprehensive patient care provides higher quality of care and achieves higher patient compliance. We believe that higher compliance rates are directly correlated to higher revenue generation per patient compared to our competitors through increased utilization of our patient reorder supply program, or PRSP, and a greater likelihood of full reimbursement from federal payors and those commercial carriers who have adopted federal payor standards.

Referral and Diagnosis

Patients at risk for, or suspected of suffering from, a sleep disorder are referred to one of our sleep clinics by independent physicians, dentists, group practices, or self-referrals. At our independent sleep care centers and hospital sleep diagnostic programs, which we refer to as our sleep clinics, we administer an overnight polysomnogram, or sleep study, to determine if our patients suffer from a sleep disorder. Our medical directors provide a diagnosis and comprehensive report to the referring physician based on analysis of the patient’s sleep study results.

 

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CPAP Device Supply

If the physician determines the patient suffers from OSA following the review of the sleep study results, then the patient is generally prescribed the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment, which is with a CPAP device. Patients return to our clinic for an overnight study to determine the optimal air pressure to prescribe with the CPAP device. Sometimes, both the diagnosis and air pressure study are done in one night. Effective January 1, 2010, regulatory restrictions prevent Medicare from making payments to sleep diagnostics centers that sell CPAP devices unless the diagnosis has been made by a medical director who is board-certified in sleep medicine or who meets other specified criteria. All of the sleep studies we conduct, except for those conducted at one of our non-accredited centers, qualify us to receive Medicare reimbursement for the sale of CPAP devices.

Re-supply

In addition to selling CPAP devices to people with OSA, we offer our patient reorder supply program, or PRSP. The PRSP periodically supplies the components of the CPAP device that must be regularly replaced (such as masks, hoses, filters, and other parts) to our patients and other CPAP users. This enables them to better maintain their CPAP devices, increasing the probability of ongoing compliance and a better long-term clinical outcome and providing us with a long-term recurring revenue stream.

Care Management

Our thorough wellness and continuing care program led by our medical staff provides the greatest opportunity for our patients to use their CPAP devices properly and stay compliant. After the initial CPAP device set-up, our clinical staff contacts the patient regularly during the initial six months (at 48 hours, two weeks, two months and six months) and each six months thereafter to enhance patient understanding and to ensure the greatest chance for the short- and long-term success for the patient. Most importantly, where we have the program in place, our medical staff has an in-person visit with the patient and their CPAP device approximately 45 days after the initial set-up. The purpose of the visit is to verify initial compliance and to enhance compliance by assuring proper fit and feel of the CPAP device (usually the mask), determining if there are any medical impediments to compliance (such as untreated allergies), and answering any questions about the operation or care of the equipment. We also work closely with the patient’s physicians to aid in their follow-up care and monitoring of the treatment.

Recently, as the public and medical communities have become increasingly aware of the sleep diagnostic and treatment markets, federal and state lawmakers and regulators have taken a greater interest in implementing stricter criteria to ensure a high standard of care. Beginning in 2009, federal payors, and commercial carriers who have adopted similar standards, will only pay CPAP providers for equipment over a 13-month period in equal installments. Payment is stopped if the CPAP provider cannot document patient compliance levels that meet their established standards within the first 90 days after the initial set-up.

Discontinued Operations Overview

In May 2011 and December 2010, we executed the sale of substantially all of the assets of the Company’s subsidiaries, Nocturna East, Inc. (“East”) and ApothecaryRx, LLC (“ApothecaryRx”), respectively. East operated the Management Services Agreement (“MSA”) under which we provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services. ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. See “Discontinued Operations” for more information on our sale of East’s and ApothecaryRx’s assets and East’s and ApothecaryRx’s historical businesses.

 

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Our Growth Strategy

We intend to grow our business as a provider of sleep diagnostic services and care management for sleep disorders. The following are the key elements of our growth strategy:

 

  Expand sleep diagnostic and care management capabilities through strategic acquisitions. We intend to drive growth primarily by acquiring successful sleep clinics and hospital sleep diagnostic centers in our existing geographic markets and by expanding into new markets. We believe that we are well-positioned to acquire and successfully integrate sleep clinics because of our size, our experienced management team, and our knowledge of the regulatory environment. Our scale allows us to provide central services to our sleep clinics, which create economic synergies across acquired sleep clinics and reduces our operating costs per clinic. We expect to focus our acquisition opportunities on large diagnostic clinics that will be accretive to our earnings and that have not previously provided, or have not maximized the opportunity for providing, comprehensive services to their patients. When we acquire additional hospital sleep diagnostic centers we enter into a management contract to manage the existing sleep center without any purchase price or capital outlay on our part which allows us to increase our therapy business through additional patient referrals without adding to our cost base. We expect to add our care management and ongoing re-supply services to existing high volume diagnostic services to generate additional revenues. Through acquisitions, we intend to continue to standardize and integrate billing, human resources, purchasing and IT systems, diversify our payor rates through expansion into different geographic markets and promote best clinical and operational practices across each of our sleep clinics.

 

  Drive internal growth. We use marketing initiatives to increase the awareness of sleep disorders and their negative health effects, as well as to promote our comprehensive solution to those that suffer from sleep disorders in the markets we serve. We also use direct marketing representatives to identify strategic hospital and physician group alliances and to market our sleep diagnostic services and care management alternatives to area physicians. We believe that these initiatives, along with a growing, underserved primary target demographic, will increase utilization rates at our sleep clinics and drive revenue growth. We intend to increase referrals from non-traditional sources, including a focus on self-pay customers and corporate customers. We believe that corporate payors in a number of industries, such as trucking and other common carriers, could benefit from the diagnosis and treatment of sleep disorders of their employees. In addition, based on our understanding of and compliance with heightened regulatory requirements, we believe that we will be able to expand our business more easily than other independent sleep care centers.

 

  Expand on-going care management and disposable re-supply program. Generally OSA is a long-term chronic disorder, and patients being treated for OSA are generally treated for life. With our comprehensive model of care, ability to improve patient compliance with therapy, and scale, we are able to maintain a long-term, diversified, recurring revenue stream. We provide our patients with an ongoing supply of disposable supplies for their therapy as well as periodic replacement of their CPAP devices. In addition, by virtue of our long-term approach to managing a patient’s sleep disorder, patients periodically undergo additional diagnostic tests and CPAP pressure optimization.

Company History

We were formed on January 2, 2008, when our predecessor company, Graymark Productions Inc., acquired ApothecaryRx, LLC, and SDC Holdings, LLC, collectively referred to as the “Graymark Acquisition.” For financial reporting purposes, Graymark was deemed acquired by ApothecaryRx, LLC and SDC Holdings, LLC and, accordingly, the historical financial statements prior to December 31, 2007 are those of ApothecaryRx, LLC and SDC Holdings, LLC as adjusted for the effect of the Graymark Acquisition. In conjunction with the Graymark Acquisition, all former operations of Graymark Productions were discontinued. On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx. As a result of the sale of ApothecaryRx’s assets, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations. Over the last three years, we have acquired and continue to operate three sleep businesses, raising the total number of sleep clinics and therapy locations we operate to 22 independent sleep care and therapy centers in five states: Oklahoma (5), Texas (7), Nevada (3), Iowa (3) and Kansas (4). In addition, we manage 78 hospital sleep diagnostic programs in 9 states: Oklahoma (2), Texas (8), Kansas (2), Nebraska (21), South Dakota (12), Minnesota (7), Iowa (22), Missouri (3) and Georgia (1).

 

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Specifically, during the period from January 1, 2009 to December 31, 2011, we completed the following acquisitions:

 

Acquisition Date

  

Business Acquired

August 2009

   somniCare, Inc.

August 2009

   somniTech, Inc.

September 2009

   Avastra Eastern Sleep Center, Inc. (disposed in April 2011)

December 2011

   Village Sleep Center

On March 13, 2008, our Board of Directors approved a reverse split of our common stock at a ratio of one-for-five shares. The effective date of the reverse split was April 11, 2008. On January 26, 2011, our Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, we received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, our Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. We executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market. The effect of the reverse split reduced our outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split.

Sleep Clinics and Care Management

We provide a comprehensive diagnosis, and care management solution for the growing population of Americans with sleep disorders. Patients at risk for, or suspected of suffering from, a sleep disorder are referred to one of our sleep clinics by independent physicians, dentists, group practices, or self-referrals that generally come from our reputation in the community and our marketing and advertising efforts. Our sleep clinics typically consist of two to eight bed facilities and are overseen by our medical directors. At our sleep clinics, we administer an overnight polysomnogram, or sleep study, to our patients, which monitors blood oxygen level, heart rate, respiratory function, brain waves, leg movement and other vital signs through small and painless electrical sensors applied to the patient. We compile this information into a detailed sleep report which includes an interpretation of the data and diagnosis by our medical director.

If the physician determines the patient suffers from OSA, the most commonly diagnosed sleep disorder, the patient is generally prescribed the AASM’s preferred method of treatment, which is a CPAP device. A CPAP device is a nasal or facial mask connected by a tube to a small portable airflow generator that delivers compressed air at a prescribed continuous positive pressure. The continuous air pressure acts as a pneumatic splint to keep the patient’s upper airway open and unobstructed, resulting in a smooth breathing pattern and the reduction or elimination of other symptoms associated with OSA, including loud snoring. Patients return to our clinic for an additional study to determine the optimal air pressure to prescribe with the patient’s CPAP device. For certain patients, we may perform a split-night study, with the first half of the night being used to perform the initial diagnosis and the second half of the night being used to determine the optimal air pressure setting for that patient’s CPAP device.

 

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After completion of the sleep study and pressure setting process, the patient can purchase a CPAP device from us. The initial CPAP device set-up for those patients that purchase a CPAP device from us typically occurs at our therapy location close to where the patient received their sleep study or in some cases at the patient’s home. Our clinical staff contacts the patient by phone two days, two weeks, two months, six months and each six months thereafter. We question each patient on their compliance, their product satisfaction and their need for additional supplies. We work with these patients to ensure that they are satisfied with the fit of their mask. Our medical staff has a meeting with each new CPAP device user approximately 45 days after receipt of the device. At that meeting, we download actual patient compliance data from their CPAP device, determine the true compliance to-date and take steps to ensure the greatest chance for long-term success for the patient, including additional medical intervention, if necessary. We believe that this continuing contact with the patient separates us from our competition, helps raise patient compliance and ultimately results in patient satisfaction. We also work closely with the patient’s physician to aid in follow-up care and monitoring of the treatment. In addition to selling CPAP devices to patients with OSA, we offer a program by which patients can routinely receive the components of the CPAP device that must be regularly replaced (such as masks, hoses, filters and other parts). Our patient reorder supply program, or PRSP, is offered through our Nocturna Sleep Therapy business. The PRSP periodically supplies the disposable components of the CPAP system to our patients, which enables them to better maintain their CPAP devices for a better patient outcome and provides us with a long-term recurring revenue stream. Typically there is a need for replacement parts in three or six month increments. We use insurance recommendations to determine the timing on shipments. We believe our PRSP program also assists in the long-term success of our patients. We believe that our compliance monitoring programs exceed industry standard practices. For example, we are not aware of any national competitor for CPAP equipment that has dedicated medical personnel that offer such in-person care. The majority of our competitors ship the CPAP device to the patient’s house with no regularly scheduled in-person contact with dedicated medical staff. We believe that our continuing care management positions us well as federal payors have implemented standards which require proof of CPAP compliance prior to payment beyond three months of treatment, and increasingly, commercial carriers are adopting similar standards.

Sleep Disorders – Obstructive Sleep Apnea

There are over 80 different sleep disorders, including obstructive sleep apnea, or OSA, insomnia, narcolepsy and restless legs syndrome. The most common diagnosis for patients at sleep medicine centers is OSA, a sleep disorder, which the National Sleep Foundation estimates occur in at least 18 million Americans. OSA occurs when the soft tissue in the rear of the throat narrows and repeatedly closes during sleep, causing the body to temporarily stop breathing. Those that suffer from OSA typically have an apnea-hypopnea index, or AHI, which represents the average number of times they stop breathing per hour during the night, of five or more. These frequent episodes can have a serious, deleterious effect on the health and personal lives of those with OSA. OSA is known to increase the risk for obesity, high blood pressure, heart disease, stroke, diabetes, depression and sexual dysfunction, among other negative health conditions. Additionally, OSA may result in excessive daytime sleepiness, memory loss, lack of concentration and irritability, all of which can increase the risk for automobile accidents and negatively affect work productivity and personal relationships.

OSA is most commonly found in obese men over the age of 40, but it can also occur in men and women of all ages and body types. The National Center for Health Statistics, or a NCHS, estimates that in 2005-2006 more than one-third of U.S. adults, or over 72 million people, were obese. According to the Centers for Disease Control and Prevention, or CDC, study obesity-related diseases accounted for over 9% of all U.S. medical spending in 2008, or over $147 billion, roughly double the amount spent in 1998. The rate of obesity in the United States is increasing at an alarming rate. Obesity increases the size of the upper airway soft tissue structures, narrowing the airway and increasing the risk of OSA. Not only does obesity contribute to sleep problems such as sleep apnea, but sleep problems can also contribute to obesity. We believe individuals suffering from OSA generally have less energy and motivation to exercise or keep a healthy diet. Studies have also shown that sleep disorders can impair metabolism and disrupt hormone levels, promoting weight gain. Additionally, an aging American population, led by approximately 78 million baby-boomers, is becoming increasingly at risk for OSA as their soft palates gets longer, their pharyngeal fat pads increase in size and the shape of bony structures around the airway change.

OSA is most commonly treated with the use of a CPAP device, the AASM’s preferred method of treatment. Other treatment alternatives include surgery, which is generally used when non-surgical alternatives fail, oral appliances, which are most commonly used in mild to moderate OSA, or nasal devices.

Sleep Disorder Product Supplier Relationships

We purchase our sleep disorder and CPAP devices from several vendors including: Fisher & Paykell Appliances Limited, Respironics Inc., ResMed Inc., DeVilbiss Healthcare LLC. We maintain a limited inventory of sleep disorder products to lessen the impact of any temporary supply disruption.

Our ability to sell sleep disorder products is restricted by strict federal regulations that prohibit us from diverging from a physician’s prescription. If a physician prescribes a sleep disorder product by name other than one of the products we offer, we are prohibited by federal regulations from substituting a different sleep disorder product.

 

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Sleep Management Solutions Advertising and Promotion

We frequently promote sleep awareness issues and our sleep testing facilities through radio commercials, billboard displays, print media and other marketing efforts. Our clinics also have a strong presence at local health fairs and other public events. We use direct marketing representatives to market to area physicians about our sleep services. Our medical directors are involved in promoting the clinics through local and regional public educational seminars, physician continuing education programs and through individual meetings with referring physicians and hospitals.

Sleep Management Solutions Management Information Systems

We employ an integrated sleep diagnostic and management information system to perform our sleep diagnostic studies. This system provides secure transfer of sleep diagnostic study results and other information from sleep studies to the appropriate physicians and corporate personnel. We also employ an integrated scheduling and medical billing information system which allows for optimal utilization of available beds for sleep studies, optimizes labor scheduling, and streamlines information transfer for insurance and patient billing. We also utilize an enterprise reporting and planning system to track and report both our financial performance and operational metrics, allowing us to provide timely management information on the performance of our sleep centers and overall business.

Sleep Disorder Diagnostic and Care Management Competition

Competition within the sleep disorder diagnostic and care management market is intense. We face competition in each area of our sleep management solutions segment.

Sleep Diagnostics. In the sleep diagnostics business we compete primarily with independent sleep care centers, hospital sleep diagnostic programs and with home testing services. Competition in the sleep diagnostic market is primarily based on market presence and reputation, price, quality, patient or client service, and achieved treatment results. We believe that our services and products compete favorably with respect to these alternatives as we offer patients the option of participating in our clinics as well as resupply and continuing care program, in addition to diagnosis in one of our clinics.

We also compete with providers of home sleep diagnostic tests. In a home sleep test, patients are attached to a portable monitoring device overnight while sleeping in their own bed. We believe that home sleep tests have several limitations compared to overnight sleep tests in a clinic. Home sleep tests are administered in the absence of a trained technician who, when present, is able to correct or make equipment adjustments. In many of our clinics or facilities we have the capabilities to pre-screen patients in a clinic under physician-supervised care, which provides the opportunity to test in the most conducive environment for our patients. Inherent limitations exist in home diagnostics, as the optimal pressure to be prescribed for a CPAP device still must be performed in a clinical setting. We periodically evaluate additional opportunities to expand and improve patient access and care including home testing.

Treatment Alternatives. Currently, the AASM’s preferred method of treatment for OSA is a CPAP device. Alternative treatments for OSA include surgery, oral appliances and nasal devices. In addition, pharmaceuticals may be prescribed for other sleep disorders where they offer a clinical benefit such as for insomnia, narcolepsy and restless legs syndrome.

CPAP Device Supply. We compete with durable medical equipment, or DME, providers, whether national, regional or local when providing CPAP devices. These DME providers include Apria Healthcare and Lincare Holdings. The purchase of a CPAP device is allowed by prescription only. While we believe most DME providers drop ship CPAP devices to the patient’s home, we assist the patient with the set-up of the machine at one of our sleep centers. We work with the patient to ensure proper calibration of the CPAP device as well as proper fit and comfort of the mask.

CPAP Supplies. We compete with DME providers as well as e-commerce web sites for supplying patients with the masks, hoses and filters that must be periodically replaced. We seek to have patients who utilize us for diagnostic and therapy services registered with our patient resupply program, or PRSP, to periodically receive supplies for their CPAP device. We believe that our PRSP provides a convenient way for these patients to obtain their periodic supply.

 

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Intellectual Property

In the course of our operations, we develop trade secrets and trademarks that may assist in maintaining any developed competitive position. When determined appropriate, we may enforce and defend our developed and established trade secrets and trademarks. In an effort to protect our trade secrets, we require certain employees, consultants and advisors to execute confidentiality and proprietary information agreements upon commencement of employment or consulting relationships with us.

Government Regulation

Our operations are and will be subject to extensive federal, state and local regulations. These regulations cover required qualifications, day-to-day operations, reimbursement and documentation of activities. We continuously monitor the effects of regulatory activity on our sleep center operations.

Licensure and Accreditation Requirements

The diagnosis of sleep disorders is a component of the practice of medicine. We engage physicians as independent contractors or employees to provide professional services and serve as medical directors for the sleep centers. The practice of medicine is subject to state licensure laws and regulations. We ensure that our affiliated physicians are appropriately licensed under applicable state law. If our affiliated physicians lose those licenses, our business, financial condition and results of operations may be negatively impacted.

Corporate Practice of Medicine. Generally, state laws prohibit anyone but duly licensed physicians from exercising control over the medical judgments or decisions rendered by other physicians. This is commonly referred to as the “corporate practice of medicine” doctrine. States vary widely in the interpretation of the doctrine. Some states permit a business entity (such as a regular business corporation or limited liability company) to hold, directly or indirectly, contracts for the provision of medical services, including the performance and/or interpretation of diagnostic sleep studies, and to own a medical practice that provides such services, as long as only physicians exercise control over the medical judgments or decisions of other physicians. Other states, including states such as New York, Illinois, Texas and California, have more specific and stringent prohibitions. In such states, the medical practice in which a physician is employed or engaged as an independent contractor must itself be licensed or otherwise qualified to do business as a professional entity (and owned exclusively by physicians who are licensed to practice medicine in the state) or as a licensed diagnostic and treatment facility. Failure to comply with these laws could have material and adverse consequences, including the judicially sanctioned refusal of third-party payors to pay for services rendered, based upon violation of a statute designed to protect the public, as well as civil or criminal penalties. We believe that we are in compliance with the corporate practice of medicine laws in each state in which our sleep centers operate. We do not exercise control over the medical judgments or decisions of our affiliated physicians. While we believe we are in compliance with the requirements of the corporate practice of medicine laws in each state where our sleep centers are located, these laws and their interpretations are continually evolving and may change in the future. Moreover, these laws and their interpretations are generally enforced by state courts and regulatory agencies that have broad discretion in their enforcement.

Fee Splitting. Generally, state laws prohibit a physician from splitting fees derived from the practice of medicine with anyone else. We believe that the management, administrative, technical and other nonmedical services we provide to each of our sleep centers for a service fee does not constitute fee splitting. However, these laws and their interpretations also vary from state to state and are also enforced by state courts and regulatory authorities that have broad discretion in their enforcement.

If our arrangements with our affiliated physicians or our sleep centers are found to violate state laws prohibiting the practice of medicine by general business entities or fee splitting, our business, financial condition and ability to operate in those states could be adversely affected.

 

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With respect to our sleep centers, there has been a trend developing to require facilities that provide sleep diagnostic testing to become accredited by the American Academy of Sleep Medicine (AASM) or The Joint Commission, as well as additional credentialing for physicians diagnosing sleep studies and the licensing of technical personnel to perform diagnostic testing procedures. As of December 31, 2011, 11 of our free standing sleep centers have been accredited by the AASM. We also have one free standing sleep center that is accredited through The Joint Commission. We are actively working on having our remaining sleep centers accredited. Also, Medicare requires that all Durable Medical Equipment (DME) suppliers be accredited. All of our sleep therapy facilities providing DME are accredited by The Joint Commission or by the Accreditation Commission for Healthcare (ACHC).

Medicare and Medicaid

Our sleep centers operate under regulatory and cost containment pressures from federal and state legislation primarily affecting Medicaid and Medicare.

In order to submit claims directly to Medicare for reimbursement, our centers must be enrolled as independent diagnostic testing facilities, or IDTFs. Some of our centers are not enrolled as IDTFs and do not accept Medicare patients for testing. Our centers that are not enrolled as IDTFs may perform sleep studies for Medicare patients if the center enters into a contract with a hospital to perform the studies “under arrangements” for the hospital, in which case the hospital bills Medicare under its own provider number. Enrollment as an IDTF or the performance of services “under arrangements” for hospitals requires compliance with numerous regulations, and the failure to comply with applicable requirements could result in revocation of an IDTF enrollment or the ineligibility of the hospital to obtain reimbursement for services performed on its behalf by one of our centers. Additionally, not all private health plans permit services to be performed by our sleep centers under arrangements for a hospital.

In some locations, we supply CPAP devices and other DME to sleep studies patients who are diagnosed with sleep disorders, as ordered by a physician. Medicare suppliers of DME, prosthetics, orthotics and supplies, or DMEPOS, unless exempt, must be accredited and secure a surety bond.

Medicare generally prohibits a physician who performs a covered medical service from “reassigning” to anyone else the performing physician’s right to receive payment directly from Medicare, except in certain circumstances. We believe we satisfy one or more of the exceptions to this prohibition.

The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our sleep center operations. There is no assurance that payments for sleep testing services and DME under the Medicare and Medicaid programs will continue to be based on current methodologies or even remain similar to present levels. We may be subject to rate reductions as a result of federal or state budgetary constraints or other legislative changes related to the Medicare and Medicaid programs.

We receive reimbursement from government sponsored third-party plans, including Medicaid and Medicare, non-government third-party plans, including managed-care organizations, and also directly from individuals, or private-pay. During 2011, our sleep center payor mix, as a percentage of total sleep center revenues, was approximately 56% commercial insurance, 11% Medicaid/Medicare, 10% private-pay and 23% from hospital contracts. During 2010, our sleep center payor mix, as a percentage of total sleep center revenues, was approximately 61% commercial insurance, 12% Medicaid/Medicare, 5% private-pay and 22% from hospital contracts. Pricing for private-pay patients is based on prevailing regional market rates.

In addition to requirements mandated by federal law, individual states have substantial discretion in determining administrative, coverage, eligibility and reimbursement policies under their respective state Medicaid programs that may affect our sleep center operations.

 

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Fraud and Abuse Laws

We are subject to federal and state laws and regulations governing financial and other arrangements among healthcare providers. Commonly referred to as the Fraud and Abuse laws, these laws prohibit certain financial relationships between pharmacies, physicians, vendors and other referral sources. During the last several years, there has been increased scrutiny and enforcement activity by both government agencies and the private plaintiffs’ bar relating to pharmaceutical marketing practices under the Fraud and Abuse laws. Violations of Fraud and Abuse laws and regulations could subject us to, among other things, significant fines, penalties, injunctive relief, pharmacy shutdowns and possible exclusion from participation in federal and state healthcare programs, including Medicare and Medicaid. Additionally, in its Fiscal Year 2010 Work Plan, the Office of Inspector General of the Department of Health and Human Services identified that it would study the appropriateness of Medicare payments for polysomnography and assess provider compliance with federal program requirements. Changes in healthcare laws or new interpretations of existing laws may significantly affect our business. Some of the Fraud and Abuse Laws that have been applied are discussed below.

Federal and State Anti-Kickback Statutes: The federal anti-kickback statute, Section 1128B(b) of the Social Security Act (42 U.S.C. 1320a-7b(b)), prohibits, among other things, the knowing and willful offer, payment, solicitation or acceptance of remuneration, directly or indirectly, in return for referring an individual to a provider of services for which payment may be made in whole or in part under a federal healthcare program, including the Medicare or Medicaid programs. Remuneration has been interpreted to include any type of cash or in-kind benefit, including the opportunity to participate in investments, long-term credit arrangements, gifts, supplies, equipment, prescription switching fees, or the furnishing of business machines. Several courts have found that the anti-kickback statute is violated if any purpose of the remuneration, not just the primary purpose, is to induce referrals.

Potential sanctions for violations of the anti-kickback statute include felony convictions, imprisonment, substantial criminal fines and exclusion from participation in any federal healthcare program, including the Medicare and Medicaid programs. Violations may also give rise to civil monetary penalties in the amount of $50,000, plus treble damages.

Similarly, many state laws prohibit the solicitation, payment or receipt of remuneration in return for, or to induce, the referral of patients to private as well as government programs. Violation of these anti-kickback laws may result in substantial civil or criminal penalties for individuals or entities and/or exclusion from participating in federal or state healthcare programs.

Although we believe that our relationships with vendors, physicians, and other potential referral sources comply with Fraud and Abuse laws, including the federal and state anti-kickback statutes, the Department of Health and Human Services has acknowledged in its industry compliance guidance that many common business activities potentially violate the anti-kickback statute. There is no assurance that a government enforcement agency, private litigant, or court will not interpret our business relations to violate the Fraud and Abuse laws.

The False Claims Act: Under the False Claims Act, or FCA, civil penalties may be imposed upon any person who, among other things, knowingly or recklessly submits, or causes the submission of false or fraudulent claims for payment to the federal government, for example in connection with Medicare and Medicaid. Any person who knowingly or recklessly makes or uses a false record or statement in support of a false claim, or to avoid paying amounts owed to the federal government, may also be subject to damages and penalties under the FCA.

Furthermore, private individuals may bring “whistle blower” (“qui tam”) suits under FCA, and may receive a portion of amounts recovered on behalf of the federal government. These actions must be filed under seal pending their review by the Department of Justice. Penalties of between $5,500 and $11,000 and treble damages may be imposed for each violation of FCA. Several federal district courts have held that FCA may apply to claims for reimbursement when an underlying service was delivered in violation of other laws or regulations, including the anti-kickback statute.

In addition to FCA, the federal government has other civil and criminal statutes that may be utilized if the Department of Justice suspects that false claims have been submitted. Criminal provisions that are similar to FCA provide that if a corporation is convicted of presenting a claim or making a statement that it knows to be false, fictitious or fraudulent to any federal agency, it may be fined not more than twice any pecuniary gain to the corporation, or, in the alternative, no more than $500,000 per offense. Many states also have similar false claims statutes that impose liability for the types of acts prohibited by FCA. Finally, the submission of false claims may result in termination of our participation in federal or state healthcare programs. Members of management and persons who actively participate in the submission of false claims can also be excluded from participation in federal healthcare programs.

 

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Additionally, some state statutes contain prohibitions similar to and possibly even more restrictive than the FCA. These state laws may also empower state administrators to adopt regulations restricting financial relationships or payment arrangements involving healthcare providers under which a person benefits financially by referring a patient to another person.

We believe that we have sufficient procedures in place to provide for the accurate completion of claim forms and requests for payment. Nonetheless, given the complexities of the Medicare and Medicaid programs, we may code or bill in error, and such claims for payment may be treated as false claims by the enforcing agency or a private litigant.

Physician Self-Referral Prohibitions. The federal physician self-referral statute, known as the “Stark” law, prohibits a physician from making a referral of Medicare beneficiaries for certain designated health services, including outpatient prescription drugs and DME (including CPAPs), to any entity with which the physician has a financial relationship, unless there is an exception in the law that allows the referral. Sleep studies are not designated health services unless they are performed under arrangements for a hospital and billed by the hospital. The entity that receives a prohibited referral from a physician may not submit a bill to Medicare for that service. Federal courts have ruled that a violation of the Stark statute, as well as a violation of the federal anti-kickback law described above, can serve as the basis for an FCA suit. Many state laws prohibit physician referrals to entities with which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. Violation of the Stark law can result in substantial civil penalties for both the referring physician and any entity that submits a claim for a healthcare service made pursuant to a prohibited referral. We believe that all of our customer arrangements are in compliance with the Stark law. However, these laws could be interpreted in a manner inconsistent with our operations. Federal or state self-referral regulation could impact our arrangements with certain physician investors or independent contractors.

Medicare Anti-Markup Rule. CMS has recently finalized certain anti-markup rules relating to diagnostic tests paid for by the Medicare program. The anti-markup rules are generally applicable where a physician or other supplier bills for the technical component or professional component of a diagnostic test that was ordered by the physician or other supplier (or ordered by a party related to such physician or other supplier through common ownership or control), and the diagnostic test is performed by a physician that does not share a practice with the billing physician or other supplier. If the anti-markup rule applies to a diagnostic test, then the reimbursement provided by Medicare to a billing physician or other supplier for that transaction may be limited. Because our sleep labs bill Medicare for the technical and professional fees of sleep diagnostic tests that are ordered by community physicians or our affiliated physicians, we believe that the anti-markup rule does not apply to the professional services our affiliated physicians perform or the technical services that our sleep labs perform.

Healthcare Information Practices

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, sets forth standards for electronic transactions; unique provider, employer, health plan and patient identifiers; security and electronic signatures as well as privacy protections relating to the exchange of individually identifiable health information. The Department of Health and Human Services, or DHHS, has released several rules mandating compliance with the standards set forth under HIPAA. We believe our sleep centers achieved compliance with DHHS’s standards governing the privacy of individually identifiable health information and DHHS’s standards governing the security of electronically stored health information. In addition, we have fully implemented the required uniform standards governing common healthcare transactions. Finally, we have taken or will take all necessary steps to achieve compliance with other HIPAA rules as applicable, including the standard unique employer identifier rule, the standard healthcare provider identifier rule and the enforcement rule.

HIPAA authorizes the imposition of civil money penalties against entities that employ or enter into contracts with individuals or entities that have been excluded from participation in the Medicare or Medicaid programs. We perform background checks on our affiliated physicians, and we do not believe that we engage or contract with any excluded individuals or entities. However, a finding that we have violated this provision of HIPAA could have a material adverse effect on our business and financial condition.

 

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HIPAA also establishes several separate criminal penalties for making false or fraudulent claims to insurance companies and other non-governmental payors of healthcare services. These provisions are intended to punish some of the same conduct in the submission of claims to private payors as the FCA covers in connection with governmental health programs. We believe that our services have not historically been provided in a way that would place either our clients or ourselves at risk of violating the HIPAA anti-fraud statutes, including those in which we received direct reimbursement because of the reassignment by affiliated physicians to us or those in which we may be considered to receive an indirect reimbursement because of the reassignment by us to hospitals of the right to collect for professional interpretations and technical services.

We continue to evaluate the effect of the HIPAA standards on our business. At this time, we believe that our sleep centers have taken all appropriate steps to achieve compliance with the HIPAA requirements. Moreover, HIPAA compliance is an ongoing process that requires continued attention and adaptation. We do not currently believe that the cost of compliance with the existing HIPAA requirements will be material to our operations; however, we cannot predict the cost of future compliance with HIPAA requirements. Noncompliance with HIPAA may result in criminal penalties and civil sanctions. The HIPAA standards have increased our regulatory and compliance burden and have significantly affected the manner in which our sleep centers use and disclose health information, both internally and with other entities.

In addition to the HIPAA restrictions relating to the exchange of healthcare information, individual states have adopted laws protecting the confidentiality of patient information which impact the manner in which patient records are maintained. Violation of patient confidentiality rights under common law, state or federal law could give rise to damages, penalties, civil or criminal fines and/or injunctive relief. We believe that our sleep center operations are in compliance with federal and state privacy protections. However, an enforcement agency or court may find a violation of state or federal privacy protections arising from our sleep center operations.

Third-Party Reimbursement

The cost of medical care in the United States and many other countries is funded substantially by government and private insurance programs. We receive payment for our products or services directly from these third-party payors and our continued success is dependent upon the ability of patients and their healthcare providers to obtain adequate reimbursement for those products and sleep disorder diagnostic services. In most major markets, our services and supplies are utilized and purchased primarily by patients suffering from obstructive sleep apnea. Patients are generally covered by private insurance. In those cases, the patient is responsible for his or her co-payment portion of the fee and we invoice the patient’s insurance company for the balance. Billings for the products or services reimbursed by third-party payors, including Medicare and Medicaid, are recorded as revenues net of allowances for differences between amounts billed and the estimated receipts from the third-party payors. In hospitals, we contract with the hospital on a “fee for service” basis and the hospital assumes the risk of billing.

The third-party payors include Medicare, Medicaid and private health insurance providers. These payors may deny reimbursement if they determine that a device has not received appropriate FDA clearance, is not used in accordance with approved applications, or is experimental, medically unnecessary or inappropriate. Third-party payors are also increasingly challenging prices charged for medical products and services, and certain private insurers have initiated reimbursement systems designed to reduce healthcare costs. The trend towards managed healthcare and the growth of health maintenance organizations, which control and significantly influence the purchase of healthcare services and products, as well as ongoing legislative proposals to reform healthcare, may all result in lower prices for our products and services. There is no assurance that our sleep disorder products and services will be considered cost-effective by third-party payors, that reimbursement will be available or continue to be available, or that payors’ reimbursement policies will not adversely affect our ability to sell our products and services on a profitable basis, if at all.

Discontinued Operations

On May 10, 2011, we executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which we sold substantially all of the assets of our subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which we provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. Our decision to sell the assets of East was primarily based on management’s determination that the operations of East no longer fit into our strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit our ability to sell CPAP devices and other supplies at the East locations.

 

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On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx’s independent retail pharmacy business to Walgreens. Through ApothecaryRx, we operated independent retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. We had historically grown our pharmacy business by acquiring financially successful independently-owned retail pharmacies from long-term owners that were approaching retirement. The acquired pharmacies successfully maintained market share due to their convenient proximity to healthcare providers and services, high customer service levels, longevity in the community, competitive pricing. Additionally, our independent pharmacies offered supportive services and products such as pharmaceutical compounding, durable medical equipment, and assisted and group living facilities. The pharmacies were located in mid-size, economically-stable communities and we believed that a significant amount of the value of the pharmacies resides in retaining the historical pharmacy name and key staff relationships in the community. Prior to the sale, we owned and operated 18 retail pharmacies located in Colorado, Illinois, Missouri, Minnesota, and Oklahoma.

Employees

As of March 15, 2012, we had 186 full-time and 31 part-time employees at Graymark Healthcare, Inc. and its wholly-owned subsidiaries. Our employees are not represented by a labor union.

Item 1A. Risk Factors.

We have a bank credit facility of approximately $19 million and we may not achieve compliance with the Debt Service Coverage Ratio requirements which begin March 31, 2013.

We are party to an amended Loan Agreement with Arvest Bank (the “Arvest Credit Facility”). The Arvest Credit Facility provides for a term loan in the principal amount of $30 million (referred to as the “Term Loan”) and provides an additional credit facility in the principal amount of $15 million (the “Acquisition Line”) for total principal of $45 million. As of December 31, 2011, the outstanding principal amount of the Arvest Credit Facility was $18,823,129. In connection with our sale of the assets of ApothecaryRx to Walgreens, we reduced the outstanding balance on the Arvest Credit Facility by $22 million during 2010. We made additional principal payments of $3.4 million in 2011. Commencing with the calendar quarter beginning January 1, 2013 and thereafter during the term of the Arvest Credit Facility, based on the latest four rolling quarters, we agreed to continuously maintain a “Debt Service Coverage Ratio” of not less than 1.25 to 1. As of December 31, 2011, our Debt Service Coverage Ratio is less than 1.25 to 1. The Debt Service Coverage Ratio is calculated using the latest four rolling quarters. We are currently developing and executing a combination of strategic, operational and debt reduction strategies aimed at achieving compliance with the Debt Service Coverage Ratio covenant. If we are unsuccessful in achieving compliance with the Debt Service Coverage Ratio covenant, there is no assurance that Arvest Bank will waive or further delay the requirement.

In the event we receive a notice of default from Arvest Bank and the default is not cured within 10 days following notice of the default by Arvest Bank, Arvest Bank will have the right to declare the outstanding principal and accrued and unpaid interest immediately due and payable. Payment and performance of our obligations under the Arvest Credit Facility are secured by the personal guaranties of certain of our current and former executive officers and our largest stockholder and in general our assets. In addition, in connection with a third amendment to the Arvest Credit Facility in July 2010, we also entered into a Deposit Control Agreement with Arvest Bank covering our accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Control Agreement only in the event of an uncured default under the Loan Agreement, as amended.

 

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If Arvest Bank accelerates the payment of outstanding principal and interest, we will need to file a current report on Form 8-K with the SEC disclosing the event of default and the acceleration of payment of all principal and interest. In addition, we do not expect to be able to pay all outstanding principal and interest if Arvest Bank accelerates the due dates for such amounts. Since we have granted Arvest Bank a security interest in all of our assets, Arvest Bank could elect to foreclose on such assets as well as to move to enforce the guaranty which is provided by certain of our current and former officers and directors. If Arvest Bank declares an event of default and/or accelerates the payment of our obligations under the Arvest Credit Facility, then the disclosure of such fact may cause a material decrease in the price of our stock on The Nasdaq Capital Market. The declaration of an event of default and the move to foreclose on our assets may cause a material adverse effect on our ability to operate our business in the ordinary course of business as well as a material adverse effect on our liquidity, results of operations and financial position.

We require a significant amount of cash flow from operations and third-party financing to pay our indebtedness, to execute our business plan and to fund our other liquidity needs.

We may not be able to generate sufficient cash flow from operations, and future borrowings may not be available to us under existing loan facilities or otherwise in an amount sufficient to pay our indebtedness, to execute our business plan or to fund our other liquidity needs. We anticipate the need for substantial cash flow to fund future acquisitions, which is our primary growth strategy. In addition, we may need to refinance some or all of our current indebtedness at or before maturity.

We incurred indebtedness with an outstanding balance at December 31, 2011 of approximately $19 million to fund the acquisitions of our existing sleep centers. The outstanding principal amounts under the Arvest Bank credit facility and the term loan bear interest at the greater of the Wall Street Journal prime rate or 6%. Prior to June 30, 2010, the floor rate was 5%. Further details about this indebtedness can be found in the footnotes to our consolidated financial statements included elsewhere in this report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

At December 31, 2011, we had total liabilities of approximately $23.2 million. Because of our history of incurring significant losses, there is no assurance that our operating results will provide sufficient funding to pay our liabilities on a timely basis. There is no assurance that we will be able to refinance any of our current indebtedness on commercially reasonable terms or at all. Failure to generate or raise sufficient funds may require us to modify, delay or abandon some of our future business growth strategies or expenditure plans.

We have incurred significant operating losses since our inception and anticipate that we will incur continued losses for the foreseeable future.

We have financed our operations through revenues from operations, as well as the issuance of debt and equity securities and have incurred losses in the past two years. Net losses were $5.9 million in 2011 and $19.1 million in 2010. As of December 31, 2011, we had an accumulated deficit of $35.1 million. While we have instituted a strategy for re-engineering our operations to reduce costs, generate additional revenues, and generate operating cash flow, we continue to incur losses and do not yet generate cash flows from operations. As a result, we expect to continue to incur significant operating losses. Because of the numerous risks and uncertainties associated with our business re-engineering plan, we are unable to predict the extent of any future losses or when we will become profitable, if at all.

The markets for sleep diagnostic services and sale of related products are highly competitive, and we compete against substantially larger healthcare providers, including hospitals and clinics.

Competition among companies that provide healthcare services and supplies is intense. If we are unable to compete effectively with existing or future competitors, we may be prevented from retaining our existing customers or from attracting new customers, which could materially impair our business. There are a number of companies that currently offer or are in the process of offering services and supplies that compete with our sleep diagnostic and care management services and related product and supplies sales. These competitors may succeed in providing services and products that are more effective, less expensive or both, than those we currently offer or that would render some of our services or supplies obsolete or non-competitive. Some of our competitors may submit lower bids in a competitive bidding process or may be able to accept lower reimbursement rates from third party payors, thus gaining market share in our target markets. Many of our competitors have greater financial, research and development, manufacturing, and marketing resources than we have and may be in a better position than us to withstand the adverse effects on gross margins and profitability caused by price decreases prevalent in this competitive environment.

 

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If third party payors determine that we violate Medicare, Medicaid or other payor reimbursement laws, regulations, or requirements, our revenues may decrease, we may have to restructure our method of billing and collecting Medicare, Medicaid or other payor program payments, respectively, and we could incur substantial defense costs and be subject to fines, monetary penalties and exclusion from participation in government-sponsored programs such as Medicare and Medicaid.

Our operations, including our billing and other arrangements with healthcare providers, are subject to extensive federal and state government regulation and requirements of other third-party payors. Such regulations and requirements include numerous laws directed at payment for services, conduct of operations, preventing fraud and abuse, laws prohibiting general business corporations, such as us, from practicing medicine, controlling physicians’ medical decisions or engaging in some practices such as splitting fees with physicians, laws regulating billing and collection of reimbursement from government programs, such as Medicare and Medicaid, and requirements of other payors. Those laws and requirements may have related rules and regulations that are subject to alternative interpretations and may not provide definitive guidance as to their application to our operations, including our arrangements with hospitals, physicians and professional corporations.

We verify patient benefit eligibility prior to providing services or products. We submit claims for service and products after they have been provided. Claims are supported by required documentation including physician orders. Despite our measures to ensure compliance with Medicare, Medicaid, or other payor billing standards, such third-party payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain amounts are not reimbursable, that the service was not medically necessary, that there was a lack of sufficient supporting documentation, or for other reasons. Incorrect or incomplete documentation and billing information could result in nonpayment, recoupment or allegations of billing fraud.

We are not aware of any inquiry, investigation or notice from any governmental entity or other payor indicating that we are in violation of any of the Medicare, Medicaid or other payor reimbursement laws, regulations, or requirements. We believe we are in substantial compliance with these laws, rules and regulations based upon what we believe are reasonable and defensible interpretations of these laws, rules and regulations. However, such laws and related regulations and regulatory guidance may be ambiguous or contradictory, and may be interpreted or applied by prosecutorial, regulatory or judicial authorities in ways that we cannot predict. If federal or state government officials or other payors challenge our operations or arrangements with third parties that we have structured based upon our interpretation of these laws, rules and regulations, the challenge could potentially disrupt our business operations and we may incur substantial defense costs, even if we successfully defend our interpretation of these laws, rules and regulations. In addition, if the government or other payors successfully challenge our interpretation as to the applicability of these laws, rules and regulations as they relate to our operations and arrangements with third parties, we would potentially incur substantial cost restructuring our billing practice, as well as fines or penalties for non-compliance which could have a material adverse effect on our business, financial condition and results of operations.

In the event regulatory action were to limit or prohibit us from carrying on our business as we presently conduct it or from expanding our operations to certain jurisdictions, we may need to make structural, operational and organizational modifications to our company and/or our contractual arrangements with third-party payors, physicians, or others. Our operating costs could increase significantly as a result. We could also lose contracts or our revenues could decrease under existing contracts. Any restructuring would also negatively impact our operations because our management’s time and attention would be diverted from running our business in the ordinary course.

We are subject to complex rules and regulations that govern our licensing and certification, and the failure to comply with these rules can result in delays in, or loss of, reimbursement for our services or civil or criminal sanctions.

 

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There has been a trend developing to require facilities that provide sleep diagnostic testing and durable medical equipment to become accredited by an approved accreditation organization as well as additional credentialing for physicians diagnosing sleep disorders and the licensing of technical personnel to perform diagnostic testing procedures. As of March 1, 2012, 11 of our free standing sleep centers are accredited by the American Academy of Sleep Medicine, or the AASM. In addition, we have one free standing sleep center that is accredited through The Joint Commission. We are actively pursuing accreditation for our remaining sleep centers. Also, Medicare requires that all Durable Medical Equipment (DME) suppliers be accredited. All of our sleep therapy facilities providing DME were granted accreditation by The Joint Commission or by the Accreditation Commission for Healthcare, or ACHC. During 2010, one of our DME suppliers, somniCare Overland Park, Kansas location, became the first sleep therapy company in America to be accredited by the AASM.

Physicians, physician assistants, nurse practitioners, and respiratory therapists who provide services as part of our operations are required to obtain and maintain certain professional licenses or certifications and are subject to state regulations regarding professional standards of conduct.

Some states also require our free-standing diagnostic testing facilities and DME providers to be licensed by or registered with state authorities such as state departments of health. We believe that we are in compliance with the licensing and registration in applicable states.

Some state laws require that companies dispensing DME and supplies within the state be licensed by the state board of pharmacy. We currently have a pharmacy license for dispensing of durable medical equipment and supplies in applicable states.

The relevant laws and regulations are complex and may be unclear or subject to interpretation. Currently we believe we are in compliance with all requisite regulatory authorities; however, agencies that administer these programs may find that we have failed to comply in some material respects. Failure to comply with these licensing, certification and accreditation laws, regulations and standards could result in our services being found non-reimbursable or prior payments being subject to recoupment, and can give rise to civil or, in extreme cases, criminal penalties.

Government and private insurance plans may further reduce or discontinue healthcare reimbursements, which could result in reductions in our revenue and operating margins.

A substantial portion of the cost of medical care in the United States is funded by managed care organizations, insurance companies, government funded programs, employers and other third-party payors, which are collectively referred to as “third-party plans.” These plans continue to seek cost containment. If this funding were to be reduced in terms of coverage or payment rates or were to become unavailable to our sleep disorder patients, our business will be adversely affected. Furthermore, managed care organizations and insurance companies are evaluating approaches to reduce costs by decreasing the frequency of treatment or the utilization of a medical device or product. These cost containment measures have caused the decision-making function with respect to purchasing to shift in many cases from the physician to the third-party plans or payors, resulting in an increased emphasis on reduced price, as opposed to clinical benefits or a particular product’s features. Efforts by U.S. governmental and private payors to contain costs will likely continue. Because we generally receive payment for our sleep diagnostic services and related products directly from these third-party plans, our business operations are dependent upon our ability to obtain adequate and timely reimbursement for our sleep diagnostic services and related products.

The third-party payors include Medicare, Medicaid and private health insurance providers. These payors may deny reimbursement if they determine that a diagnostic test was not covered under the patient’s plan or performed properly or that a device is not covered under the patient’s plan, is not used in accordance with approved indications, or is unnecessary or deemed to be inappropriate treatment for the patient. For example, federal payors and commercial concerns that have adopted similar standards will only fully reimburse us for a CPAP device if the patient can demonstrate compliance for the first 90 days after the initial set-up. Third-party payors are also increasingly challenging prices charged for medical products and services. There is no assurance that our sleep diagnostic services and the related products will be considered cost-effective by third-party payors, that reimbursement will be available, or that payors’ reimbursement policies will not adversely affect our ability to offer and sell our services and products on a profitable basis, if at all.

 

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Changes in reimbursement levels for sleep diagnostic services and related products continue to reduce our margins and could have a material, adverse effect on our overall operating results.

During the years ended December 31, 2011 and 2010, we were wholly or partially reimbursed by third-party plans for approximately 90% and 95%, respectively of our revenue from sleep diagnostic services and product sales. The sleep diagnostic revenue reimbursed by third-party plans, including Medicare and Medicaid plans, generally have lower gross margins compared to sales or services paid outside a third-party plan. Increases in the costs of our sleep related products may not be sufficiently offset by increases in reimbursement rates. In addition, continued increases in co-payments by third-party plans may result in decreases in sales and revenue, operating and cash flow losses, and may deplete working capital reserves.

In particular, Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective reimbursement rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our operations. During the years ended December 31, 2011 and 2010, 11% and 12%, respectively, of our sleep diagnostic revenues were attributable to Medicaid and Medicare reimbursement. Over the last several years, a number of states experiencing budget deficits have moved to reduce Medicaid reimbursement rates as part of healthcare cost containment.

We depend on reimbursements by third-party payors, as well as payments by individuals, which could lead to delays and uncertainties in the reimbursement process.

We receive a substantial portion of our payments for sleep center services and related supplies from third-party payors, including Medicare, Medicaid, private insurers and managed care organizations. The reimbursement process for these third-party payors is complex and can involve lengthy delays. Third-party payors continue their efforts to control expenditures for healthcare, including proposals to revise reimbursement policies. While we recognize revenue when healthcare services are provided, there can be delays before we receive payment. In addition, third-party payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain amounts are not reimbursable under plan coverage, that services provided were not medically necessary, or that additional supporting documentation is necessary. Retroactive adjustments may change amounts realized from third-party payors. These risks may be exacerbated for patients for whom we are out-of-network. We are subject to governmental audits of our reimbursement claims under Medicare and Medicaid and may be required to repay these agencies if a finding is made that we were incorrectly reimbursed. Delays and uncertainties in the reimbursement process may adversely affect accounts receivable, increase the overall costs of collection and cause us to incur additional borrowing costs.

We also may not be paid with respect to co-payments and deductibles that are the patient’s financial responsibility, or in those instances when our facilities provide services to uninsured and underinsured individuals. Amounts not covered by third-party payors are the obligations of individual patients for which we may not receive whole or partial payment. In such an event, our earnings and cash flow would be adversely affected.

Healthcare reform has been enacted into law and could impact the profitability of our business.

The Affordable Care Act, enacted in March 2010, is dramatically altering the U.S. health care system. The law is intended to increase access to health care and health insurance services, increase the quality of care that is provided, and control or reduce health care spending. In addition, health care reform reduces Medicare and Medicaid payments to hospitals and other healthcare providers and bundle payments to hospitals, physicians, and other providers for certain services. We are unable to predict how changes in the law or new interpretations of existing laws may have a dramatic effect on the costs associated with doing business and the amount of reimbursement patients and customers receive both from government and third-party plans or payors. Federal, state and local government representatives will, in all likelihood, continue to review and assess alternative regulations and payment methodologies.

 

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Healthcare reform and enforcement initiatives of federal and state governments may also affect our sales and revenue. These include:

 

  Significant reductions in spending on Medicare, Medicaid and other government programs;

 

  changes in programs providing for lower reimbursement rates for the cost healthcare products and services by third-party plans or payors;

 

  regulatory changes relating to the approval process for healthcare products and services in general.

There is uncertainty regarding the nature of healthcare reform implementation and whether there will be other changes in the administration of governmental healthcare programs or interpretations of governmental policies or other changes affecting the healthcare system. Recently enacted or future healthcare or budget legislation or other changes, including those referenced above, may materially adversely affect our business resulting in operating and cash flow losses, depletion of working capital reserves and adversely affect our financial condition.

We rely on primary suppliers of sleep related products to sell their products to us on satisfactory terms, and a disruption in our relationship with these suppliers could have a material, adverse effect on our business.

We are dependent on merchandise vendors to provide sleep disorder related products for our resale. Our largest sleep product suppliers are Fisher & Paykel Healthcare, which supplied approximately 38% and 39% of our sleep supplies in the years ended December 31, 2011 and 2010, respectively, and ResMed, Inc., which supplied approximately 32% and 30% of our sleep supplies in the years ended December 31, 2011 and 2010, respectively. In our opinion, if any of these relationships were terminated or if any contracting party were to experience events precluding fulfillment of our needs, we would be able to find a suitable alternative supplier, but possibly not without significant disruption to our business. This could take a significant amount of time and result in a loss of customers and revenue, operating and cash flow losses and may deplete working capital reserves.

We could be subject to professional liability lawsuits, some of which we may not be fully insured against or reserved for, which could adversely affect our financial condition and results of operations.

In recent years, physicians, hospitals and other participants in the healthcare industry have become subject to an increasing number of lawsuits alleging medical malpractice and related legal theories such as negligent hiring, supervision and credentialing, and vicarious liability for acts of their employees or independent contractors. Many of these lawsuits involve large claims and substantial defense costs. We maintain professional liability insurance, which covers third-party claims that may be brought against the physicians and staff that work at our sleep centers, up to a maximum of $3 million, which amount may be insufficient to satisfy all third-party claims that may be brought against our healthcare professionals.

We are dependent upon our ability to recruit and retain physicians who are properly licensed and certified in the specialty of sleep medicine to oversee our sleep centers and provide medical services to our patients.

Our success depends largely upon our ability to recruit and retain physicians who are licensed to practice medicine in the jurisdictions relevant to the sleep diagnostic testing centers. We currently have medical directors who oversee each of our sleep centers, provide sleep study interpretations and consultations to our patients. The loss of one or more medical directors could result in a time-consuming search for a replacement, and could distract our management team from the day-to-day operations of our business. Any change in our relationship with our supervising or interpreting physicians, whether resulting from a dispute between the parties, a change in government regulation, or the loss of contracts with these physicians, could impair our ability to provide services and could have a material adverse affect on our business, financial condition and operations.

In many markets our success is highly dependent upon the continuing ability to recruit and retain qualified sleep specialists to supervise sleep diagnostic testing services and interpret results of such tests for us due to the current shortage of sleep specialists in the medical profession. We face competition for sleep specialists from other healthcare providers, including hospitals and other organizations. The competitive demand for sleep specialists may require us in the future to offer higher compensation in order to secure the services of sleep specialists. As a result, our compensation expense for our affiliated sleep specialists may increase and if we were not able to offset any such increase by increasing our prices, this could have a material adverse effect on our results of operations. An inability to recruit and retain sleep specialists would have a material adverse effect on our ability to maintain accreditation status and would adversely affect our results of operations.

 

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The loss of our accreditation or our inability to obtain accreditation could negatively impact our business and operating results.

There has been a trend developing to require facilities that provide sleep diagnostic testing and equipment to become accredited by a Medicare approved accreditation organization in order to obtain reimbursement for provided such services. It is anticipated that many other government and private payors will follow suit requiring accreditation by certain approved organizations as a condition to reimbursement for sleep testing and treatment services or products. The loss of our accreditation or our inability to obtain accreditation for new facilities or existing facilities not yet accredited could cause us to be unable to provide services to certain accredited institutions, could cause non-compliance with certain of our third party payor contracts, and could cause us to lose our ability to participate in certain government programs such as Medicare, all of which could, in turn, negatively impact our financial condition and results of operations.

If our arrangements with physicians or our patients are found to violate state laws prohibiting the practice of medicine by general business corporations or fee splitting, our business, financial condition and ability to operate in those states could be adversely affected.

The laws of many states, including states in which we engage physicians to perform medical services, prohibit us from exercising control over the medical judgments or decisions of physicians and from engaging in certain financial arrangements, such as splitting professional fees with physicians. These laws and their interpretations vary from state to state and are enforced by state courts and regulatory authorities, each with broad discretion. In states which do not allow us to exercise control over physicians or prohibit certain financial arrangements, we enter into agreements with physicians as independent contractors pursuant to which they render professional medical services. In addition, in some states, we enter into agreements with physicians to deliver professional sleep interpretation services and professional clinic services in exchange for a service fee.

We structure our relationships with physicians in a manner that we believe is in compliance with prohibitions against the corporate practice of medicine and fee splitting. While we have not received notification from any state regulatory or similar authorities asserting that we are engaged in the corporate practice of medicine or that the payment of service fees to us by physicians or to physicians by us constitutes fee splitting, if such a claim were successful we could be subject to substantial civil and criminal penalties and could be required to restructure or terminate the applicable contractual arrangements and our contractual arrangements may be unenforceable in that particular state. A determination that our arrangements with physicians violate state statutes, a change in government regulation, or our inability to successfully restructure these arrangements to comply with these statutes, could eliminate business located in certain states from the market for our services, which would have a material adverse effect on our business, financial condition and operations.

Our failure to comply with government regulations, including broad and complex federal and state fraud and abuse laws, may result in substantial reimbursement obligations, damages, penalties, injunctive relief or exclusion from participation in federal or state healthcare programs.

Our sleep diagnostic, therapy, and supply operations are subject to a variety of complex federal, state and local government laws and regulations targeted at fraud and abuse, including:

 

  The federal Anti-Kickback Statute, which prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind: (i) for referring an individual to a person for the provision of an item or service for which payment may be made under federal healthcare programs such as Medicare and Medicaid; or (ii) to induce a person to refer an individual to a person for the provision of an item or service covered under a federal healthcare program, or arrange for or recommend that someone purchase, lease, or order a good, facility, service, or item covered under a federal healthcare program;

 

  State law equivalents to the federal Anti-Kickback Statute, which may not be limited to government reimbursed items;

 

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  The federal False Claims Act, which prohibits any person from knowingly presenting, or causing to be presented, a false claim for payment to the federal government or knowingly making, or causing to be made, a false statement in order to have a false claim paid. The federal government’s interpretation of the scope of the law has in recent years grown increasingly broad. Most states also have statutes or regulations similar to the federal false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payor;

 

  The Health Insurance Portability and Accountability Act of 1996, or HIPAA, which prohibits fraud on a health benefit plan and false statements. HIPAA created a federal healthcare fraud statute that prohibits knowingly and willfully executing a scheme to defraud any healthcare benefit program, including private payors. Among other things, HIPAA also imposes criminal penalties for knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services, along with theft or embezzlement in connection with a healthcare benefits program and willful obstruction of a criminal investigation involving a federal healthcare offense;

 

  The Stark Law prohibits the referral of Medicare and Medicaid “designated health services” which includes outpatient prescription drugs and durable medical equipment such as CPAP devices and may also include sleep diagnostic testing if the testing is billed by a hospital to Medicare or Medicaid to an entity if the physician or a member of such physician’s immediate family has a “financial relationship” with the entity, unless an exception applies. The Stark Law provides that the entity that renders the “designated health services” may not present or cause to be presented a claim for “designated health services” furnished pursuant to a prohibited referral. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each applicable arrangement or scheme.

In addition, anyone who presents or causes to be presented a claim in violation of the Stark Law is subject to payment denials, mandatory refunds, monetary penalties of up to $15,000 per service, an assessment of up to three times the amount claimed, and possible exclusion from participation in federal healthcare programs; and

 

  Many state laws prohibit physician referrals to entities with which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. State law equivalents to the Stark law may be applicable to different types of services than those that are “designated health services” under the federal law and may have fewer or different exceptions.

In addition to those sanctions described above, violations of these or other government regulations could result in material penalties, including: civil monetary penalties, suspension of payments from government programs, loss of required government certifications, loss of licenses, loss of authorizations to participate in or exclusion from government reimbursement programs (including Medicare and Medicaid programs). Also, violations of federal, state, and common law privacy protections could give rise to significant damages, penalties, or injunctive relief. We believe that our practices are not in violation of the federal anti-kickback statute, false claims laws, HIPAA, the Stark law, or state equivalents, but we cannot assure you that enforcement authorities will not take action against us and, if such action were successful, we could be required to pay significant fines and penalties and change our corporate practices. Such enforcement could have a significant adverse effect on our ability to operate our business and to enforce our contracts with payors and others.

Non-compliance with federal and state anti-kickback laws could affect our business, operations or financial condition.

 

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Various federal and state laws govern financial arrangements among healthcare providers. The federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation or receipt of any form of remuneration in return for, or with the purpose to induce, the referral of Medicare, Medicaid or other federal healthcare program patients, or in return for, or with the purpose to induce, the purchase, lease or order of items or services that are covered by Medicare, Medicaid or other federal healthcare programs. Similarly, many state laws prohibit the solicitation, payment or receipt of remuneration in return for, or to induce, the referral of patients in private as well as government programs. There is a risk that an investment in our shares or in our subsidiary sleep centers by our affiliated physicians, including the distribution of any profits to our affiliated physicians, referrals for sleep testing or treatment services by physicians who own our securities, the marketing of our affiliated physicians’ services or our compensation arrangements with our affiliated physicians may be considered a violation of these laws. Violation of these anti-kickback laws may result in substantial civil or criminal penalties for individuals or entities and/or exclusion from participating in federal or state healthcare programs. If we are excluded from federal or state healthcare programs, our affiliated physicians who participate in those programs would not be permitted to continue doing business with us. We believe that we are operating in compliance with applicable laws and believe that our arrangements with providers would not be found to violate the anti-kickback laws. However, these laws could be interpreted in a manner inconsistent with our operations.

We have physicians who own non-controlling investment interests in some of our sleep diagnostic testing facilities who also have a referral relationship with our sleep testing or care management services. If the ownership distributions paid to physicians by our testing facilities are found to constitute prohibited payments made to physicians under the federal Anti-kickback Statute, physician self-referral or other fraud and abuse laws, our business may be adversely affected. Over the years, the federal government has published regulations that established “safe harbors” to the federal Anti-Kickback Statute. An arrangement that meets all of the elements of the safe harbor is immunized from prosecution under the federal Anti-Kickback Statute. The failure to satisfy all elements, however, does not necessarily mean the arrangement violates the federal Anti-Kickback Statute. We endeavor to meet safe harbors designed for small entity investments and believe we are in compliance with such laws. However, if we were found to be violation of a federal or state anti-kickback statute, our business, results of operations, and financial condition would be harmed and we would be subject to substantial civil and criminal penalties.

If government laws or regulations change or the enforcement or interpretation of them change, we may be obligated to purchase some or all of the ownership interests of the physicians associated with us.

Changes in government regulation or changes in the enforcement or interpretation of existing laws or regulations could obligate us to purchase at the then fair market value some or all of the ownership interests of the physicians who have invested in our sleep diagnostic facilities. Regulatory changes that could create this obligation include changes that:

 

  make illegal the referral of Medicare or other patients to our sleep diagnostic facilities by physicians affiliated with us,

 

  create the substantial likelihood that cash distributions from our sleep diagnostic facilities to our physician partners will be illegal, or

 

  make illegal the ownership by physicians of their interests in our sleep diagnostic facilities.

From time to time, we may voluntarily seek to increase our ownership interest in one or more of our sleep diagnostic testing facilities, in accordance with any applicable limitations. We may seek to use shares of our common stock to purchase physicians’ ownership interests instead of cash. If the use of our stock is not permitted or attractive to us or the physicians, we may use cash or promissory notes to purchase the physicians’ ownership interests. Our existing capital resources may not be sufficient for the acquisition or the use of cash may limit our ability to use our capital resources elsewhere, limiting our growth and impairing our operations. The creation of these obligations and the possible adverse effect on our affiliation with these physicians could have a material adverse effect on us.

Federal or state self-referral regulations could impact our arrangements with our affiliated physicians.

 

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The federal physician self-referral statute, known as the “Stark” statute, prohibits a physician from making a referral for certain designated health services, including DME such as CPAP devices, to any entity with which the physician has a financial relationship, unless there is an exception in the statute that allows the referral. The entity that receives a prohibited referral from a physician may not submit a bill to Medicare for that service. Many state laws prohibit physician referrals to entities in which the physician has a financial interest, or require that the physician provide the patient notice of the physician’s financial relationship before making the referral. There is a risk that an investment in our shares or in our subsidiary sleep centers by our affiliated physicians, including the distribution of any profits to our affiliated physicians, the use of our equipment by physicians who own our securities, any assistance from healthcare providers in acquiring, maintaining or operating sleep diagnostic testing equipment, the marketing of our affiliated physicians’ services or our compensation arrangements with our affiliated physicians, could be interpreted as a violation of the federal Stark statute or similar state laws, if we were to accept referrals from our affiliated physicians. Violation of the Stark statute can result in substantial civil penalties for both the referring physician and any entity that submits a claim for a healthcare service made pursuant to a prohibited referral. In addition, federal courts have ruled that violations of the Stark statute can be the basis for a legal claim under the Federal False Claims Act. We believe that all of our affiliated physician arrangements are in compliance with the Stark statute. However, these laws could be interpreted in a manner inconsistent with our operations.

Because we submit claims to the Medicare program based on the services we provide, it is possible that a lawsuit could be brought against us under the Federal False Claims Act, and the outcome of any such lawsuit could have a material adverse effect on our business, financial condition and results of operations.

The federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person whom it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to have a claim approved. Federal courts have ruled that a violation of the anti-kickback provision of the Stark statute can serve as the basis for the federal False Claims Act suit. The federal False Claims Act further provides that a lawsuit brought under that act may be initiated in the name of the United States by an individual who was the original source of the allegations, known as the relator. Actions brought under the federal False Claims Act are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government and the court. Therefore, it is possible that lawsuits have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Penalties include fines ranging from $5,500 to $11,000 for each false claim, plus three times the amount of damages that the federal government sustained because of the act of the violator.

We believe that we are operating in compliance with the Medicare rules and regulations and, thus, the federal False Claims Act. However, if we were found to have violated certain rules and regulations and, as a result, submitted or caused our affiliated physicians to submit allegedly false claims, any sanctions imposed under the federal False Claims Act could result in substantial fines and penalties or exclusion from participation in federal and state healthcare programs, which could have a material adverse effect on our business and financial condition. If we are excluded from participation in federal or state healthcare programs, our affiliated physicians who participate in those programs could not do business with us.

Federal regulatory and law enforcement authorities have recently increased enforcement activities with respect to Medicare and Medicaid fraud and abuse regulations and other reimbursement laws and regulations, including laws and regulations that govern our activities and the activities of providers of sleep diagnostic testing and durable medical equipment. These increased enforcement activities may have a direct or indirect adverse affect on our business, financial condition and results of operations.

Additionally, some state statutes contain prohibitions similar to and possibly even more restrictive than the federal False Claims Act. These state laws may also empower state administrators to adopt regulations restricting financial relationships or payment arrangements involving healthcare providers under which a person benefits financially by referring a patient to another person. We believe that we are operating in compliance with these laws. However, if we are found to have violated such laws, our business, results of operations and financial condition would be harmed.

 

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Future changes in healthcare regulation are difficult to predict and may constrain or require us to restructure our operations, which could negatively impact our business and operating results.

The healthcare industry is heavily regulated and subject to frequent changes in governing laws and regulations as well as to evolving administrative interpretations. Our business could be adversely affected by regulatory changes at the federal or state level that impose new requirements for licensing, new restrictions on reimbursement for medical services by government programs, new pretreatment certification requirements for patients seeking sleep testing procedures or treatment products, or new limitations on services that can be performed by us. In addition, federal, state and local legislative bodies have adopted and continue to consider medical cost-containment legislation and regulations that have restricted or may restrict reimbursement to entities providing services in the healthcare industry and referrals by physicians to entities in which the physicians have a direct or indirect financial interest or other relationship. For example, Medicare recently adopted a regulation that limits the technical component of the reimbursement for multiple diagnostic tests performed during a single session at medical facilities other than hospitals. Any of these or future reimbursement regulations or policies could limit the number of diagnostic tests ordered and could have a material adverse effect on our business.

The Center for Medicare & Medicaid Services, or CMS, recently finalized certain anti-markup rules relating to diagnostic tests paid for by the Medicare program. The anti-markup rules are generally applicable where a physician or other supplier bills for the technical component or professional component of a diagnostic test that was ordered by the physician or other supplier (or ordered by a party related to such physician or other supplier through common ownership or control), and the diagnostic test is performed by a physician who does not share a practice with the billing physician or other supplier. If the anti-markup rule applies to an interpretation, then the reimbursement provided by Medicare to a billing physician or other supplier for that interpretation may be limited. Because our sleep diagnostic testing facilities bill Medicare for the technical and professional fees of sleep diagnostic tests that are ordered by community physicians or our affiliated physicians, we believe that the anti-markup rule does not apply to the professional services our affiliated physicians perform or the technical services that our sleep diagnostic testing facilities perform. However, this rule could be subject to an interpretation that affects the amounts that may be reimbursed by Medicare for professional diagnostic interpretations.

Although we monitor legal and regulatory developments and modify our operations from time to time as the regulatory environment changes, we may not be able to adapt our operations to address every new regulation, and such regulations may adversely affect our business. In addition, although we believe that we are operating in compliance with applicable federal and state laws, our business operations have not been scrutinized or assessed by judicial or regulatory agencies. We cannot assure you that a review of our business by courts or regulatory authorities would not result in a determination that adversely affects our operations or that the healthcare regulatory environment will not change in a way that will restrict our operations.

Non-compliance with state and federal regulations concerning health information practices may adversely affect our business, financial condition or operations, and the cost of compliance may be material.

We collect and use information about individuals and their medical conditions. Numerous federal and state laws and regulations, including the federal Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) and the Health Information Technology For Economic and Clinical Health Act (“HITECH Act”), govern the collection, dissemination, security, use and confidentiality of such patient-identifiable health information. HIPAA sets forth standards for electronic transactions between health plans, providers and clearinghouses; unique provider, employer, health plan and patient identifiers; security and electronic signatures as well as privacy protections relating to the exchange of individually identifiable health information. The Department of Health and Human Services (“DHHS”) has released several rules mandating compliance with the standards set forth under HIPAA. We believe our sleep centers and sleep related products and services achieved compliance with DHHS’s standards governing the privacy of individually identifiable health information and DHHS’s standards governing the security of electronically stored health information. In addition, we have fully implemented the required uniform standards governing common healthcare transactions. Finally, we have taken or will take all necessary steps to achieve compliance with other HIPAA rules as applicable, including the standard unique employer identifier rule, the standard health care provider identifier rule and the enforcement rule. While it is believed that we currently comply with HIPAA, there is some uncertainty of the extent to which the enforcement or interpretation of the HIPAA regulations will affect our business. Continuing compliance and the associated costs with these regulations may have a significant impact on our business operations. Criminal and civil sanctions may be imposed for failing to comply with HIPAA.

 

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In addition to the HIPAA restrictions relating to the exchange of healthcare information, individual states have adopted laws protecting the confidentiality of patient information which impact the manner in which patient records are maintained. Violation of patient confidentiality rights under common law, state or federal law could give rise to damages, penalties, civil or criminal fines and/or injunctive relief. We believe that our sleep center operations are in compliance with federal and state privacy protections. However, an enforcement agency or court may find a violation of state or federal privacy protections arising from our sleep center operations.

The failure to comply with other provisions of HIPAA potentially could result in liability, civil and criminal penalties, and could have a material adverse effect on our business and financial condition.

HIPAA authorizes the imposition of civil money penalties against entities that employ or enter into contracts with individuals or entities that have been excluded from participation in the Medicare or Medicaid programs. We perform background checks on our affiliated physicians, and we do not believe that we engage or contract with any excluded individuals or entities. However, a finding that we have violated this provision of HIPAA could have a material adverse effect on our business and financial condition.

HIPAA also establishes several separate criminal penalties for making false or fraudulent claims to insurance companies and other non-governmental payors of healthcare services. These provisions are intended to punish some of the same conduct in the submission of claims to private payors as the federal False Claims Act covers in connection with governmental health programs. We believe that our services have not historically been provided in a way that would place either our clients or ourselves at risk of violating the HIPAA anti-fraud statutes, including those in which we received direct reimbursement because of the reassignment by affiliated physicians to us or those in which we may be considered to receive an indirect reimbursement because of the reassignment by us to hospitals of the right to collect for professional interpretations and technical services.

We believe that our sleep centers have taken all appropriate steps to achieve compliance with the HIPAA requirements. We do not currently believe that the ongoing cost of compliance with the existing HIPAA requirements will be material to our operations; however, we cannot predict the cost of future compliance with HIPAA requirements.

Our failure to successfully implement our growth plan may adversely affect our financial performance.

We have grown primarily through acquisitions. We intend to continue to grow incrementally through acquisitions with our current focus primarily on the sleep disorder market through our comprehensive sleep management care model. As this growth plan is pursued, we may encounter difficulties expanding and improving our operating and financial systems to maintain pace with the increased complexity of the expanded operations and management responsibilities.

The success of our growth strategy will also depend on a number of other factors, including:

 

  economic conditions;

 

  competition;

 

  consumer preferences and purchasing power;

 

  the ability to attract and retain sleep technicians and physicians;

 

  financing and working capital requirements;

 

  the ability to negotiate sleep center leases on favorable terms; and

 

  the availability of new locations at a reasonable cost.

 

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Even if we succeed in acquiring established sleep centers as planned, those acquired facilities may not achieve the projected revenue or profitability levels comparable to those of currently owned sleep centers in the time periods we estimate or at all. Moreover, our newly acquired sleep centers may reduce the revenues and profitability of our existing locations and other operations. The failure of our growth strategy may have a material adverse effect on our operating results and financial condition.

Material weaknesses in the design and operation of the internal controls over financial reporting of companies that we acquire could have a material adverse effect on our financial statements.

Our business has primarily grown through the acquisition of existing businesses and in the future we intend to continue to grow our business through the acquisition of existing businesses. When we acquire such existing businesses our due diligence may fail to discover defects or deficiencies in the design and operations of the internal controls over financial reporting of such companies, or defects or deficiencies in the internal controls over financial reporting may arise when we try to integrate the operations of these newly acquired businesses with our own. We can provide no assurances that we will not experience such issues in future acquisitions, the result of which could have a material adverse effect on our financial statements.

The goodwill and other intangible assets acquired pursuant to our acquisitions of sleep centers may become further impaired and require additional write-downs and the recognition of additional substantial impairment expense.

At December 31, 2011, we had approximately $13.8 million and $1.2 million in goodwill and other intangible assets, respectively, that were recorded in connection with the acquisitions of our sleep centers during the years 2007 through 2011. We periodically evaluate whether or not to take an impairment charge on our goodwill, as required by the applicable accounting literature. Our evaluation is based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units. Our evaluation of goodwill and indefinite lived intangible assets completed during 2011 did not identify any impairment. During our evaluation in 2010, we determined that the carrying value of goodwill related to our sleep centers located in Oklahoma, Nevada and Texas exceeded their fair value. In addition, we determined the carrying value of our intangible assets associated with Nocturna East, Inc. and certain other intangibles exceeded their fair value. Accordingly, we recorded a noncash impairment charge, in December 2010, of $7.5 million and $3.2 million, respectively, on goodwill and other intangible assets.

In the event that this goodwill or other intangible assets are determined to be further impaired for any reason, we will be required to write-down or reduce the value of the goodwill and recognize an impairment expense. The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.

Risks Related to Ownership of Our Common Stock

If the trading price of our common stock remains below $1 per share or if we fail to maintain any of the other required listing standards, our common stock could be delisted from the NASDAQ Capital Market.

We must meet NASDAQ’s continuing listing requirements in order for our common stock to remain listed on the NASDAQ Capital Market. The listing criteria we must meet include, but are not limited to, a minimum bid price for our common stock of $1.00 per share. Failure to meet NASDAQ’s continued listing criteria may result in the delisting of our common stock on the NASDAQ Capital Market.

On December 21, 2011, we received a notice from NASDAQ stating that the minimum bid price of our common stock had been below $1.00 per share for 30 consecutive business days and that we were therefore not in compliance with the minimum bid price requirement for continued listing on The NASDAQ Capital Market set forth in Listing Rule 5550(a)(2). The notice indicated that we had been granted 180 calendar days, or until June 18, 2012, to regain compliance.

 

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In addition, we have a history of continuing operating losses. Net losses were $5.9 million in 2011 and $19.1 million in 2010. As of December 31, 2011, we had an accumulated deficit of $35.1 million and stockholders’ equity of $4.8 million. NASDAQ Marketplace Rule 5550(b), the continued listing standards for primary equity securities on The Nasdaq Capital Market requires stockholders’ equity of at least $2.5 million. Given our history of operating losses and our forecasts for 2012, we expect to have stockholders’ equity of less than $2.5 million during 2012 absent the issuance of additional equity securities, the sale of assets, or the acquisition of another company or business. If we were to have less than $2.5 million in stockholders’ equity as at the end of a reporting period, we would be in violation of the Nasdaq continuing listing rules. If we did not regain compliance with the continued listing standards, our common stock would be subject to delisting.

A delisting from the NASDAQ Capital Market would make the trading market for our common stock less liquid, and would also make us ineligible to use Form S-3 to register the sale of shares of our common stock or to register the resale of our securities held by certain of our security holders with the SEC, thereby making it more difficult and expensive for us to register our common stock or other securities and raise additional capital.

Our current principal stockholders have significant influence over us and they could delay, deter or prevent a change of control or other business combination or otherwise cause us to take action with which you might not agree.

Our executive officers, directors and holders of greater than 5% of our outstanding common stock together beneficially own approximately 61% of our outstanding common stock. As a result, our executive officers, directors and holders of greater than 5% of our outstanding common stock will have the ability to significantly influence all matters submitted to our stockholders for approval, including:

 

  changes to the composition of our Board of Directors, which has the authority to direct our business and appoint and remove our officers;

 

  proposed mergers, consolidations or other business combinations; and

 

  amendments to our certificate of incorporation and bylaws which govern the rights attached to our shares of common stock.

This concentration of ownership of shares of our common stock could delay or prevent proxy contests, mergers, tender offers, open market purchase programs or other purchases of shares of our common stock that might otherwise give you the opportunity to realize a premium over the then prevailing market price of our common stock. The interests of our executive officers, directors and holders of greater than 5% of our outstanding common stock may not always coincide with the interests of the other holders of our common stock. This concentration of ownership may also adversely affect our stock price.

The market price of our common stock may be volatile and this may adversely affect our stockholders.

The price at which our common stock trades may be volatile. The stock market has recently experienced significant price and volume fluctuations that have affected the market prices of securities, including securities of healthcare companies. The market price of our common stock may be influenced by many factors, including:

 

  our operating and financial performance;

 

  variances in our quarterly financial results compared to expectations;

 

  the depth and liquidity of the market for our common stock;

 

  future sales of common stock or the perception that sales could occur;

 

  investor perception of our business and our prospects;

 

  developments relating to litigation or governmental investigations;

 

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  changes or proposed changes in healthcare laws or regulations or enforcement of these laws and regulations, or announcements relating to these matters; or

 

  general economic and stock market conditions.

In addition, the stock market in general has experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of healthcare companies. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance. In the past, securities class-action litigation has often been brought against companies following periods of volatility in the market price of their respective securities. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert our management team’s attention as well as resources from the operation of our business.

We do not anticipate paying dividends on our common stock in the foreseeable future and, consequently, your ability to achieve a return on your investment will depend solely on appreciation in the price of our common stock.

We do not pay dividends on our shares of common stock and intend to retain all future earnings to finance the continued growth and development of our business and for general corporate purposes. In addition, we do not anticipate paying cash dividends on our common stock in the foreseeable future. Any future payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our Board of Directors. Our current credit facility with Arvest Bank restricts our ability to pay dividends, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Arvest Credit Facility.”

Item 1B. Unresolved Staff Comments.

None

Item 2. Properties.

Facilities

Our corporate headquarters and offices are located in Oklahoma City, Oklahoma. These office facilities consist of approximately 14,900 square feet and are occupied under a lease agreement with City Place, LLC (“City Place”), requiring monthly rental payments of $17,970 plus additional payments for our allocable share of the basic expenses of City Place. The lease agreement with City Place expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of our greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, our Chief Executive Officer. We believe that suitable additional or substitute space will be available as needed on reasonable terms.

As of December 31, 2011, we operated 22 free standing sleep clinics and therapy locations in 5 states. Each location is occupied under multiple-year (or long-term) lease arrangements requiring monthly rental payments. The following table presents, as of December 31, 2011, the locations and lease expiration dates of occupancy leases of each sleep center or clinic.

 

Sleep Center and Therapy Service Center

(City and State)

   Lease
Expiration
Date

Iowa:

  

Waukee

   Mar. 2012

Waukee

   Mar. 2012

Pleasant Hill

   Nov. 2012

Kansas:

  

Overland Park

   Jun. 2015

 

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Sleep Center and Therapy Service Center

(City and State)

   Lease
Expiration
Date

Overland Park

   Oct. 2027

Missouri:

  

Lee’s Summit

   Sep. 2015

Kansas City

   Dec. 2014

Nebraska:

  

Omaha

   Jan. 2013

Nevada:

  

Charleston

   Month-to-month

Henderson

   Dec. 2013

Oklahoma:

  

Tulsa

   Nov. 2015

Oklahoma City

   Sep. 2014

Norman

   Jan. 2014

South Dakota:

  

Sioux Falls

   Nov. 2013

Texas:

  

Southlake – Keller

   Jul. 2013

McKinney

   Oct. 2016

Bedford

   Dec. 2013

Waco

   Jan. 2018

Item 3. Legal Proceedings.

From time to time, we are subject to claims and suits arising in the ordinary course of our business, including claims for damages for personal injuries. In our management’s opinion, the ultimate resolution of any of these pending claims and legal proceedings will not have a material adverse effect on our financial position or results of operations.

Item 4. Mine Safety Disclosures.

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market

Our common stock is listed on The Nasdaq Capital Market (“Nasdaq”) under the symbol GRMH. The following table sets forth, during the calendar quarters presented, the high and low sale prices of our common stock for the period our common stock was listed on Nasdaq and as reported by the Nasdaq.

 

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Quarter Ended

   High      Low  

December 31, 2011

   $ 1.10       $ 0.46   

September 30, 2011

   $ 1.30       $ 1.00   

June 30, 2011

   $ 2.60       $ 1.25   

March 31, 2011

   $ 3.60       $ 2.68   

December 31, 2010

   $ 6.00       $ 2.80   

September 30, 2010

   $ 5.36       $ 4.36   

June 30, 2010

   $ 6.08       $ 4.00   

March 31, 2010

   $ 7.36       $ 4.24   

The share prices listed above have been adjusted to reflect the 1-for-4 reverse stock split effected after the close of business on June 3, 2011. On March 26, 2012, the closing price of our common stock as quoted on Nasdaq was $0.80.

The market price of our common stock is subject to significant fluctuations in response to, and may be adversely affected by:

 

  variations in quarterly operating results,

 

  changes in earnings estimates by analysts,

 

  developments in the sleep disorder diagnostic and treatment markets,

 

  announcements and introductions of product or service innovations, and

 

  general stock market conditions.

Holders of Equity Securities

As of March 15, 2012, we have 639 owners of our common stock; 96 record owners and 543 owners in street name.

Dividend Policy

Historically, we have not paid dividends on our common stock, and we do not currently intend to pay and you should not expect to receive cash dividends on our common stock. Our dividend policy is to retain earnings to support the expansion of our operations. If we were to change this policy, any future cash dividends will depend on factors deemed relevant by our board of directors. These factors will generally include future earnings, capital requirements, our financial condition contractual restrictions, such as our existing credit facilities. Our existing credit facility restricts our ability to pay dividends without the approval of our lenders. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Arvest Credit Facility.” Furthermore, in the event we issue preferred stock shares, although unanticipated, no dividends may be paid on our outstanding common stock shares until all dividends then due on our outstanding preferred stock will have been paid.

Securities Authorized for Issuance under Equity Compensation Plans

The following table sets forth as of December 31, 2011, information related to each category of equity compensation plan approved or not approved by our shareholders, including individual compensation arrangements with our non-employee directors. The equity compensation plans approved by our shareholders are our 2008 Long-Term Incentive Plan and 2003 Stock Option Plan. All stock options and rights to acquire our equity securities are exercisable for or represent the right to purchase our common stock.

 

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Plan category

   Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
     Weighted-average
exercise price of
outstanding
options, warrants
and rights
     Number  of
securities
remaining
available for
future issuance
under equity
compensation
plans
 

Equity compensation plans approved by security holders:

        

2008 Long-Term Incentive Plan

     238,216       $ 1.98         142,992   

2003 Stock Option Plan

     1,000       $ 15.00         —     

Equity compensation plans not approved by security holders:

        

Warrants issued to ViewTrade Financial

and its assigns

     25,068       $ 4.80         —     

Options issued to directors

     30,000       $ 15.00         —     
  

 

 

       

 

 

 

Total

     294,284       $ 1.73         142,992   
  

 

 

       

 

 

 

Unregistered Sales of Equity Securities

All of our unregistered sales of equity securities during 2011 have been previously reported in the Quarterly Reports on Form 10-Q or in a Current Report on Form 8-K.

Repurchases of Equity Securities

During the three months ended December 31, 2011, we acquired, by means of net share settlements, 22,216 shares of Graymark common stock, at an average price of $1.10 per share, related to the vesting of employee restricted stock awards to satisfy withholding tax obligations. We do not have any on-going stock repurchase programs.

Item 6. Selected Financial Data.

We are a smaller reporting company as defined in Rule 12b-2 of the Exchange Act and, accordingly, not required to provide the information required by Item 301 of Regulation S-K with respect to Selected Financial Data.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Graymark Healthcare, Inc. is organized under the laws of the State of Oklahoma and is one of the largest providers of care management solutions to the sleep disorder market based on number of independent sleep care centers and hospital sleep diagnostic programs operated in the United States. We provide a comprehensive diagnosis and care management solutions for patients suffering from sleep disorders.

We provide diagnostic sleep testing services and care management solutions, or SMS, for people with chronic sleep disorders. In addition, we provide therapy services (delivery and set up of CPAP equipment together with training related to the operation and maintenance of CPAP equipment) and the sale of related disposable supplies and components used to maintain the CPAP equipment. Our products and services are used primarily by patients with obstructive sleep apnea, or OSA. Our sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s, or AASM, preferred method of treatment for obstructive sleep apnea. Our sleep diagnostic facilities also determine the correct pressure settings for patient CPAP devices via titration testing. We sell CPAP devices and disposable supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined.

 

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There are non-controlling interests held in some of our testing facilities, typically by physicians located in the geographical area being served by the diagnostic sleep testing facility.

Basis of Presentation

As of December 31, 2010, we had an accumulated deficit of approximately $29.2 million and reported a net loss of approximately $19.1 million for the year then ending. We used approximately $2.4 million in cash from operating activities of continuing operations during the year ending December 31, 2010. Furthermore, we had a working capital deficit of approximately $20.5 million as of December 31, 2010. At that time, there was substantial doubt about our ability to continue as a going concern.

During May 2011 and June 2011, we raised a total of $9.3 million in net proceeds from a private and public offering of common stock and warrants. As of December 31, 2011, we had cash and cash equivalents of $4.9 million and total equity of $4.8 million. In addition, we expect to collect $1.0 million in June 2012 from the Indemnity Escrow Fund related to the ApothecaryRx sale transaction. The $4.9 million in cash and cash equivalents, as of December 31, 2011, and the expected cash availability over the next twelve months of $5.9 million are both more than our projected cash needs for the next twelve months of approximately $5.0 million. As a result, the substantial doubt about our ability to continue as a going concern has been alleviated.

As of December 31, 2011 and 2010, our Debt Service Coverage Ratio is less than 1.25 to 1 which is ratio required by our loan agreement with Arvest Bank. We have obtained a waiver from Arvest Bank for the Debt Service Coverage Ratio until March 31, 2013. As a result, the associated debt with Arvest Bank has been classified as long-term in the accompanying consolidated balance sheets. As of December 31, 2010, we did not have a waiver that extended past twelve months, so the associated debt with Arvest Bank was classified as current at that time. There are no assurances that Arvest Bank will waive any future debt covenant violations. However, we have historically been successful in obtaining waivers from Arvest Bank.

Public Offering and Private Placement Offering

In June 2011, we completed a public offering of 6,000,000 shares of common stock and warrants exercisable for the purchase of 6,700,000 shares for gross proceeds of $8,400,000 or $1.40 per combination of one share of common stock and a warrant to purchase one share of common stock. The underwriter of the offering received sales commissions of $420,350 (5% of the gross proceeds), a corporate finance fee of $168,140 (2% of the gross proceeds) and a legal and other expense allowance of $116,094 (1.4% of the gross proceeds). In conjunction with the offering, each investor received a warrant to purchase one share of common stock for each share of common stock purchased. The warrants are exercisable for the purchase of one share of common stock for $1.50 beginning June 20, 2011 and on or before June 20, 2016. We incurred $824,603 in expenses directly associated with the offering.

In conjunction with the offering, the underwriter had an option to purchase an additional 700,000 shares of our common stock and warrants to purchase 700,000 shares of our common stock solely to cover over-allotments. The underwriter exercised the full over-allotment option with respect to the warrants in June 2011 in connection with the initial closing and we received $7,000 for the purchase of such warrants. In July 2011, we received $472,600 in gross proceeds from the sale of 340,000 over-allotment shares that the underwriter purchased directly from us. The net proceeds of the over-allotment were $439,518.

In May 2011, we executed subscription agreements with existing accredited investors or their affiliates to sell 1,293,103 shares of our common stock in a private placement. The proceeds of the private placement were approximately $3 million ($2.32 per share). The proceeds included $2 million in cash and $1 million from the conversion of the Valiant Note. In conjunction with the private placement, each investor received a warrant to purchase one share of common stock for each common share purchased pursuant to the subscription agreement. The warrants are exercisable for the purchase of one share of common stock for $1.80 beginning November 4, 2011 and on or before May 4, 2014.

 

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Reverse Stock Split

On January 26, 2011, our Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, we received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, our Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. We executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market. The Nasdaq Capital Market requires issuers to maintain a $1.00 minimum bid price. In determining a reverse stock split ratio of 1-for-4, the Board of Directors considered the continued listing standards of the Nasdaq Capital Markets, considered a ratio that would allow us to achieve long-term compliance with the listing standards and which allowed us to have a number of outstanding shares to have sufficient trading volume. Our Board of Directors determined that a ratio of 1-for-4 was the best balance of these various factors. The effect of the reverse split reduced our outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split.

Discontinued Operations

On May 10, 2011, we executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which we sold substantially all of the assets of our subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which we provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. Our decision to sell the assets of East was primarily based on our determination that the operations of East no longer fit into our strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit the our ability to sell CPAP devices and other supplies at the East locations. As a result of the sale of East, the related assets, liabilities, results of operations and cash flows of East have been classified as discontinued operations in the accompanying consolidated financial statements.

On September 1, 2010, we executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of our subsidiary, ApothecaryRx to Walgreens. ApothecaryRx operated 18 retail pharmacies selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx’s assets occurred in December 2010. As a result of the sale of ApothecaryRx’s assets, the remaining assets, and liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations for financial statement reporting purposes.

Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location. We received approximately $24.5 million in net proceeds from the sale of assets of which $2.0 million was deposited into an indemnity escrow account (the “Indemnity Escrow Fund”) as previously agreed pursuant to the terms of an indemnity escrow agreement. These proceeds are net of approximately $1.0 million of security deposits transferred to the buyer and the assumption by the buyer of liabilities associated with goodwill protection agreements and promissory notes. We also received an additional $3.8 million for the sale of inventory to Buyer at 17 of our pharmacies with the inventory for the remaining pharmacy being sold as part of the litigation settlement. We used $22.0 million of the proceeds to pay-down our senior credit facility. In addition, we are required to pay an additional $3.0 million towards the outstanding balance related to our senior credit facility by June 30, 2011. We are currently in discussions with our senior lender regarding this payment and our compliance with required financial covenants.

In December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds held in the Indemnity Escrow Fund were released, without deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund will be released in June 2012 (the 18- month anniversary of the final closing date of the sale), subject to any pending claims for indemnification.

 

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On October 8, 2010, we commenced litigation in U.S. District Court for the District of Colorado against certain former employees of our retail pharmacy in Sterling, Colorado and their affiliates. We claimed, among other things, breaches of certain contractual arrangements and sought monetary damages. On October 13, 2010, a stipulated preliminary injunction was issued in our favor. On December 6, 2010, we settled the non-competition related litigation with certain former employees of our retail pharmacy in Sterling, Colorado and their affiliates. As part of the settlement, we and Walgreens sold assets comprising the long-term care pharmacy business and certain other assets to certain of the defendants. We also agreed to revoke the preliminary injunction in return the defendants agreed to non-competition arrangements acceptable to the Buyer.

Business Operations —Strategic Plan

Over the last twelve months, we have developed a strategic plan for our business operations that is focused on the following goals:

 

  generate significant organic revenue growth;

 

  expand operating margins;

 

  improve and accelerate cash flow; and

 

  increase net income and shareholder value.

Significant Organic Revenue Growth. Management believes that we can achieve significant organic revenue growth by pursuing the following initiatives:

Independent Sleep Care Centers.

We have set specific volume goals by month in 2012 for each of our facilities. We are designing and implementing an incentive pay structure for our sales force to reward them for achieving and surpassing the volume goals. Furthermore, we will enhance our existing monitoring process to enable management to follow volume by location on a daily, weekly and monthly basis to facilitate meeting our volume goals.

We have reengineered our scheduling process in order to schedule patients faster, minimize no shows and last minute cancellations, maximize operating efficiencies by improving tech to patient ratio and maximizing the use of our existing capacity. We feel our reengineered process will increase the rate at which we convert positively diagnosed sleep study patients to therapy services and increase the rate at which we convert therapy service patients to re-supply patients which builds our recurring revenue patient base.

Hospital Sleep Diagnostic Program Management Agreements.

We continue to identify new hospital-based sleep labs and execute management agreements with the facilities that have existing diagnostic sleep operations. We believe that working with facilities that have existing operations ensures that the agreements will be immediately accretive to our earnings. We have set specific volume goals by month in 2012 for each of our management agreements. We have developed and implemented an incentive pay structure for our sales force to reward them for achieving and surpassing volume goals.

In addition, we continue to make joint presentations with hospital administration to hospital’s physician staff delineating the benefits of the diagnosis and treatment of sleep disorders particularly obstructive sleep apnea. We believe this will increase the rate at which we convert positively diagnosed sleep study patients to therapy services and increase the rate at which we convert therapy service patients to re-supply patients which builds our recurring revenue patient base.

 

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Expand Operating Margins, Increase Net Income and Enhance Shareholder Value. Management believes that we can achieve expansion of our operating margins, improved net income and increased shareholder value by pursuing the following initiatives:

Evaluate, minimize and leverage our existing corporate and support services.

We continue to evaluate and right size our finance, billing, scheduling, human resources, re-supply service, sales and marketing departments in terms of structure, staffing requirements, facilities operated and information system integration. We will also evaluate and reengineer our purchasing function to ensure that we are paying the best prices available for our medical and business supplies and services.

We entered into an outsourcing partnership for our re-supply fulfillment and shipping functions.

Improve and Accelerate Cash Flow. Management believes that we can achieve improved and accelerated cash flow by pursuing the following initiatives:

Reengineer Scheduling and Billing Functions.

We have evaluated and are continuing to reengineer our scheduling and billing functions to reduce the time between when our service or supplies are provided and when we receive payment for those services and supplies (“the billing cycle”). During 2012, we will implement a new integrated facility management, scheduling and billing system. This will enhance our scheduling process to ensure that all required documentation is gathered prior to services being rendered or supplies being shipped thereby reducing significantly the number of claims that have to be reworked by the billing department prior to initial billing or after denial by the payor. We will also review and update our policy related to the payment of patient deductible and coinsurance amounts prior to services being rendered or supplies being shipped in order to significantly condense “the billing cycle” and reduce our bad debt write-offs.

Acquisitions Growth Strategy

We plan to grow our business via organic growth related to our Independent Sleep Care Centers, Hospital Sleep Diagnostic Programs (both increased volumes related to existing management agreements and the execution of new management agreements), therapy services and recurring re-supply fulfillment. Acquisitions and the opening of new facilities will also be an integral part of our growth strategy going forward. We will seek to acquire business operations that can be tucked into our existing operations as well as additional independent sleep care centers. We will also seek acquisition opportunities related to therapy service and re-supply business operations. We expect all acquisitions to be accretive to our earnings and fully integrated within ninety (90) days of closing.

On December 12, 2011, we acquired 80% of the Village Sleep Center (“Village”), located in Plano, Texas, for a purchase price of up to $960,000. Under the purchase agreement, we paid $596,000 in cash and withheld $364,000 of the purchase price (“Withheld Funds”) as collateral to secure any obligations the sellers have pursuant to the indemnification clauses of the purchase agreement. The Withheld Funds, less any amounts deducted, shall be paid in two equal installments, not to exceed $182,000. In order to receive the maximum installment payment, the trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) for Village for the years ended December 31, 2012 and 2013 must be at least $200,000, respectively. If the EBITDA for 2012 and or 2013 is less than $200,000, the payment of Withheld Funds will be reduced by the ratio of actual EBITDA to the required EBITDA of $200,000. We estimated the fair value of the contingent consideration or Withheld Funds to be $234,565. We will revalue the contingent consideration on a recurring basis at each reporting period. During the twelve months after the date of the acquisition, any difference between the $234,565 of contingent consideration recorded and the actual payment for Withheld Funds will be recorded as an adjustment to the original purchase accounting. Any adjustments recorded after one year will be recorded as an adjustment to earnings.

Acquisition Goodwill

As of December 31, 2011, we have goodwill of $13.7 million and intangible assets, net of accumulated amortization, of $1.2 million related to the acquisitions we have made since 2008.

 

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Goodwill and other indefinite-lived assets are not amortized, but are subject to impairment reviews annually, or more frequent if necessary. We are required to evaluate the carrying value of goodwill during the fourth quarter of each year and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the related operating unit below its carrying amount. These circumstances may include without limitation

 

  a significant adverse change in legal factors or in business climate,

 

  unanticipated competition, or

 

  an adverse action or assessment by a regulator.

In evaluating whether goodwill is impaired, we must compare the fair value of the operating unit to which the goodwill is assigned to the operating units carrying amount, including goodwill. The fair value of the operating unit will be estimated using a combination of the income, or discounted cash flows, approach and the market approach that utilize comparable companies data. If the carrying amount of the operating unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of an operating unit to its carrying amount. In calculating the implied fair value of the operating unit goodwill, the fair value of the operating unit will be allocated to all of the other assets and liabilities of that operating unit based on their fair values. The excess of the fair value of an operating unit over the amount assigned to its other assets and liabilities will be the implied fair value of goodwill. An impairment loss will be recognized when the carrying amount of goodwill exceeds its implied fair value.

Our evaluation of goodwill and indefinite lived intangible assets completed during December 2011 resulted in no impairment. During 2010, based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units, we determined that the carrying value of goodwill related to our sleep centers located in Oklahoma, Nevada and Texas exceeded their fair value. In addition, we determined the carrying value our intangible assets associated with East and certain other intangibles exceeded their fair value. Accordingly, we recorded a noncash impairment charge, in December 2010, of $7.5 million and $0.4 million, respectively, on goodwill and other intangible assets.

Operating Statistics:

The following table summarizes our locations as of December 31, 2011 and 2010:

 

     Number of Locations  

Location Type

   2011      2010  

Sleep centers

     22         26   

Managed sleep centers

     78         72   
  

 

 

    

 

 

 

Total

     100         98   
  

 

 

    

 

 

 

The following table summarizes unit sales and other operating statistics, by quarter, for the years ended December 31, 2011 and 2010:

 

     1st Qtr.      2nd Qtr.      3rd Qtr.      4th Qtr.      Total  

Sleep studies performed:

              

2011

     3,515         4,005         4,245         4,101         15,866   

2010

     4,083         4,358         4,060         3,754         16,255   

CPAP set ups performed:

              

2011

     684         683         694         610         2,671   

2010

     620         744         807         860         3,031   

 

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Results of Operations

The following table sets forth selected results of our operations for the years ended December 31, 2011 and 2010. The following information was derived and taken from our audited financial statements appearing elsewhere in this report.

Comparison of 2011 and 2010

 

     For the Years Ended
December 31,
 
     2011     2010  

Net revenues

   $ 17,509,794      $ 20,521,371   

Cost of services and sales

     6,880,144        7,144,066   

Selling, general and administrative expenses

     13,743,820        15,821,701   

Bad debt expense

     895,863        1,803,100   

Impairment of goodwill and intangible assets

     —          7,874,886   

Impairment of fixed assets

     —          762,224   

Depreciation and amortization

     1,110,735        1,278,594   

Net other expense

     1,282,884        1,428,382   
  

 

 

   

 

 

 

Loss from continuing operations, before taxes

     (6,403,652     (15,591,582

Provision for income taxes

     (13,992     (118,000
  

 

 

   

 

 

 

Loss from continuing operations, net of taxes

     (6,417,644     (15,709,582

Income (loss) from discontinued operations, net of taxes

     291,155        (3,579,937
  

 

 

   

 

 

 

Net loss

     (6,126,489     (19,289,519

Less: Non-controlling interests

     (232,080     (153,513
  

 

 

   

 

 

 

Net loss attributable to Graymark Healthcare

   $ (5,894,409   $ (19,136,006
  

 

 

   

 

 

 

Discussion of Years Ended December 31, 2011 and 2010

Services revenues decreased $2.4 million (a 16.1% decrease) for the fiscal year ended December 31, 2011 compared with 2010. Our sleep diagnostic services are performed in two environments, our independent diagnostic testing facilities (“IDTF”) and at contracted client locations (“Hospital/Outreach”). For studies performed in our IDTF locations, we generally bill third-party payors for the sleep study. In our hospital and outreach agreements, we are paid a contracted fee per study performed. In our more rural outreach locations, our contracted rates are typically higher due to the additional costs associated with servicing more remote locations. Our urban hospital agreements tend to be at a lower rate due to the reimbursement environment and lower costs to serve. The decline in revenues from sleep diagnostic services during 2011 compared to 2010 was due to a $2.9 million decrease at our IDTF locations and a $0.1 million decrease in our clinics, offset by a $0.6 million increase at our Hospital/Outreach locations.

The $2.9 million decrease at our IDTF locations was due to the following:

 

  In May 2011, we transitioned our Tulsa Midtown IDTF location to a contracted hospital location. As part of this transition, reimbursement at this location changed from the IDTF third-party billing model to a rate per day model under the hospital contract and is now included in the Hospital/Outreach category. This change resulted in a reduction in revenue of $0.7 million during 2011 compared to 2010.

 

  During 2011, we have closed three unprofitable IDTF facilities. The closing of these facilities accounted for $0.4 million of the reduction in IDTF revenue in 2011 compared to 2010.

 

  A decrease in volumes at our existing IDTF locations during 2011compared to 2010 resulted in a revenue reduction of $0.8 million. During the first quarter of 2011, we incurred a series of severe weather events at our locations in Kansas, Iowa, South Dakota, Oklahoma and Texas which negatively impacted our volumes in those months. As a result of the severe weather, several of our labs were forced to close on multiple days during those months, contributing to reduced volumes compared to 2010.

 

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  A decrease in our average reimbursement per sleep study from our existing facilities during 2011 resulted in a revenue reduction of $1.0 million compared to 2010. Of the year to date variance $0.9 million occurred in the first six months of 2011 compared to the first six months of 2010 and was driven by a significant shift to in-network reimbursement beginning in the third quarter of 2010. The revenue reduction related to rate for the second half of 2011 compared to the second half of 2010 is $0.1 million.

The $0.6 million increase in our Hospital/Outreach locations was due to the following:

 

  As described above, we transitioned our Tulsa Midtown IDTF location to a contracted hospital location in May 2011. As a result for the third quarter, revenue from this location is included in our Hospital/Outreach category. This change accounts for $0.4 million of the revenue increase for 2011 compared to 2010.

 

  During 2011, we commenced operations at thirteen new hospital locations. The addition of these Hospital/Outreach locations resulted in a revenue increase $0.5 million for in 2011 compared to 2010.

 

  Periodically, we receive revenues from performing research studies at our clinics in Kansas City, Missouri. The volume of research studies is sporadic and is driven by the physicians who lead the studies. During 2011, we performed significantly fewer research sleep studies compared to 2010. This decline in research studies resulted in a reduction of $0.2 million in revenue in 2011 compared to 2010.

 

  A reduction in the average revenue per sleep study in our existing Hospital/Outreach business resulted in decreased revenue of $0.1 million during 2011 compared to 2010. The lower average reimbursement is primarily due to a change in sleep study mix between facilities towards lower average reimbursement locations.

The $0.1 million decline in revenues related to our clinic services was related to the closing of our clinics in the Oklahoma City area.

During the first quarter of 2011, we focused on driving increased volume in our sleep diagnostic centers by making several key management changes in our sales team and implementing new sales incentive initiatives. In addition, during the third and fourth quarters of 2011, we centralized our benefits verification and scheduling processes, which drove an improvement in our conversion rate of referrals to sleep studies.

Product revenues from our sleep therapy business decreased $0.6 million (a 10.9% decrease) during 2011 compared to 2010. The decrease was due to $0.9 million in lower set-up revenue driven by a combination of lower volumes due to lower conversion rates of sleep studies to CPAP set-ups and lower average reimbursement per set-up, offset by a $0.3 million increase in supply revenues reflecting the continued growth of our re-supply business.

Cost of services decreased $0.4 million (a 6.9% decrease) to $5.1 million from $5.5 million during 2011 compared to 2010. The decrease in cost of services was primarily due to decreased sleep study volumes and operational efficiencies including a decrease in technician labor cost per sleep study performed and the renegotiation and resulting reduction of professional interpretation fees.

Cost of services as a percent of service revenue was 40.9% and 36.9% during 2011 and 2010, respectively. The increase in cost of services as a percent of service revenue was primarily due to the shift in our business towards Hospital/Outreach sleep studies which have a lower reimbursement per sleep study compared to our IDTF locations, and as a result has a higher cost of service as a percentage of revenue. During 2011, 61% of our sleep studies were performed in an IDTF location compared to 73% in 2010. The higher cost of service percentage in Hospital/Outreach locations is more than offset by the significantly lower operating expense associated with these locations, primarily related to the lack of facility costs.

 

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Cost of sales from our sleep therapy business increased $0.1 million during 2011 compared with 2010. The increase was due to an adjustment of approximately $0.1 million in the second quarter of 2010 to reflect the appropriate cost of sales and inventory levels for in-service equipment. Net of that adjustment, cost of sales from our therapy business would have been flat compared to 2010.

Cost of sales as a percent of product sales was 35.2% and 29.3% during 2011 and 2010, respectively. The increase in cost of sales as a percent of product sales was partly due to the previously described adjustment in the third quarter of 2010 (accounting for 2.0% of the 6.0% variance). In addition, the following changes contributed to the increase in the cost of sales as a percent of product sales:

 

  Beginning in July 2011, we began providing certain CPAP supplies to patients in our Texas, Oklahoma and Nevada markets every month rather than once a quarter which has the effect of increasing our sales of theses supplies by four times over a twelve month period. The monthly supply items have a lower margin than the supply items we sale on a quarterly basis and a lower margin than CPAP set-ups.

 

  Beginning in the third quarter of 2011, due to the CPAP prescribing patterns of a few physicians in our Texas and Oklahoma markets, our mix of CPAP equipment shifted to higher cost equipment which caused an increase in the average cost of our CPAP equipment compared to the second half of 2010.

Selling, general and administrative expenses decreased $2.1 million (a 13.1% decrease) to $13.7 million or 78.5% of revenue in 2011 from $15.8 million or 77.1% of revenue during 2010. The decrease in selling, general and administrative expenses was primarily due to:

 

  a decrease in operating expenses in our sleep diagnostic business of $1.5 million due to the implementation of several cost reduction initiatives including staff reductions, renegotiation of facility leases, consolidation of non-profitable facilities during the last three quarters of 2010 and the first quarter of 2011 and the increase in Hospital/Outreach agreements which have significantly lower operating costs than our IDTF facilities;

 

  an increase in operating expense in our sleep therapy business of $0.4 million as we expanded our infrastructure in order to gain operating efficiencies and prepare for continued growth in this business unit; and

 

  a decrease in overhead incurred at the parent-company level of $1.0 million due to decreased stock compensation expense of $0.1 million, $0.7 million related to reductions in executive staff reductions and $0.4 million in lower accounting and other professional service fees. These reductions were partially offset by an increase in bank fees of $0.2 million primarily related to waivers from our primary lender.

Bad debt expense for 2011 decreased $0.9 million (a 50.3% decrease) to $0.9 million or 5.1% of revenue from $1.8 million or 8.8% of revenue for 2010. Overall, we have improved our collections on current claims compared to 2010 and we have implemented specific programs in the third and fourth quarters of 2011 to address the growth in our older aging categories, both of which have driven the improvement in our bad debt expense in 2011 compared to 2010.

Depreciation and amortization represents the depreciation expense associated with our fixed assets and the amortization attributable to our intangible assets. Depreciation and amortization decreased $0.2 million (a 13.2% decrease) during 2011 compared to 2010. The decrease is primarily due to the fixed asset impairment of $0.8 million recorded in the third quarter of 2010 which reduced the overall asset base and depreciation rates.

 

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Impairment of goodwill and intangible assets – during the fourth quarter of 2010, we completed our annual impairment review of goodwill and other intangible assets. Based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units, we determined that the carrying value of goodwill related to our sleep centers located in Oklahoma, Nevada and Texas exceeded their fair value. In addition, we determined the carrying value our intangible assets associated with East and certain other intangibles exceeded their fair value. Accordingly, we recorded a noncash impairment charge, in December 2010, of $7.5 million and $3.2 million, respectively, on goodwill and other intangible assets. Our evaluation of goodwill and indefinite lived intangible assets completed during December 2011 resulted in no impairment losses.

Impairment of fixed assets – during the third quarter of 2010, we identified impairment indicators at certain sleep diagnostic facilities and office facilities. The impairment indicators related to certain sleep diagnostic systems that were no longer compatible with current systems and assets associated with certain sleep diagnostic and office facilities closed or consolidated into existing facilities. Accordingly, we performed a recoverability test and an impairment test on these locations and determined, based on the results of an undiscounted cash flow analysis (level 3 in the fair value hierarchy), that the fair value of the identified assets was less than their carrying value. As a result, an impairment charge of $762,224 was recorded.

Net other expense represents interest expense on borrowings reduced by interest income earned on cash and cash equivalents. Net other expense decreased $0.1 million (a 10.2% decrease) during 2011 compared with 2010. The decrease is related to reduced interest expense in 2011 due to the payment of principal on our senior debt with Arvest bank.

Income from discontinued operations represents primarily the net income (loss) from East and ApothecaryRx. In May 2011 and December 2010, we executed sale substantially all of the assets of East and ApothecaryRx. As a result of the sale of East and ApothecaryRx, the related assets, liabilities, results of operations and cash flows of East and ApothecaryRx have been classified as discontinued operations. In addition, we have discontinued operations related to our discontinued internet sales division and discontinued film operations. The results of East, ApothecaryRx and our other discontinued operations for the years ended December 31, 2011 and 2010 follows:

 

     2011     2010  

Revenues

   $ 410,683      $ 81,299,700   
  

 

 

   

 

 

 

Income (loss) before taxes – East

   $ 25,796      $ (2,163,854

Income (loss) before taxes – ApothecaryRx

     (426,067     (324,092

Income (loss) before taxes – other

     (43,298     (220,258

Income tax (provision)

     —          —     
  

 

 

   

 

 

 

Income (loss) from operations of discontinued operations, net of tax

     (443,569     (2,708,204

Special (charges) incurred on sale

     —          (6,516,613

Gain recorded on sale

     734,724        5,644,880   
  

 

 

   

 

 

 

Income (loss) from discontinued operations

   $ 291,155      $ (3,579,937
  

 

 

   

 

 

 

During 2010, we recorded a special charge of approximately $6.5 million related to certain estimated costs resulting from the ApothecaryRx Sale. The components of the special charge are as follows:

 

Loss on liquidation of inventory

   $ 2,041,051   

Bad debt expense on remaining accounts receivable

     3,003,190   

Lease termination costs

     859,580   

Severance and payroll costs

     493,303   

Equipment removal and lease termination costs

     119,489   
  

 

 

 

Total charge

   $ 6,516,613   
  

 

 

 

 

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The charges noted above were incurred as a result of the following:

 

  We did not sell certain of the front-end merchandise and private-label and other over the counter drugs as part of the ApothecaryRx Sale. The loss on liquidation of inventory represents the loss on items that have been liquidated and the write-down of remaining inventory to expected liquidated values.

 

  We recorded a reserve for substantially all outstanding accounts receivable that have not been collected as of January 31, 2011. Historically, we collected accounts receivable within 30 days, but after the ApothecaryRx sale, we saw a significant delay from third-party payers. During 2011, we collected approximately $427,000 from the accounts that were outstanding at January 31, 2011. This amount was recorded as a bad debt recovery in 2011. We do not anticipate any future collections from the remaining ARx accounts receivable.

 

  We incurred certain severance and payroll costs, lease termination costs and equipment removal costs related to the pharmacy locations which were not assumed by the buyer.

Additional charges may be recorded in future periods dependent upon the final resolution of the items listed above.

Noncontrolling interests were allocated approximately $232,000 and $154,000 of net losses during 2011 and 2010. Noncontrolling interests are the equity ownership interests in our SDC Holdings subsidiaries that are not wholly-owned.

Net income (loss) attributable to Graymark Healthcare. Our operations resulted in a net loss of approximately $5.9 million (34% of approximately $17.5 million in net revenues) during 2011, compared to a net loss of approximately $19.1 million (93% of approximately $20.5 million in net revenues) during 2010.

Liquidity and Capital Resources

Generally our liquidity and capital resources needs are funded from operations, loan proceeds and equity offerings. As of December 31, 2011, our liquidity and capital resources included cash and cash equivalents of $4.9 million and working capital of $3.9 million. As of December 31, 2010, our liquidity and capital resources included cash and cash equivalents of $0.6 million and a working capital deficit of $20.5 million. The working capital deficit as of December 31, 2010 was a result of classifying our Arvest Credit Facility as current due to non-compliance with certain loan covenants.

Cash used in operating activities from continuing operations was $5.0 million during 2011 compared to $3.2 million during 2010. During 2011, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net of non-cash adjustments) of $4.1 million, a net reduction of accounts payable and accrued liabilities totaling $0.2 million, and an increase in accounts receivable and other assets totaling $1.4 million. The primary sources of cash from operating activities during 2011 were a decrease in inventory and other assets of $0.7 million. During 2010, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net of non-cash adjustments) of $3.6 million, increase in inventories and accounts receivable totaling $0.7 million. The primary sources of cash from operating activities from continuing operations during 2010 was a net increase in accounts payable and accrued liabilities of $0.9 million.

Cash provided by discontinued operations during 2011 was $1.2 million compared to 2010 when discontinued operations used cash of $0.7 million. The cash provided by discontinued operations during 2011 was primarily related to $1.0 million received from the release of escrow funds related to the sale of ApothecaryRx.

Net cash used by investing activities from continuing operations during 2011 was approximately $0.7 million, including $0.6 million related to the acquisition of Village Sleep, compared to 2010 when investing activities from continuing operations used approximately $0.3 million resulting from the purchase of equipment net of dispositions.

 

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Net cash provided by investing activities from discontinued operations during 2011 was $2.5 million compared to $29.1 million in 2010. In May 2011, we sold substantially all of the assets of East for $2.5 million. In December 2010, we sold substantially all of the assets of ApothecaryRx for $29.3 million.

Net cash provided by financing activities from continuing operations during 2011 was $6.3 million compared to net cash used in financing activities of $5.2 million during 2010. During 2011, we raised $7.3 million and $2.0 million in a public offering and private placement offering, respectively. We also received $1.0 million in proceeds from our credit facility with Valiant Investments, LLC which was subsequently repaid with common stock in conjunction with the private placement. During 2011, we made debt payments of $3.9 million. During 2010, the primary use of cash from financing activities from continuing operations was debt payments totaling $5.2 million.

Net cash used in financing activities from discontinued operations during 2010 was $20.0 million which was primarily related to $22 million in debt payments that were made from the proceeds of the sale of ApothecaryRx assets.

In December 2011, 50% of the funds held in the Indemnity Escrow Fund ($1.0 million) were released, without deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund will be released on the 18-month anniversary of the final closing date of the sale (June 2012), subject to any pending claims for indemnification at that time. Of the $2,000,000 Indemnity Escrow Fund, $1,000,000 was subject to partial or full recovery by the buyer if the average daily prescription sales at the buyer’s location in Sterling, Colorado over a six-month period after the buyer purchased the ApothecaryRx location in Sterling, Colorado did not increase by a certain percentage of the average daily prescription sales of ApothecaryRx’s Sterling, Colorado location during a period prior to the closing (the “Retention Rate Earnout”). The six-month period has passed and there was no adjustment as a result of the Retention Rate Earnout.

Arvest Credit Facility

Effective May 21, 2008, we and each of Oliver Company Holdings, LLC, Roy T. Oliver, The Roy T. Oliver Revocable Trust, Stanton M. Nelson, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and, Lewis P. Zeidner (the “Guarantors”) entered into a Loan Agreement with Arvest Bank (the “Arvest Credit Facility”). The Arvest Credit Facility consolidated the prior loan to our subsidiaries, SDC Holdings and ApothecaryRx in the principal amount of $30 million (referred to as the “Term Loan”) and provided an additional credit facility in the principal amount of $15 million (the “Acquisition Line”) for total principal of $45 million. The Loan Agreement was subsequently amended in January 2009 (the “Amendment”), May 2009, July 2010, December 2010 and March 2012. As of December 31, 2010, the outstanding principal amount of the Arvest Credit Facility was $22,396,935.

Personal Guaranties. The Guarantors unconditionally guarantee payment of our obligations owed to Arvest Bank and our performance under the Loan Agreement and related documents. The initial liability of the Guarantors as a group is limited to $15 million of the last portion or dollars of our obligations collected by Arvest Bank. The liability of the Guarantors under the guaranties initially was in proportion to their ownership of our common stock shares as a group on a several and not joint basis. In conjunction with the employment termination of Mr. Luster, we agreed to obtain release of his guaranty. The Amendment released Mr. Luster from his personal guaranty and the personal guaranties of the other Guarantors were increased, other than the guaranties of Messrs. Salalati and Ely. During the third quarter of 2010, Mr. Oliver and Mr. Nelson assumed the personal guaranty of Mr. Salalati.

Furthermore, the Guarantors agreed to not sell, transfer or otherwise dispose of or create, assume or suffer to exist any pledge, lien, security interest, charge or encumbrance on our common stock shares owned by them that exceeds, in one or an aggregate of transactions, 20% of the respective common stock shares owned at May 21, 2008, except after notice to Arvest Bank. Also, the Guarantors agreed to not sell, transfer or permit to be transferred voluntarily or by operation of law assets owned by the applicable Guarantor that would materially impair the financial worth of the Guarantor or Arvest Bank’s ability to collect the full amount of our obligations.

Maturity Dates. Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of advance or tranche (the “Tranche Note Maturity Date”). The maturity dates of each tranche of debt under the Acquisition Line range from June 2014 to August 2015. The Term Loan will become due on May 21, 2014.

 

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Interest Rate. The outstanding principal amounts of Acquisition Line and Term Loan bear interest at the greater of the prime rate as reported in the “Money Rates” section of The Wall Street Journal (the “WSJ Prime Rate”) or 6% (“Floor Rate”). Prior to June 30, 2010, the Floor Rate was 5%. The WSJ Prime Rate is adjusted annually, subject to the Floor Rate, then in effect on May 21 of each year of the Term Loan and the anniversary date of each advance or tranche of the Acquisition Line. In the event of our default under the terms of the Arvest Credit Facility, the outstanding principal will bear interest at the per annum rate equal to the greater of 15% or the WSJ Prime Rate plus 5%.

Interest and Principal Payments. Provided we are not in default, the Term Note is payable in quarterly payments of accrued and unpaid interest on each September 1, December 1, March 1, and June 1. Commencing on September 1, 2011, and quarterly thereafter on each December 1, March 1, June 1 and September 1, we are obligated to make equal payments of principal and interest calculated on a seven-year amortization of the unpaid principal balance of the Term Note as of June 1, 2011 at the then current WSJ Prime Rate or Floor Rate, and adjusted annually thereafter for any changes to the WSJ Prime Rate or Floor Rate as provided herein. The entire unpaid principal balance of the Term Note plus all accrued and unpaid interest thereon will be due and payable on May 21, 2014.

Furthermore, each advance or tranche of the Acquisition Line is repaid in quarterly payments of interest only for up to three years and thereafter, principal and interest payments based on a seven-year amortization until the balloon payment on the Tranche Note Maturity Date. We agreed to pay accrued and unpaid interest only at the WSJ Prime Rate or Floor Rate in quarterly payments on each advance or tranche of the Acquisition Line for the first three years of the term of the advance or tranche commencing three months after the first day of the month following the date of advance and on the first day of each third month thereafter. Commencing on the third anniversary of the first quarterly payment date, and each following anniversary thereof, the principal balance outstanding on an advance or tranche of the Acquisition Line, together with interest at the WSJ Prime Rate or Floor Rate on the most recent anniversary date of the date of advance, will be amortized in quarterly payments over a seven-year term beginning on the third anniversary of the date of advance, and recalculated each anniversary thereafter over the remaining portion of such seven-year period at the then applicable WSJ Prime Rate or Floor Rate. The entire unpaid principal balance of the Acquisition Line plus all accrued and unpaid interest thereon will be due and payable on the respective Tranche Note Maturity Date.

Use of Proceeds. All proceeds of the Term Loan were used solely for the funding of the acquisition and refinancing of the existing indebtedness and loans owed to Intrust Bank, the refinancing of the existing indebtedness owed to Arvest Bank; and other costs we incurred by Arvest Bank in connection with the preparation of the loan documents, subject to approval by Arvest Bank.

The proceeds of the Acquisition Line are to be used solely for the funding of up to 70% of either the purchase price of the acquisition of existing pharmacy business assets or sleep testing facilities or the startup costs of new sleep centers and other costs incurred by us or Arvest Bank in connection with the preparation of the Loan Agreement and related documents, subject to approval by Arvest Bank.

Collateral. Payment and performance of our obligations under the Arvest Credit Facility are secured by the personal guaranties of the Guarantors and in general our assets. If we sell any assets which are collateral for the Arvest Credit Facility, then subject to certain exceptions and without the consent of Arvest Bank, such sale proceeds must be used to reduce the amounts outstanding to Arvest Bank.

Debt Service Coverage Ratio. Based on the latest four rolling quarters, we agreed to continuously maintain a “Debt Service Coverage Ratio” of not less than 1.25 to 1. Debt Service Coverage Ratio is, for any period, the ratio of:

 

  the net income of Graymark Healthcare (i) increased (to the extent deducted in determining net income) by the sum, without duplication, of our interest expense, amortization, depreciation, and non-recurring expenses as approved by Arvest, and (ii) decreased (to the extent included in determining net income and without duplication) by the amount of minority interest share of net income and distributions to minority interests for taxes, if any, to

 

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  the annual debt service including interest expense and current maturities of indebtedness as determined in accordance with generally accepted accounting principles.

If we acquire another company or its business, the net income of the acquired company and the new debt service associated with acquiring the company may both be excluded from the Debt Service Coverage Ratio, at our option.

Compliance with Financial Covenants. As of December 31, 2011, our Debt Service Coverage Ratio is less than 1.25 to 1. Arvest Bank has waived the Debt Service Coverage Ratio and Minimum Net Worth requirements until March 31, 2013. In April 2012 and as a condition of obtaining the waiver, we agreed to the following conditions:

 

  We paid all principal and interest due on the Arvest Debt through June 30, 2012.

 

  We will pay on or before June 30, 2012, all principal and interest due on the Arvest Debt through December 31, 2012.

 

  Beginning on April 1, 2012, and continuing through June 4, 2012, we must have $1.75 million in cash on hand and beginning June 5, 2012 and ending on June 30, 2012, we must have $2.5 million in cash prior to making the required principal and interest prepayment due on June 30, 2012.

 

  Beginning on September 30, 2012, and on the last day of each quarter thereafter, our EBITDA must be positive for the immediately prior quarter. EBITDA is defined as net income plus: (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense and (iv) non-cash charges including impairment charges and stock compensation.

There is no assurance that Arvest Bank will waive any future violations of the Debt Service Coverage Ratio covenant. However, we have historically been successful in obtaining waivers from Arvest Bank.

Default and Remedies. In addition to the general defaults of failure to perform our obligations and those of the Guarantors, collateral casualties, misrepresentation, bankruptcy, entry of a judgment of $50,000 or more, failure of first liens on collateral, default also includes our delisting by The Nasdaq Stock Market, Inc. In the event a default is not cured within 10 days or in some case five days following notice of the default by Arvest Bank (and in the case of failure to perform a payment obligation for three times with notice), Arvest Bank will have the right to declare the outstanding principal and accrued and unpaid interest immediately due and payable.

Deposit Account Control Agreement. Effective June 30, 2010, we entered into a Deposit Control Agreement (“Deposit Agreement”) with Arvest Bank and Valliance Bank covering the deposit accounts that we have at Valliance Bank. The Deposit Agreement requires Valliance Bank to comply with instructions originated by Arvest Bank directing the disposition of the funds held by us at Valliance Bank without our further consent. Without Arvest Bank’s consent, we cannot close any of our deposit accounts at Valliance Bank or open any additional accounts at Valliance Bank. Arvest Bank may exercise its rights to give instructions to Valliance Bank under the Deposit Agreement only in the event of an uncured default under the Loan Agreement, as amended.

Loan Agreement

On March 16, 2011, we entered into a Loan Agreement with Valiant Investments, LLC, an entity owned and controlled by Roy T. Oliver one of our controlling shareholders, of up to $1 million. We used the loan proceeds to fund our working capital needs. We fully advanced the loan during the third quarter of 2011 and in May 2011, we repaid the loan with common stock as part of our private placement offering. On March 11, 2011, we received the consent of Arvest to obtain this loan and requirements for payments of interest and principal on this loan.

 

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Financial Commitments

We do not have any material capital commitments during the next 12 months except for a commitment for leasehold improvements of approximately $0.5 million. The commitment for leasehold improvements relates to a lease executed in March 2012 for our new corporate headquarters and offices. These offices are occupied under a lease agreement with City Place, LLC (“City Place”), requiring monthly rental payments of $17,970 plus additional payments for our allocable share of the basic expenses of City Place. The lease agreement with City Place expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of our greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, our Chief Executive Officer. In addition, we have contractual commitments of approximately $4.6 million for payments on our indebtedness, operating lease payments and other long-term liabilities. Although we have not entered into any definitive arrangements for obtaining additional capital resources, either through long-term lending arrangements or equity offering, we continue to explore various capital resource alternatives to replace our long-term bank indebtedness.

Our future commitments under contractual obligations by expected maturity date at December 31, 2011 are as follows:

 

     < 1 year      1-3 years      3-5 years      > 5 years      Total  

Long-term debt (1)

   $ 3,196,478       $ 15,224,100       $ 3,867,503       $ —         $ 22,288,081   

Operating leases

     1,257,709         1,954,000         812,011         2,103,253         6,126,973   

Other long-term liabilities (2)

     117,283         117,282         —           —           234,565   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 4,571,470       $ 17,295,382       $ 4,679,514       $ 2,103,253       $ 28,649,619   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
(1) Includes principal and interest obligations.
(2) Represents contingent purchase consideration on our acquisition of Village Sleep Center in December 2011.

Off-Balance Sheet Arrangements

We had no material off-balance sheet arrangements (as defined in Item 303(a) (4) of Regulation S-K) as of December 31, 2011 and 2010.

CRITICAL ACCOUNTING POLICIES

The consolidated condensed financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future statements. Some of the more significant estimates include revenue recognition, allowance for contractual adjustments and doubtful accounts, and goodwill and intangible asset impairment. We use the following methods to determine our estimates:

Revenue recognition – Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payers. Insurance benefits are assigned to us and, accordingly, we bill on behalf of our customers. For our sleep diagnostic business, we estimate the net realizable amount based primarily on the contracted rates stated in the contracts we have with various payors. We have used this method to determine the net revenue for the business acquired from somniCare, Inc. and somniTech, Inc. (“Somni”) business since the date of the acquisition in 2009 and for our remaining sleep diagnostic business since the fourth quarter of 2010. We do not anticipate any future changes to this process. In our historic sleep therapy business, the business has been predominantly out-of-network and as a result, we have not had contract rates to use for determining net revenue for a majority of our payors. For this portion of the business, we perform a quarterly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, we calculate the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. During the fourth quarter of 2010, we migrated much of our historic sleep diagnostic business to an in-network position. As a result, commencing with the fourth quarter of 2010, the revenue from our historic sleep diagnostic business was determined using the process utilized in the Somni business. We expect to transition our historic sleep therapy business to the same process currently used for our sleep diagnostic business by the end of 2011. This change in process and assumptions for our historic sleep therapy business is not expected to have a material impact on future operating results.

 

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For certain sleep therapy and other equipment sales, reimbursement from third-party payers occur over a period of time, typically 10 to 13 months. We recognize revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.

We have established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to our collection procedures. Revenues are reported net of such adjustments.

Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payers may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for our products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service. Starting in 2010, we implemented a process to estimate amounts due from patients prior to service and increase collection of those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

Cost of Services and Sales – Cost of services includes technician labor required to perform sleep diagnostics, fees associated with interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the revenue from the sale is recognized over a specified period, the product cost associated with that sale is recognized over that same period. If the revenue from a product sale is recognized in one period, the cost of sale is recorded in the period the product was sold.

Accounts Receivable – Accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts. The majority of our accounts receivable is due from private insurance carriers, Medicare and Medicaid and other third-party payors, as well as from customers under co-insurance and deductible provisions.

Third-party reimbursement is a complicated process that involves submission of claims to multiple payers, each having its own claims requirements. Adding to this complexity, a significant portion of our business has historically been out-of-network with several payors, which means we do not have defined contracted reimbursement rates with these payors. For this reason, our systems reported revenue at a higher gross billed amount, which we adjusted to an expected net amount based on historic payments. This process continues in our historic sleep therapy business, but was changed in the fourth quarter of 2010 for our historic sleep diagnostic business. As a result, the reserve for contractual allowance has been reduced, compared to the same periods in 2010, as our systems now report a larger portion of our business at estimated net contract rates. As we continue to move more of our business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. We have established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payers and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.

 

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We offer payment plans to patients for amounts due from them for the sales and services we provide. For patients with a balance of $500 or less, we allow a maximum of three months for the patient to pay the amount due. For patients with a balance over $500, we allow a maximum of six months to pay the full amount due. The minimum monthly payment amount for both plans is calculated based on the down payment and the remaining balance divided by three or six months, respectively.

Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, we utilize a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin at 60 days from the initial statement. If the patient is on a payment program, these efforts begin within 30 days of the patient failing to make a planned payment. For our diagnostic patients, we submit patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For our therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 240 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is our policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by our collection agency, the amounts previously written-off are accounted for as a recovery of bad debt. For amounts due from third party payors, it is our policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.

Included in accounts receivable are earned but unbilled receivables. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, we perform certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payers. Billing delays, ranging from several weeks to several months, can occur due to delays in obtaining certain required payer-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payer does not accept the claim for payment, the customer is ultimately responsible.

A summary of the Days Sales Outstanding (“DSO”) and management’s expectations for the years ended December 31, 2011 and 2010 follows:

 

     2011      2010  
     Actual      Expected      Actual      Expected  

Sleep diagnostic business

     63.52         55 to 60         51.25         50 to 55   

Sleep therapy business

     71.45         65 to 70         52.14         55 to 60   

Our DSO during 2011 was higher than our levels in 2010 in part due to the increase in sales, during the 4th quarter of 2011 versus the same quarter in 2010, driving an increase in our overall accounts receivable balances. We began to see the increase in DSO and overall accounts receivable in the third quarter of 2011. We began to implement specific action plans in the third and fourth quarters of 2011 to address the increase in both the overall level of receivables and the DSO. The plans addressing the older receivable balances (over 180 days) were implemented in the fourth quarter and therefore have not yet had the full expected impact on our receivable balances. Based on the third quarter DSO levels and based on the expected timing for the process improvement and collection efforts to impact our receivables, we adjusted our DSO expectations upward during the fourth quarter of 2011. While we saw improvement in our DSO in December compared to the other months in the quarter, we still exceeded our DSO expectations at December 31, 2011. However we expect to see the continued impact of our process improvements and collections efforts in the first quarter of 2012 and as a result DSO should return to these expected levels and then continue to improve during 2012.

Goodwill and Intangible Assets – Goodwill is the excess of the purchase price paid over the fair value of the net assets of the acquired business. Goodwill and other indefinitely-lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.

 

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Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to fifteen years. We evaluate the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Change in Accounting Method – On January 1, 2010, we elected to change our method of revenue recognition for sleep therapy equipment sales that are paid for over time (“rental equipment”) to recognize the revenue for rental equipment over the life of the rental period which typically ranges from 10 to 13 months. Prior to the business acquisitions made in the 3rd quarter of 2009, we recognized the total amount of revenue for entire rental equipment period at the inception of the rental period with an offsetting entry for estimated returns. The entities that were acquired in 2009 recorded revenue for rental equipment consistent with method being adopted. Recording revenue for rental equipment over the life of the rental period will provide more accurate interim information as this method relies less on estimates than the previous method in which potential rental returns had to be estimated.

We have determined that it is impracticable to determine the cumulative effect of applying this change retrospectively because historical transactional level records are no longer available in a manner that would allow for the appropriate calculations for the historical periods presented. As a result, we will apply the change in revenue recognition for rental equipment on a prospective basis. As a result of the accounting change, our accumulated deficit increased $213,500, as of January 1, 2010, from $9,689,471, as originally reported, to $10,082,971.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

On January 1, 2011, we adopted changes issued by the Financial Accounting Standards Board (FASB) to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on our consolidated financial statements, as we do not currently have any such arrangements with its customers.

On January 1, 2011, we adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on our consolidated financial statements.

On January 1, 2011, we adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on our consolidated financial statements.

 

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Effective January 1, 2010, we adopted changes issued by the FASB on January 6, 2010, for a scope clarification to the FASB’s previously-issued guidance on accounting for noncontrolling interests in consolidated financial statements. These changes clarify the accounting and reporting guidance for noncontrolling interests and changes in ownership interests of a consolidated subsidiary. An entity is required to deconsolidate a subsidiary when the entity ceases to have a controlling financial interest in the subsidiary. Upon deconsolidation of a subsidiary, an entity recognizes a gain or loss on the transaction and measures any retained investment in the subsidiary at fair value. The gain or loss includes any gain or loss associated with the difference between the fair value of the retained investment in the subsidiary and its carrying amount at the date the subsidiary is deconsolidated. In contrast, an entity is required to account for a decrease in its ownership interest of a subsidiary that does not result in a change of control of the subsidiary as an equity transaction. The adoption of these changes had no impact on our consolidated financial statements.

Effective January 1, 2010, we adopted changes issued by the FASB on January 21, 2010, to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. The changes also clarify existing disclosure requirements related to how assets and liabilities should be grouped by class and valuation techniques used for recurring and nonrecurring fair value measurements. The adoption of these changes had no impact on our consolidated financial statements.

Effective January 1, 2010, we adopted changes issued by the FASB on February 24, 2010, to accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued, otherwise known as “subsequent events.” Specifically, these changes clarified that an entity that is required to file or furnish its financial statements with the SEC is not required to disclose the date through which subsequent events have been evaluated. Other than the elimination of disclosing the date through which management has performed its evaluation for subsequent events, the adoption of these changes had no impact on our consolidated financial statements.

Issued Guidance

In September 2011, the FASB issued changes to the testing of goodwill for impairment. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of a reporting unit is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, go directly to the two-step quantitative impairment test. These changes become effective for us for any goodwill impairment test performed on January 1, 2012 or later, although early adoption is permitted. The adoption of these changes is not expected to have a material impact on our consolidated financial statements.

In July 2011, the FASB issued “Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities” (ASU 2011-07), which requires healthcare organizations that perform services for patients for which the ultimate collection of all or a portion of the amounts billed or billable cannot be determined at the time services are rendered to present all bad debt expense associated with patient service revenue as an offset to the patient service revenue line item in the statement of operations. The ASU also requires qualitative disclosures about our policy for recognizing revenue and bad debt expense for patient service transactions and quantitative information about the effects of changes in the assessment of collectability of patient service revenue. This ASU is effective for fiscal years beginning after December 15, 2011, and will be adopted by us in the first quarter of 2012. We are currently assessing the potential impact the adoption of this ASU will have on its consolidated results of operations and consolidated financial position.

 

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Cautionary Statement Relating to Forward Looking Information

We have included some forward-looking statements in this section and other places in this report regarding our expectations. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, levels of activity, performance or achievements, or industry results, to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Some of these forward-looking statements can be identified by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategies that involve risks and uncertainties. You should read statements that contain these words carefully because they:

 

  discuss our future expectations;

 

  contain projections of our future operating results or of our future financial condition; or

 

  state other “forward-looking” information.

We believe it is important to discuss our expectations; however, it must be recognized that events may occur in the future over which we have no control and which we are not accurately able to predict. Readers are cautioned to consider the specific business risk factors described in the report and not to place undue reliance on the forward-looking statements contained herein, which speak only as of the date hereof. We undertake no obligation to publicly revise forward-looking statements to reflect events or circumstances that may arise after the date of this report.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 305 of Regulation S-K with respect to Quantitative and Qualitative Disclosures about Market Risk.

Item 8. Financial Statements and Supplementary Data.

Our financial statements which are prepared in accordance with Regulation S-X are set forth in this report beginning on page F-1.

We are a smaller reporting entity as defined in Rule 12b-2 of the Exchange Act and as such, are not required to provide the information required by Item 302 of Regulation S-K with respect to Supplementary Financial Information.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

During 2011 and 2010, there were no disagreements concerning matters of accounting principle or financial statement disclosure between us and our independent accountants of the type requiring disclosure hereunder.

Item 9A. Controls and Procedures.

Disclosure Controls and Procedures

Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2011. Our Principal Executive Officer and Principal Financial Officer are responsible primarily for establishing and maintaining disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission. The controls and procedures are those defined in Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934. These controls and procedures are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on such evaluations, our Principal Executive Officer and Principal Financial Officer concluded that, as of December 31, 2011, our disclosure controls and procedures were effective.

 

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Internal Controls over Financial Reporting

Furthermore, our Principal Executive Officer and Principal Financial Officer are responsible for the design and supervision of our internal controls over financial reporting as defined in Rule 13a-15 of the Securities Exchange Act of 1934. These internal controls over financial reporting are then effected by and through our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. These policies and procedures

 

  (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;

 

  (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and

 

  (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

Our Principal Executive Officer and Principal Financial Officer, conducted their evaluation using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework. Based upon their evaluation of the effectiveness of our internal controls over financial reporting as of December 31, 2011, management, including our Principal Executive Officer and Principal Accounting Officer, concluded that our internal controls over financial reporting were effective as of December 31, 2011, and reported to our auditors and the audit committee of our board of directors that no changes had occurred in our internal control over financial reporting during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. In conducting their evaluation of our internal controls over financial reporting, these executive officers did not discover any fraud that involved management or other employees who have a significant role in our disclosure controls and procedures and internal controls over financial reporting. Furthermore, there were no significant changes in our internal controls over financial reporting, or other factors that could significantly affect our internal controls over financial reporting subsequent to the date of their evaluation.

Item 9B. Other Information.

Annual Stockholders Meeting

The 2011 Annual Meeting of Stockholders of Graymark Healthcare, Inc. will be held at 11:30 a.m. on May 14, 2012.

Amended Loan Agreement

On April 3, 2012, we executed the First Amendment to Amended and Restated Loan Agreement (“Amended Loan Agreement”) by and among Graymark Healthcare, Inc., SDC Holding, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Kevin Lewis, Roger Ely, Lewis P. Zeidner and Arvest Bank. Under the Amended Loan Agreement, our financial covenant requiring that we maintain a Debt Service Coverage Ratio of 1.25 to 1 was waived until March 31, 2013. As a condition of obtaining the waiver, we agreed to the following conditions:

 

   

We paid all principal and interest due on the Arvest Debt through June 30, 2012.

 

   

We will pay on or before June 30, 2012, all principal and interest due on the Arvest Debt through December 31, 2012.

 

   

Beginning on April 1, 2012, and continuing through June 4, 2012, we must have $1.75 million in cash on hand and beginning June 5, 2012 and ending on June 30, 2012, we must have $2.5 million in cash prior to making the required principal and interest prepayment due on June 30, 2012.

 

   

Beginning on September 30, 2012, and on the last day of each quarter thereafter, our EBITDA must be positive for the immediately prior quarter. EBITDA is defined as net income plus: (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense and (iv) non-cash charges including impairment charges and stock compensation.

A copy of the Amended Loan Agreement is filed herewith as Exhibits 10.7.6 and is incorporated herein by reference. The foregoing summary of the Amended Loan Agreement is qualified in its entirety by reference to the exhibits filed herewith.

Office Lease Agreement

On April 2, 2012, we entered into an Office Lease Agreement with City Place L.L.C., for our new executive offices located at 204 N. Robinson, Oklahoma City, Oklahoma. The lease covers approximately 14,872 square feet is for a term of 60 months and requires monthly rent payments of approximately $18 thousand per month plus a pro rata share of common area maintenance and other costs. Prior to occupying the premises, we completed a build out of the space to accommodate its centralization of operations and serve as its new executive offices. The aggregate cost of such leasehold improvements is being considered a prepayment of the rent by us. Mr. Roy Oliver, one of our greater than 5% shareholders, Mr. Stanton Nelson, our Chief Executive Officer and a director, each have an ownership interest in City Place L.L.C.

A copy of the Office Lease Agreement is filed herewith as Exhibit 10.22 and is incorporated herein by reference. The foregoing summary of the Office Lease Agreement is qualified in its entirety by reference to the exhibit filed herewith.

 

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Amended and Restated Employment Agreements

On April 6, 2012, we entered into Amended and Restated Employment Agreements with each of Stanton Nelson, our Chief Executive Officer, and Edward M. Carriero, Jr., our Chief Financial Officer. The material terms of the amended agreements are summarized below.

Amended and Restated Employment Agreement with Stanton Nelson.

The amended employment agreement with Mr. Nelson replaces his prior employment agreement that became effective on October 1, 2009. Under the terms of the amended agreement, Mr. Nelson will continue to serve as Chief Executive Officer of the Company. Mr. Nelson’s employment is “at will” and may be terminated at any time by Mr. Nelson or the Company, subject to the terms of the amended agreement. Except to a limited extent and as expressly permitted by our Board of Directors, Mr. Nelson is prohibited from serving as an officer or director of a publicly-held company or owning an interest in a company that interferes with his full-time employment or that is engaged in a business activity similar to our business. Mr. Nelson will receive a base salary of $199,000, which may be increased in the discretion of the Compensation Committee of the Board of Directors of the Company. Mr. Nelson is eligible for participation in any and all benefit programs that the Company makes available to its employees, including health, dental and life insurance to the extent that he meets applicable eligibility requirements. Mr. Nelson is entitled to four weeks paid vacation yearly. We have the right to terminate Mr. Nelson’s agreement without cause for any reason, and Mr. Nelson may terminate his employment for cause, in either case on at least 30-day advance notice. In the event of termination without cause by us or termination by Mr. Nelson for cause, Mr. Nelson shall be entitled to a payment equal to 18-months of his most recent base salary plus eligibility in health and certain other benefit plans for 18 months from termination.

In addition, Mr. Nelson agreed that, during the 24 months following termination of his employment, he will:

 

   

Not acquire, attempt to acquire, solicit, perform services (directly or indirectly) in any capacity for, or aid another in the acquisition or attempted acquisition of an interest in any business involved in providing sleep disorder diagnostic services, sleep therapy or re-supply services in any city in the United States where the Company or any of its affiliates owns a sleep center, or that is within 40 miles of a sleep center location owned by the Company or any of its affiliates; and

 

   

Not solicit, induce, entice or attempt to entice (directly or indirectly) any employee, officer or director (except the executive officer’s personal secretary, if any), contractor, customer, vendor or subcontractor of the Company or any of its affiliates, or breach any relationship with the Company or any of its affiliates, and

 

   

Not solicit, induce, entice or attempt to entice any customer, vendor or subcontractor of the Company or any of its affiliates to cease doing business with the Company or any of its affiliates.

Amended and Restated Employment Agreement with Edward Carriero, Jr.

The amended employment agreement with Mr. Carriero replaces his prior employment agreement entered into on October 7, 2010. Under the amended agreement, Mr. Carriero will continue to serve as our Chief Financial Officer. Mr. Carriero’s employment is “at will” and may be terminated at any time by Mr. Carriero or the Company, subject to the terms of the amended agreement. Mr. Carriero will receive a base salary of $200,000, which may be increased in the discretion of the Compensation Committee of the Board of Directors of the Company. Mr. Carriero is eligible for participation in any and all benefit programs that the Company makes available to its employees, including health, dental and life insurance to the extent that he meets applicable eligibility requirements. Mr. Carriero is entitled to twenty days of paid vacation yearly. Upon termination of Mr. Carriero’s employment by us without cause or by him with good reason, Mr. Carriero shall be entitled to a payment equal to his most recent annual base salary plus eligibility in health and certain other benefit plans for 18 months from termination. In addition, Mr. Carriero agreed not to, directly or indirectly, seek to persuade any employee, contractor, customer, vendor or subcontractor of the Company, or any affiliated entity to discontinue, breach or terminate his or her employment, contract, or relationship with the Company, or such affiliated entity or to become employed or engaged in a business or activities likely to be competitive with the Company, or any affiliated entity, for a period of two years following his termination.

A copy of the Amended and Restated Employment Agreements with each of Mr. Nelson and Mr. Carriero are filed herewith as Exhibits 10.12.1 and 10.16.1, respectively, and are incorporated herein by reference. The foregoing summaries of the Amended and Restated Employment Agreements are qualified in their entirety by reference to the exhibits filed herewith.

PART III

Item 10. Directors, Executive Officers and Corporate Governance.

The information required by this item is incorporated herein by reference to our Proxy Statement for our annual shareholders’ meeting (the “2011 Proxy Statement”).

Item 11. Executive Compensation.

The information required by this item is incorporated herein by reference to the 2011 Proxy Statement.

 

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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by this item is incorporated herein by reference to the 2011 Proxy Statement.

Item 13. Certain Relationships and Related Transactions, and Director Independence.

The information required by this item is incorporated herein by reference to the 2011 Proxy Statement.

Item 14. Principal Accounting Fees and Services

The information required by this item is incorporated herein by reference to the 2011 Proxy Statement.

PART IV

Item 15. Exhibits, Financial Statement Schedules

 

(a) Exhibits:

 

Exhibit No.

  

Description

3.1    Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation is incorporated by reference to Exhibit 3.1.1 to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on May 7, 2011.
3.1.1    Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation, is incorporated by reference to Exhibit 3.1.1 of Registrant’s Registration Statement on Form S-1 as filed with the U.S. Securities and Exchange Commission on June 7, 2011.
3.2    Registrant’s Amended and Restated Bylaws, incorporated by reference to Exhibit 3.2 of Registrant’s Quarterly Report on Form 10-Q as filed with the U.S. Securities and Exchange Commission on August 14, 2008.
4.1    Form of Certificate of Common Stock of Registrant, incorporated by reference to Exhibit 4.1 of Registrant’s Registration Statement on Form SB-2 (No. 333-111819) as filed with the U.S. Securities and Exchange Commission on January 9, 2004.
4.2    Form of Amended and Restated Common Stock Purchase Warrant Agreement issued to SXJE, LLC and dated March 2007, is incorporated by reference to Exhibit 4.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
4.3    Financial Advisor Warrant Agreement issued to ViewTrade Securities, Inc. and dated June 11, 2009, is incorporated by reference to Exhibit 4.7 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
4.4    Form of Warrant Agreement dated May 4, 2011 and issued to each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on May 5, 2011.
4.5    Form of Warrant to Purchase Common Stock issued pursuant to the Underwriting Agreement dated June 14, 2011, is incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 15, 2011.

 

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Exhibit No.

  

Description

10.1*    Graymark Productions, Inc. 2003 Stock Option Plan, incorporated by reference to Exhibit 10.5 of Registrant’s Registration Statement on Form SB-2 (No. 333-111819) as filed with the U.S. Securities and Exchange Commission on January 9, 2004.
10.2*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan adopted by Registrant on the effective date of October 29, 2008, is incorporated by reference to Exhibit 4.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on December 9, 2008.
10.2.1*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Restricted Stock Award Agreement, is incorporated by reference to Exhibit 10.3.1 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.2.2*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Stock Option Agreement, is incorporated by reference to Exhibit 10.3.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.3    Registration Rights Agreement between Registrant, Oliver Company Holdings, LLC, Lewis P. Zeidner, Stanton Nelson, Vahid Salalati, Greg Luster, William R. Oliver, Kevin Lewis, John B. Frick Revocable Trust, Roger Ely, James A. Cox, Michael Gold, Katrina J. Martin Revocable Trust, dated January 2, 2008, is incorporated by reference to Registrant’s Schedule 14 Information Statement filed with the U.S. Securities and Exchange Commission on December 5, 2007.
10.4    Purchase Agreement between TCSD of Waco, LLC and Sleep Center of Waco, Ltd., dated May 30, 2008, is incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.5    Purchase Agreement between Capital Sleep Management, LLC, Plano Sleep Center, Ltd., and Southlake Sleep Center, Ltd., dated May 30, 2008, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.6    Asset Purchase Agreement between SDC Holdings, LLC, Christina Molfetta and Hanna Friends Trust, dated June 1, 2008, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.7    Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trusteeof the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, dated May 21, 2008 is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2009.
10.7.1    Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective May 21, 2008 is incorporated by reference to Exhibit 10.32 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2009.

 

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Exhibit No.

  

Description

10.7.2    Second Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective May 21, 2008, is incorporated by reference to Exhibit 10.1 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2009.
10.7.3    Third Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective June 30, 2010, is incorporated by reference to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on December 30, 2010.
10.7.4    Amended and Restated Loan Agreement dated December 17, 2010 by and among Graymark Healthcare, Inc., SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Kevin Lewis, Roger Ely, Lewis P. Zeidner and Arvest Bank, is incorporated by reference to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on March 28, 2011.
10.7.5    Letter Agreement dated March 11, 2011 by and between Graymark Healthcare, Inc. and Arvest Bank, is incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on March 22, 2011.
10.7.6+    First Amendment to Amended and Restated Loan Agreement dated January 1, 2012 by and among Graymark Healthcare, Inc., SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Kevin Lewis, Roger Ely, Lewis P. Zeidner and Arvest Bank.
10.8    Stock Sale Agreement dated August 19, 2009 by and among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 26, 2009.
10.8.1    First Amendment to Stock Sale Agreement dated August 23, 2009 among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 26, 2009.
10.8.2    Second Amendment to Stock Sale Agreement dated September 14, 2009 among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 16, 2009.
10.9    Lock up and Stock Pledge Agreement dated September 14, 2009 among Graymark Healthcare, Inc., SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 16, 2009.
10.10    Settlement Agreement and Release dated September 14, 2009 among Daniel I. Rifkin, M.D., Graymark Healthcare, Inc., SDC Holdings, LLC, Avastra Sleep Centers Limited, AvastraUSA, Inc. is incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K/A filed with the U.S. Securities and Exchange Commission on September 21, 2009.

 

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Exhibit No.

  

Description

10.11*    Amended and Restated Employment Agreement between Registrant and Grant A. Christianson, dated October 19, 2010, is incorporated by reference to Exhibit 10.4 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 15, 2010.
10.12*    Employment Agreement between Registrant and Stanton Nelson, dated October 13, 2009, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 14, 2009.
10.12.1+*    Amended and Restated Employment Agreement between Registrant and Stanton Nelson, dated April 6, 2012.
10.13*    Employment Agreement between Registrant and Joseph Harroz, Jr., dated December 5, 2008, is incorporated by reference to Exhibit 10.2 of Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on December 9, 2008.
10.14*    Agreement between the Registrant and Joseph Harroz, Jr., dated March 25, 2010, is incorporated by reference to Exhibit 10.30 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.15*    Restricted Stock Award Agreement between the Registrant and Stanton Nelson, dated March 25, 2010 is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.16*    Employment Agreement between the Registrant and Edward M. Carriero, Jr., dated October 7, 2010, is incorporated by reference to Exhibit 10.3 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 15, 2010.
10.16.1+*    Amended and Restated Employment Agreement between the Registrant and Edward M. Carriero, Jr., dated April 6, 2012.
10.17    Asset Purchase Agreement dated September 1, 2010 among Walgreen Co., ApothecaryRx, LLC, and, to certain sections only, Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 2, 2010.
10.17.1    First Amendment to Asset Purchase Agreement dated October 29, 2010 among Walgreen Co., ApothecaryRx, LLC, and, to certain sections only, Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 29, 2010.
10.18    Form of Indemnification Agreement between the Company and each of its directors and executive officers, is incorporate by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 24, 2010.
10.19.1    Loan Agreement dated March 16, 2011 by and between Valiant Investments LLC and Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011.
10.19.2    Note dated March 16, 2011 issued by Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011.
10.19.3    Subordination Agreement dated March 16, 2011 by and among Valiant Investments, L.L.C., ApothecaryRx, LLC, SDC Holdings LLC and Graymark Healthcare, Inc., in favor of Arvest Bank, is incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011.

 

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Table of Contents

Exhibit No.

  

Description

10.20    Form of Subscription Agreement dated April 30, 2011 by and between each of Graymark Healthcare, Inc., and each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on May 5, 2011.
10.21+*    Chairman of the Board Agreement dated as of July 1, 2011 by and between Graymark Healthcare, Inc. and Jamie Hopping.
10.22+    Office Lease Agreement between the Registrant and City Place, L.L.C., dated as of February 15, 2012.
21+    Subsidiaries of Registrant.
23.1+    Consent of Independent Registered Public Accounting Firm.
31.1+    Certification of Stanton Nelson, Chief Executive Officer of Registrant.
31.2+    Certification of Edward M. Carriero, Jr., Chief Financial Officer of Registrant.
31.3+    Certification of Grant A. Christianson, Chief Accounting Officer of Registrant.
32.1+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Stanton Nelson, Chief Executive Officer of Registrant.
32.2+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Edward M. Carriero, Chief Financial Officer of Registrant.
32.3+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Grant A. Christianson, Chief Accounting Officer of Registrant.
101.INS    XBRL Instance Document.
101.SCH    XBRL Taxonomy Extension Schema Document.
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB    XBRL Taxonomy Extension Label Linkbase Document.
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document.

 

+ Filed herewith.
* Management contract or compensatory plan or arrangement.

 

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Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

GRAYMARK HEALTHCARE, INC.

(Registrant)

By:   /S/ STANTON NELSON
 

Stanton Nelson

Chief Executive Officer

Date: April 9, 2012

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Each person whose signature appears below in so signing also makes, constitutes and appoints Stanton Nelson, Edward M. Carriero, Jr. and Grant A. Christianson, and each of them, his true and lawful attorney-in-fact, with full power of substitution, for him in any and all capacities, to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this Form 10-K, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof.

 

Signature

  

Title

 

Date

/S/ STANTON NELSON

   Chief Executive Officer   April 9, 2012

Stanton Nelson

   (Principal Executive Officer)  

/S/ EDWARD M. CARRIERO, JR.

   Chief Financial Officer   April 9, 2012

Edward M. Carriero, Jr.

   (Principal Financial Officer)  
/S/ GRANT A. CHRISTIANSON   

Chief Accounting Officer

  April 9, 2012
Grant A. Christianson    (Principal Accounting Officer)  
/S/ JAMIE HOPPING   

Chairman of the Board

  April 9, 2012

Jamie Hopping

    

/S/ JOSEPH HARROZ, JR.

   Director   April 9, 2012

Joseph Harroz, Jr.

    

/S/ SCOTT MUELLER

   Director   April 9, 2012

Scott Mueller

    

/S/ S. EDWARD DAKIL, M.D.

   Director   April 9, 2012

S. Edward Dakil, M.D.

    

/S/ STEVEN L. LIST

   Director   April 9, 2012

Steven L. List

    

 

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Table of Contents

Exhibit Index

 

Exhibit No.

  

Description

3.1    Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation is incorporated by reference to Exhibit 3.1.1 to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on May 7, 2011.
3.1.1    Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation, is incorporated by reference to Exhibit 3.1.1 of Registrant’s Registration Statement on Form S-1 as filed with the U.S. Securities and Exchange Commission on June 7, 2011.
3.2    Registrant’s Amended and Restated Bylaws, incorporated by reference to Exhibit 3.2 of Registrant’s Quarterly Report on Form 10-Q as filed with the U.S. Securities and Exchange Commission on August 14, 2008.
4.1    Form of Certificate of Common Stock of Registrant, incorporated by reference to Exhibit 4.1 of Registrant’s Registration Statement on Form SB-2 (No. 333-111819) as filed with the U.S. Securities and Exchange Commission on January 9, 2004.
4.2    Form of Amended and Restated Common Stock Purchase Warrant Agreement issued to SXJE, LLC and dated March 2007, is incorporated by reference to Exhibit 4.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
4.3    Financial Advisor Warrant Agreement issued to ViewTrade Securities, Inc. and dated June 11, 2009, is incorporated by reference to Exhibit 4.7 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
4.4    Form of Warrant Agreement dated May 4, 2011 and issued to each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on May 5, 2011.
4.5    Form of Warrant to Purchase Common Stock issued pursuant to the Underwriting Agreement dated June 14, 2011, is incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 15, 2011.
10.1*    Graymark Productions, Inc. 2003 Stock Option Plan, incorporated by reference to Exhibit 10.5 of Registrant’s Registration Statement on Form SB-2 (No. 333-111819) as filed with the U.S. Securities and Exchange Commission on January 9, 2004.
10.2*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan adopted by Registrant on the effective date of October 29, 2008, is incorporated by reference to Exhibit 4.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on December 9, 2008.
10.2.1*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Restricted Stock Award Agreement, is incorporated by reference to Exhibit 10.3.1 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.2.2*    Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Stock Option Agreement, is incorporated by reference to Exhibit 10.3.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.


Table of Contents

Exhibit No.

  

Description

10.3    Registration Rights Agreement between Registrant, Oliver Company Holdings, LLC, Lewis P. Zeidner, Stanton Nelson, Vahid Salalati, Greg Luster, William R. Oliver, Kevin Lewis, John B. Frick Revocable Trust, Roger Ely, James A. Cox, Michael Gold, Katrina J. Martin Revocable Trust, dated January 2, 2008, is incorporated by reference to Registrant’s Schedule 14 Information Statement filed with the U.S. Securities and Exchange Commission on December 5, 2007.
10.4    Purchase Agreement between TCSD of Waco, LLC and Sleep Center of Waco, Ltd., dated May 30, 2008, is incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.5    Purchase Agreement between Capital Sleep Management, LLC, Plano Sleep Center, Ltd., and Southlake Sleep Center, Ltd., dated May 30, 2008, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.6    Asset Purchase Agreement between SDC Holdings, LLC, Christina Molfetta and Hanna Friends Trust, dated June 1, 2008, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 13, 2008.
10.7    Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, dated May 21, 2008 is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2009.
10.7.1    Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective May 21, 2008 is incorporated by reference to Exhibit 10.32 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2009.
10.7.2    Second Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective May 21, 2008, is incorporated by reference to Exhibit 10.1 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2009.
10.7.3    Third Amendment to Loan Agreement between Registrant, SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Vahid Salalati, Greg Luster, Kevin Lewis, Roger Ely and Lewis P. Zeidner and Arvest Bank, effective June 30, 2010, is incorporated by reference to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on December 30, 2010.


Table of Contents

Exhibit No.

  

Description

10.7.4    Amended and Restated Loan Agreement dated December 17, 2010 by and among Graymark Healthcare, Inc., SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Kevin Lewis, Roger Ely, Lewis P. Zeidner and Arvest Bank, is incorporated by reference to the Registrant’s Registration Statement on Form S-1 filed with the U.S. Securities and Exchange Commission on March 28, 2011.
10.7.5    Letter Agreement dated March 11, 2011 by and between Graymark Healthcare, Inc. and Arvest Bank, is incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on March 22, 2011.
10.7.6+    First Amendment to Amended and Restated Loan Agreement dated January 1, 2012 by and among Graymark Healthcare, Inc., SDC Holdings, LLC, ApothecaryRx, LLC, Oliver Company Holdings, LLC, Roy T. Oliver, Stanton M. Nelson, Roy T. Oliver as Trustee of the Roy T. Oliver Revocable Trust dated June 15, 2004, Kevin Lewis, Roger Ely, Lewis P. Zeidner and Arvest Bank.
10.8    Stock Sale Agreement dated August 19, 2009 by and among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 26, 2009.
10.8.1    First Amendment to Stock Sale Agreement dated August 23, 2009 among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 26, 2009.
10.8.2    Second Amendment to Stock Sale Agreement dated September 14, 2009 among SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 16, 2009.
10.9    Lock up and Stock Pledge Agreement dated September 14, 2009 among Graymark Healthcare, Inc., SDC Holdings, LLC, AvastraUSA, Inc. and Avastra Sleep Centers Limited, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 16, 2009.
10.10    Settlement Agreement and Release dated September 14, 2009 among Daniel I. Rifkin, M.D., Graymark Healthcare, Inc., SDC Holdings, LLC, Avastra Sleep Centers Limited, AvastraUSA, Inc. is incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K/A filed with the U.S. Securities and Exchange Commission on September 21, 2009.
10.11*    Amended and Restated Employment Agreement between Registrant and Grant A. Christianson, dated October 19, 2010, is incorporated by reference to Exhibit 10.4 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 15, 2010.
10.12*    Employment Agreement between Registrant and Stanton Nelson, dated October 13, 2009, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 14, 2009.
10.12.1+*    Amended and Restated Employment Agreement between Registrant and Stanton Nelson, dated April 6, 2012.
10.13*    Employment Agreement between Registrant and Joseph Harroz, Jr., dated December 5, 2008, is incorporated by reference to Exhibit 10.2 of Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on December 9, 2008.
10.14*    Agreement between the Registrant and Joseph Harroz, Jr., dated March 25, 2010, is incorporated by reference to Exhibit 10.30 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.15*    Restricted Stock Award Agreement between the Registrant and Stanton Nelson, dated March 25, 2010 is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.


Table of Contents

Exhibit No.

  

Description

10.16*    Employment Agreement between the Registrant and Edward M. Carriero, Jr., dated October 7, 2010, is incorporated by reference to Exhibit 10.3 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 15, 2010.
10.16.1+*    Amended and Restated Employment Agreement between the Registrant and Edward M. Carriero, Jr., dated April 6, 2012.
10.17    Asset Purchase Agreement dated September 1, 2010 among Walgreen Co., ApothecaryRx, LLC, and, to certain sections only, Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 2, 2010.
10.17.1    First Amendment to Asset Purchase Agreement dated October 29, 2010 among Walgreen Co., ApothecaryRx, LLC, and, to certain sections only, Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 29, 2010.
10.18    Form of Indemnification Agreement between the Company and each of its directors and executive officers, is incorporate by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 24, 2010.
10.19.1    Loan Agreement dated March 16, 2011 by and between Valiant Investments LLC and Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on March 22, 2011.
10.19.2    Note dated March 16, 2011 issued by Graymark Healthcare, Inc., is incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011.
10.19.3    Subordination Agreement dated March 16, 2011 by and among Valiant Investments, L.L.C., ApothecaryRx, LLC, SDC Holdings LLC and Graymark Healthcare, Inc., in favor of Arvest Bank, is incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report with the U.S. Securities and Exchange Commission on Form 8-K filed on March 22, 2011.
10.20    Form of Subscription Agreement dated April 30, 2011 by and between each of Graymark Healthcare, Inc., and each of MTV Investments, LP, Black Oak II, LLC, TLW Securities, LLC and Valiant Investments, LLC, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on May 5, 2011.
10.21+*    Chairman of the Board Agreement dated as of July 1, 2011 by and between Graymark Healthcare, Inc. and Jamie Hopping.
10.22+    Office Lease Agreement between the Registrant and City Place, L.L.C., dated as of February 15, 2012.
21+    Subsidiaries of Registrant.
23.1+    Consent of Independent Registered Public Accounting Firm.
31.1+    Certification of Stanton Nelson, Chief Executive Officer of Registrant.
31.2+    Certification of Edward M. Carriero, Jr., Chief Financial Officer of Registrant.
31.3+    Certification of Grant A. Christianson, Chief Accounting Officer of Registrant.
32.1+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Stanton Nelson, Chief Executive Officer of Registrant.


Table of Contents

Exhibit No.

  

Description

32.2+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Edward M. Carriero, Chief Financial Officer of Registrant.
32.3+    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Grant A. Christianson, Chief Accounting Officer of Registrant.
101.INS    XBRL Instance Document.
101.SCH    XBRL Taxonomy Extension Schema Document.
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB    XBRL Taxonomy Extension Label Linkbase Document.
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document

 

+ Filed herewith.
* Management contract or compensatory plan or arrangement.


Table of Contents

GRAYMARK HEALTHCARE, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Balance Sheets as of December 31, 2011 and 2010

   F-3

Consolidated Statements of Operations for the Years Ended December 31, 2011 and 2010

   F-4

Consolidated Statements of Shareholders’ Equity for the Years Ended December  31, 2011 and 2010

   F-5

Consolidated Statements of Cash Flows for the Years Ended December 31, 2011 and 2010

   F-6

Notes to Consolidated Financial Statements

   F-7

 

F-1


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Audit Committee, Board of Directors,

    and Shareholders of Graymark Healthcare, Inc.

    Oklahoma City, Oklahoma

We have audited the accompanying consolidated balance sheets of Graymark Healthcare, Inc. (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years then ended. Graymark Healthcare, 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 audits 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 audits 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 financial statements referred to above present fairly, in all material respects, the financial position of Graymark Healthcare, Inc. as of December 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

/s/ Eide Bailly LLP

Greenwood Village, Colorado

April 9, 2012

 

F-2


Table of Contents

GRAYMARK HEALTHCARE, INC.

Consolidated Balance Sheets

As of December 31, 2011 and 2010

 

     2011     2010  

ASSETS

    

Cash and cash equivalents

   $ 4,915,032      $ 639,655   

Accounts receivable, net of allowances for contractual adjustments and doubtful accounts of $3,100,612 and $2,791,906, respectively

     3,095,447        2,597,848   

Inventories

     427,039        553,342   

Current assets from discontinued operations

     1,059,023        3,349,567   

Other current assets

     274,049        438,315   
  

 

 

   

 

 

 

Total current assets

     9,770,590        7,578,727   
  

 

 

   

 

 

 

Property and equipment, net

     2,935,992        3,642,847   

Intangible assets, net

     1,214,633        1,313,756   

Goodwill

     13,729,571        12,844,223   

Other assets from discontinued operations

     54,255        2,579,410   

Other assets

     280,289        733,589   
  

 

 

   

 

 

 

Total assets

   $ 27,985,330      $ 28,692,552   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Liabilities:

    

Accounts payable

   $ 782,367      $ 909,983   

Accrued liabilities

     2,262,096        2,263,907   

Current portion of long-term debt

     2,071,597        22,768,781   

Current liabilities from discontinued operations

     723,274        2,140,602   
  

 

 

   

 

 

 

Total current liabilities

     5,839,334        28,083,273   
  

 

 

   

 

 

 

Long-term debt, net of current portion

     17,203,691        436,850   

Other liabilities

     117,282        —     
  

 

 

   

 

 

 

Total liabilities

     23,160,307        28,520,123   

Equity:

    

Graymark Healthcare shareholders’ equity:

    

Preferred stock $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding

     —          —     

Common stock $0.0001 par value, 500,000,000 shares authorized; 15,070,634 and 7,238,403 issued and outstanding, respectively

     1,507        724   

Paid-in capital

     40,080,923        29,521,558   

Accumulated deficit

     (35,113,386     (29,218,977
  

 

 

   

 

 

 

Total Graymark Healthcare shareholders’ equity

     4,969,044        303,305   

Noncontrolling interest

     (144,021     (130,876
  

 

 

   

 

 

 

Total equity

     4,825,023        172,429   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 27,985,330      $ 28,692,552   
  

 

 

   

 

 

 

See Accompanying Notes to Consolidated Financial Statements

 

F-3


Table of Contents

GRAYMARK HEALTHCARE, INC.

Consolidated Statements of Operations

For the Years Ended December 31, 2011 and 2010

 

     2011     2010  

Net Revenues:

    

Services

   $ 12,556,630      $ 14,963,916   

Product sales

     4,953,164        5,557,455   
  

 

 

   

 

 

 
     17,509,794        20,521,371   
  

 

 

   

 

 

 

Cost of Services and Sales:

    

Cost of services

     5,137,027        5,515,380   

Cost of sales

     1,743,117        1,628,686   
  

 

 

   

 

 

 
     6,880,144        7,144,066   
  

 

 

   

 

 

 

Gross Margin

     10,629,650        13,377,305   
  

 

 

   

 

 

 

Operating Expenses:

    

Selling, general and administrative

     13,743,820        15,821,701   

Bad debt expense

     895,863        1,803,100   

Impairment of goodwill and intangible assets

     —          7,874,886   

Impairment of property and equipment

     —          762,224   

Depreciation and amortization

     1,110,735        1,278,594   
  

 

 

   

 

 

 
     15,750,418        27,540,505   
  

 

 

   

 

 

 

Other (Expense):

    

Interest expense, net

     (1,268,219     (1,223,334

Other expense

     (14,665     (5,048

Impairment of equity investment

     —          (200,000
  

 

 

   

 

 

 

Net other (expense)

     (1,282,884     (1,428,382
  

 

 

   

 

 

 

Income (loss) from continuing operations, before taxes

     (6,403,652     (15,591,582

Provision for income taxes

     (13,992     (118,000
  

 

 

   

 

 

 

Income (loss) from continuing operations, net of taxes

     (6,417,644     (15,709,582

Income (loss) from discontinued operations, net of taxes

     291,155        (3,579,937
  

 

 

   

 

 

 

Net income (loss)

     (6,126,489     (19,289,519

Less: Net income (loss) attributable to noncontrolling interests

     (232,080     (153,513
  

 

 

   

 

 

 

Net income (loss) attributable to Graymark Healthcare

   $ (5,894,409   $ (19,136,006
  

 

 

   

 

 

 

Earnings per common share (basic and diluted):

    

Net income (loss) from continuing operations

   $ (0.54   $ (2.15

Income from discontinued operations

     0.03        (0.49
  

 

 

   

 

 

 

Net income (loss) per share

   $ (0.51   $ (2.64
  

 

 

   

 

 

 

Weighted average number of common shares outstanding

     11,526,447        7,247,826   
  

 

 

   

 

 

 

Weighted average number of diluted shares outstanding

     11,526,447        7,247,826   
  

 

 

   

 

 

 

See Accompanying Notes to Consolidated Financial Statements

 

F-4


Table of Contents

GRAYMARK HEALTHCARE, INC.

Consolidated Statements of Shareholders’ Equity

For the Years Ended December 31, 2011 and 2010

 

     Common Stock    

Additional

Paid-in

    Accumulated     Noncontrolling  
     Shares     Amount     Capital     Deficit     Interest  

Balances, January 1, 2010

     7,247,286      $ 725      $ 29,088,924      $ (9,869,471   $ 75,521   

Stock-based compensation

     (8,883     (1     432,634        —          —     

Distributions to noncontrolling interests

     —          —          —          —          (52,884

Change in accounting method

     —          —          —          (213,500     —     

Net loss

     —          —          —          (19,136,006     —     

Net loss attributable to noncontrolling interests

     —          —          —          —          (153,513
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balances, December 31, 2010

     7,238,403        724        29,521,558        (29,218,977     (130,876

Issuance of common stock in private stock offering

     1,293,103        129        2,999,871        —          —     

Issuance of common stock in public stock offering

     6,340,000        634        7,258,030        —          —     

Stock-based compensation

     159,021        16        268,486        —          —     

Stock-based professional services

     40,000        4        49,996        —          —     

Fractional shares from reverse stock split

     107        —          —          —          —     

Purchase of noncontrolling interests

     —          —          (17,018     —          11,294   

Noncontrolling interests in business acquisition

     —          —          —          —          207,641   

Net loss

     —          —          —          (5,894,409     —     

Net loss attributable to noncontrolling interests

     —          —          —          —          (232,080
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balances, December 31, 2011

     15,070,634      $ 1,507      $ 40,080,923      $ (35,113,386   $ (144,021
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See Accompanying Notes to Consolidated Financial Statements

 

F-5


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GRAYMARK HEALTHCARE, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2011 and 2010

 

     2011     2010  

Operating activities:

    

Net income (loss)

   $ (5,894,409   $ (19,136,006

Less: Net income (loss) from discontinued operations

     291,155        (3,579,937
  

 

 

   

 

 

 

Net income (loss) from continuing operations

     (6,185,564     (15,556,069

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     1,110,735        1,278,594   

Net income (loss) attributable to noncontrolling interests

     (232,080     (153,513

Stock-based compensation and professional services

     318,502        432,633   

Bad debt expense

     895,863        1,803,100   

Change in accounting method

     —          (213,500

Impairment charges

     —          8,837,110   

Changes in assets and liabilities (net of acquisitions) –

    

Accounts receivable

     (1,393,462     (479,439

Inventories

     126,303        (201,757

Other assets

     617,566        74,431   

Accounts payable

     (127,616     372,228   

Accrued liabilities

     (119,094     573,629   
  

 

 

   

 

 

 

Net cash (used in) operating activities from continuing operations

     (4,988,847     (3,232,553

Net cash provided by (used in) operating activities from discontinued operations

     1,189,525        (669,025
  

 

 

   

 

 

 

Net cash (used in) operating activities

     (3,799,322     (3,901,578
  

 

 

   

 

 

 

Investing activities:

    

Purchase of business

     (596,000     —     

Purchase of property and equipment

     (170,555     (421,287

Disposal of property and equipment

     18,657        120,969   
  

 

 

   

 

 

 

Net cash (used in) investing activities from continuing operations

     (747,898     (300,318

Proceeds from sale of assets from discontinued operations

     2,500,000        29,289,874   

Net other cash (used in) investing activities from discontinued operations

     —          (190,814
  

 

 

   

 

 

 

Net cash provided by investing activities

     1,752,102        28,798,742   
  

 

 

   

 

 

 

Financing activities:

    

Issuance of common stock in private offering

     2,000,000        —     

Issuance of common stock in public offering

     7,258,664        —     

Debt proceeds

     1,000,000        28,894   

Debt payments

     (3,930,343     (5,200,411

Purchase of noncontrolling interests

     (5,724     —     

Distributions to noncontrolling interests

     —          (52,884
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities from continuing operations

     6,322,597        (5,224,401

Net cash (used in) financing activities from discontinued operations

     —          (19,992,360
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     6,322,597        (25,216,761
  

 

 

   

 

 

 

Net change in cash and cash equivalents

     4,275,377        (319,597

Cash and cash equivalents at beginning of year

     639,655        959,252   
  

 

 

   

 

 

 

Cash and cash equivalents at end of year

   $ 4,915,032      $ 639,655   
  

 

 

   

 

 

 

See Accompanying Notes to Consolidated Financial Statements

 

F-6


Table of Contents

GRAYMARK HEALTHCARE, INC.

Notes to Consolidated Financial Statements

For the Years Ended December 31, 2011 and 2010

Note 1 – Nature of Business

Graymark Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and is one of the largest providers of care management solutions to the sleep disorder market based on number of independent sleep care centers and hospital sleep diagnostic programs operated in the United States. The Company provides a comprehensive diagnosis and care management solution for patients suffering from sleep disorders.

The Company provides diagnostic sleep testing services and care management solutions for people with chronic sleep disorders. In addition, the Company sells equipment and related supplies and components used to treat sleep disorders. The Company’s products and services are used primarily by patients with obstructive sleep apnea, or OSA. The Company’s sleep centers provide monitored sleep diagnostic testing services to determine sleep disorders in the patients being tested. The majority of the sleep testing is to determine if a patient has OSA. A continuous positive airway pressure, or CPAP, device is the American Academy of Sleep Medicine’s (“AASM”) preferred method of treatment for obstructive sleep apnea. The Company’s sleep diagnostic facilities also determine the correct pressure settings for patient treatment with positive airway pressure. The Company sells CPAP devices and disposable supplies to patients who have tested positive for sleep apnea and have had their positive airway pressure determined. There are noncontrolling interests held in some of the Company’s testing facilities, typically by physicians located in the geographical area being served by the diagnostic sleep testing facility.

In May 2011 and December 2010, the Company executed the sale of substantially all of the assets of the Company’s subsidiaries, Nocturna East, Inc. (“East”) and ApothecaryRx, LLC (“ApothecaryRx”), respectively. East operated the Management Services Agreement (“MSA”) under which the Company provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services. ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. As a result of the sale of East and ApothecaryRx, the related assets, liabilities, results of operations and cash flows of East and ApothecaryRx have been classified as discontinued operations in the accompanying consolidated financial statements.

Note 2 – Basis of Presentation

As of December 31, 2010, the Company had an accumulated deficit of approximately $29.2 million and reported a net loss of approximately $19.1 million for the year then ending. The Company used approximately $3.2 million in cash from operating activities of continuing operations during the year ending December 31, 2010. Furthermore, the Company had a working capital deficit of approximately $20.5 million as of December 31, 2010. At that time, there was substantial doubt about the Company’s ability to continue as a going concern.

During May 2011 and June 2011, the Company raised a total of $9.3 million in net proceeds from a private and public offering of common stock and warrants. As of December 31, 2011, the Company had cash and cash equivalents of $4.9 million and total equity of $4.8 million. In addition, the Company expects to collect $1.0 million in June 2012 from the Indemnity Escrow Fund related to the ApothecaryRx sale transaction. The $4.9 million in cash and cash equivalents, as of December 31, 2011, and the expected cash availability over the next twelve months of $5.9 million are both more than management’s projected cash needs for the next twelve months of approximately $5.0 million. As a result, the initial doubts about the Company’s ability to continue as a going concern have been alleviated.

 

F-7


Table of Contents

As of December 31, 2011 and 2010, the Company’s Debt Service Coverage Ratio is less than 1.25 to 1 which is ratio required by the Company’s loan agreement with Arvest Bank. The Company has obtained a waiver from Arvest Bank for the Debt Service Coverage Ratio until March 31, 2013. As a result, the associated debt with Arvest Bank has been classified as long-term in the accompanying consolidated balance sheets. As of December 31, 2010, the Company did not have a waiver that extended past twelve months, so the associated debt with Arvest Bank was classified as current at that time. There are no assurances that Arvest Bank will waive any future debt covenant violations. However, management has historically been successful in obtaining waivers from Arvest Bank. See Note 10 – Borrowings.

On June 3, 2011, the Company executed a reverse stock split of the Company’s common stock in a ratio of 1-for-4. The effect of the reverse split reduced the Company’s outstanding common stock shares from 34,126,022 to 8,531,506 shares as of the date of the reverse split. The accompanying consolidated financial statements give effect to the reverse split as of the first date presented.

Note 3 – Summary of Significant Accounting Policies

Consolidation – The accompanying consolidated financial statements include the accounts of Graymark Healthcare, Inc. and its wholly owned, majority owned and controlled subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue recognition

Sleep center services and product sales are recognized in the period in which services and related products are provided to customers and are recorded at net realizable amounts estimated to be paid by customers and third-party payers. Insurance benefits are assigned to the Company and, accordingly, the Company bills on behalf of its customers. For its sleep diagnostic business, the Company estimates the net realizable amount based primarily on the contracted rates stated in the contracts the Company has with various payors. The Company has used this method to determine the net revenue for the business acquired from somniCare, Inc. and somniTech, Inc. (“Somni”) business since the date of the acquisition in 2009 and for the Company’s remaining sleep diagnostic business since the fourth quarter of 2010. The Company does not anticipate any future changes to this process. In the Company’s historic sleep therapy business, the business has been predominantly out-of-network and as a result, the Company has not had contract rates to use for determining net revenue for a majority of its payors. For this portion of the business, the Company performs a quarterly analysis of actual reimbursement from each third party payor for the most recent 12-months. In the analysis, the Company calculates the percentage actually paid by each third party payor of the amount billed to determine the applicable amount of net revenue for each payor. The key assumption in this process is that actual reimbursement history is a reasonable predictor of the future reimbursement for each payor at each facility. During the fourth quarter of 2010, the Company migrated much of its historic sleep diagnostic business to an in-network position. As a result, commencing with the fourth quarter of 2010, the revenue from the Company’s historic sleep diagnostic business was determined using the process utilized in the Somni business. The Company expects to transition its historic sleep therapy business to the same process currently used for its sleep diagnostic business by the third quarter of 2012. This change in process and assumptions for the Company’s historic sleep therapy business is not expected to have a material impact on future operating results.

For certain sleep therapy and other equipment sales, reimbursement from third-party payers occurs over a period of time, typically 10 to 13 months. The Company recognizes revenue on these sales as payments are earned over the payment period stipulated by the third-party payor.

The Company has established an allowance to account for contractual adjustments that result from differences between the amount billed and the expected realizable amount. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for contractual adjustments and are typically identified and ultimately recorded at the point of cash application or when otherwise determined pursuant to the Company’s collection procedures. Revenues in the accompanying consolidated financial statements are reported net of such adjustments.

 

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Table of Contents

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payers may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. Starting in 2010, the Company implemented a process to estimate amounts due from patients prior to service and increase collection of those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

During the years ended December 31, 2011 and 2010, the Company’s revenue payer mix:

 

     2011     2010  

Managed care organizations

     56     61

Medicaid / Medicare

     11     12

Hospital contracts

     23     22

Private-pay

     10     5

Cost of Services and Sales – Cost of services includes technician labor required to perform sleep diagnostics, fees associated with interpreting the results of the sleep study and disposable supplies used in providing sleep diagnostics. Cost of sales includes the acquisition cost of sleep therapy products sold. Costs of services are recorded in the time period the related service is provided. Cost of sales is recorded in the same time period that the related revenue is recognized. If the sale is paid for over a specified period, the product cost associated with that sale is recognized over that same period. If the product is paid for in one period, the cost of sale is recorded in the period the product was sold.

Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Accounts receivable – The majority of the Company’s accounts receivable is due from private insurance carriers, Medicare/Medicaid and other third-party payors, as well as from patients relating to deductible and coinsurance and deductible provisions of their health insurance policies.

Third-party reimbursement is a complicated process that involves submission of claims to multiple payers, each having its own claims requirements. Adding to this complexity, a significant portion of the Company’s business has historically been out-of-network with several payors, which means the Company does not have defined contracted reimbursement rates with these payors. For this reason, the Company’s systems reported revenue at a higher gross billed amount, which the Company adjusted to an expected net amount based on historic payments. This process continues in the Company’s historic sleep therapy business, but was changed in the fourth quarter of 2010 for the Company’s historic sleep diagnostic business. As a result, the reserve for contractual allowance has been reduced, compared to the same periods in 2010, as our systems now report a larger portion of our business at estimated net contract rates. As the Company continues to move more of its business to in-network contracting, the level of reserve related to contractual allowances is expected to decrease. In some cases, the ultimate collection of accounts receivable subsequent to the service dates may not be known for several months. As these accounts age, the risk of collection increases and the resulting reserves for bad debt expense reflect this longer payment cycle. The Company has established an allowance to account for contractual adjustments that result from differences between the amounts billed to customers and third-party payers and the expected realizable amounts. The percentage and amounts used to record the allowance for doubtful accounts are supported by various methods including current and historical cash collections, contractual adjustments, and aging of accounts receivable.

 

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The Company offers payment plans to patients for amounts due from them for the sales and services the Company provides. For patients with a balance of $500 or less, the Company allows a maximum of three months for the patient to pay the amount due. For patients with a balance over $500, the Company allows a maximum of six months to pay the full amount due. The minimum monthly payment amount for both plans is calculated based on the down payment and the remaining balance divided by three or six months, respectively.

Accounts are written-off as bad debt using a specific identification method. For amounts due from patients, the Company utilizes a collections process that includes distributing monthly account statements. For patients that are not on a payment plan, collection efforts including collection letters and collection calls begin at 60 days from the initial statement. If the patient is on a payment program, these efforts begin within 30 days of the patient failing to make a planned payment. For diagnostic patients, the Company submits patient receivables to an outside collection agency if the patient has failed to pay 120 days following service or, if the patient is on a payment plan, they have failed to make two consecutive payments. For therapy patients, patient receivables are submitted to an outside collection agency if payment has not been received between 180 and 240 days following service depending on the service provided and circumstances of the receivable or, if the patient is on a payment plan, they have failed to make two consecutive payments. It is the Company’s policy to write-off as bad debt all patient receivables at the time they are submitted to an outside collection agency. If funds are recovered by a collection agency, the amounts previously written-off are accounted for as a recovery of bad debt. For amounts due from third party payors, it is the Company’s policy to write-off an account receivable to bad debt based on the specific circumstances related to that claim resulting in a determination that there is no further recourse for collection of a denied claim from the denying payor.

For the years ended December 31, 2011 and 2010, the amounts the Company collected in excess of recorded contractual allowances were approximately $81,000 and $271,000, respectively.

As of December 31, 2011 and 2010, accounts receivable are reported net of allowances for contractual adjustments and doubtful accounts as follows:

 

     2011      2010  

Allowance for contractual adjustments

   $ 1,563,324       $ 1,511,330   

Allowance for doubtful accounts

     1,537,288         1,280,576   
  

 

 

    

 

 

 

Total

   $ 3,100,612       $ 2,791,906   
  

 

 

    

 

 

 

The activity in the allowances for contractual adjustments and doubtful accounts for the years ending December 31, 2011 and 2010 follows:

 

     Contractual
Adjustments
    Doubtful
Accounts
    Total  

Balance at January 1, 2010

   $ 5,985,269      $ 3,787,311      $ 9,772,580   

Provisions

     18,502,775        1,763,736        20,266,511   

Write-offs, net of recoveries

     (22,976,714     (3,757,580     (26,734,294

Change in accounting method

     —          (512,891     (512,891
  

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

     1,511,330        1,280,576        2,791,906   

Reclass

     165,288        (165,288     —     

Provisions

     5,001,349        895,863        5,897,212   

Write-offs, net of recoveries

     (5,114,643     (473,863     (5,588,506
  

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

   $ 1,563,324      $ 1,537,288      $ 3,100,612   
  

 

 

   

 

 

   

 

 

 

 

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The aging of the Company’s accounts receivable, net of allowances for contractual adjustments and doubtful accounts as of December 31, 2011 and 2010 follows:

 

     2011      2010  

1 to 60 days

   $ 1,902,197       $ 1,890,902   

61 to 90 days

     357,775         282,807   

91 to 120 days

     268,436         170,435   

121 to 180 days

     260,134         67,394   

181 to 360 days

     306,905         186,310   

Greater than 360 days

     —           —     
  

 

 

    

 

 

 

Total

   $ 3,095,447       $ 2,597,848   
  

 

 

    

 

 

 

In addition to the aging of accounts receivable shown above, management relies on other factors to determine the collectability of accounts including the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan.

Included in accounts receivable are earned but unbilled receivables of approximately $205,000 and $129,000 as of December 31, 2011 and 2010, respectively. Unbilled accounts receivable represent charges for services delivered to customers for which invoices have not yet been generated by the billing system. Prior to the delivery of services or equipment and supplies to customers, the Company performs certain certification and approval procedures to ensure collection is reasonably assured and that unbilled accounts receivable is recorded at net amounts expected to be paid by customers and third-party payers. Billing delays can occur due to delays in obtaining certain required payer-specific documentation from internal and external sources, interim transactions occurring between cycle billing dates established for each customer within the billing system and new sleep centers awaiting assignment of new provider enrollment identification numbers. In the event that a third-party payer does not accept the claim for payment, the customer is ultimately responsible.

Approximately 11% of the Company’s accounts receivable is from Medicare and Medicaid programs and another 60% is due from major insurance companies. The Company has not experienced losses due to the inability of these major insurance companies to meet their financial obligations and does not foresee that this will change in the near future.

Restricted cash – As of December 31, 2011 and 2010, the Company had long-term restricted cash of $236,000 included in other assets in the accompanying consolidated balance sheets. This amount is pledged as collateral to the Company’s senior bank debt and bank line of credit.

Inventories – Inventories are stated at the lower of cost or market and include the cost of products acquired for sale. The Company accounts for inventories using the first in–first out method of accounting for substantially all of its inventories.

Property and equipment – Property and equipment is stated at cost and depreciated using the straight line method to depreciate the cost of various classes of assets over their estimated useful lives. At the time assets are sold or otherwise disposed of, the cost and accumulated depreciation are eliminated from the asset and depreciation accounts; profits and losses on such dispositions are reflected in current operations. Fully depreciated assets are written off against accumulated depreciation. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

The estimated useful lives of the Company’s property and equipment are as follows:

 

Asset Class

   Useful Life  

Equipment

     5 to 7 years   

Software

     3 to 7 years   

Furniture and fixtures

     7 years   

 

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Asset Class

   Useful Life  

Leasehold improvements

    
 
25 years or remaining lease period,
whichever is shorter
  
  

Vehicles

     3 to 5 years   

Goodwill and Intangible Assets – Goodwill and other indefinitely—lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment of goodwill.

Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to five years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Deferred Offering Costs – The Company defers as other assets the direct incremental costs of raising capital until such time as the offering is completed. At the time of the completion of the offering, the costs are charged against the capital raised. Should the offering be terminated, deferred offering costs are charged to operations during the period in which the offering is terminated.

Equity Investment in Non-Controlled Entity – The Company accounts for its investments in a non-controlled entity using the cost method which requires the investment to be recorded at cost plus any related guaranteed debt or other contingencies. Any earnings are recorded in the period received.

Noncontrolling Interests – Noncontrolling interests in the results of operations of consolidated subsidiaries represents the noncontrolling shareholders’ share of the income or loss of the various consolidated subsidiaries. The noncontrolling interests in the consolidated balance sheet reflect the original investment by these noncontrolling shareholders in these consolidated subsidiaries, along with their proportional share of the earnings or losses of these subsidiaries less distributions made to these noncontrolling interest holders.

Advertising Costs – Advertising and sales promotion costs are expensed as incurred. Advertising expense for 2011 and 2010, included in continuing operations, was approximately $131,000 and $357,000, respectively.

Acquisition Costs – Acquisition costs are charged directly to expense when incurred.

Legal Issues – For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis or sooner if significant changes in matters have occurred to determine if a change in the likelihood of an unfavorable outcome or the estimate of a loss is necessary.

Income Taxes – The Company recognizes deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In the event the Company determines that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which the Company makes such a determination.

 

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The Company uses a two-step process to evaluate a tax position. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met. The Company reports tax-related interest and penalties as a component of income tax expense.

Based on all known facts and circumstances and current tax law, the Company believes that the total amount of unrecognized tax benefits as of December 31, 2011, is not material to its results of operations, financial condition or cash flows. The Company also believes that the total amount of unrecognized tax benefits as of December 31, 2011, if recognized, would not have a material effect on its effective tax rate. The Company further believes that there are no tax positions for which it is reasonably possible, based on current tax law and policy that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on the Company’s results of operations, financial condition or cash flows.

Earnings (loss) per share – Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted earnings (loss) per share are excluded from the calculation.

The dilutive potential common shares on options and warrants are calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of all options and warrants are used to repurchase common stock at market value. The amount of shares remaining after the proceeds are exhausted represents the potential dilutive effect of the securities.

The following securities were not included in the computation of diluted earnings (loss) per share from continuing operations or discontinued operations as their effect would be anti-dilutive:

 

     2011      2010  

Stock options and warrants

     8,312,387         145,417   

Concentration of credit risk – The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risk. The amount of cash deposits as of December 31, 2011 in excess of FDIC limits was approximately $4.4 million. There were no cash deposits in excess of FDIC limits as of December 31, 2010.

Stock options – The Company accounts for its stock option grants using the modified prospective method. Under the modified prospective method, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

Reclassifications – Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation.

 

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Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

On January 1, 2011, the Company adopted changes issued by the Financial Accounting Standards Board (FASB) to revenue recognition for multiple-deliverable arrangements. These changes require separation of consideration received in such arrangements by establishing a selling price hierarchy (not the same as fair value) for determining the selling price of a deliverable, which will be based on available information in the following order: vendor-specific objective evidence, third-party evidence, or estimated selling price; eliminate the residual method of allocation and require that the consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method, which allocates any discount in the arrangement to each deliverable on the basis of each deliverable’s selling price; require that a vendor determine its best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis; and expand the disclosures related to multiple-deliverable revenue arrangements. The adoption of these changes had no impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements with its customers.

On January 1, 2011, the Company adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). The adoption of these changes had no impact on the Company’s consolidated financial statements.

On January 1, 2011, the Company adopted changes issued by the FASB to the disclosure of pro forma information for business combinations. These changes clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Also, the existing supplemental pro forma disclosures were expanded to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of these changes had no impact on the Company’s consolidated financial statements.

Effective January 1, 2010, the Company adopted changes issued by the FASB on January 6, 2010, for a scope clarification to the FASB’s previously-issued guidance on accounting for noncontrolling interests in consolidated financial statements. These changes clarify the accounting and reporting guidance for noncontrolling interests and changes in ownership interests of a consolidated subsidiary. An entity is required to deconsolidate a subsidiary when the entity ceases to have a controlling financial interest in the subsidiary. Upon deconsolidation of a subsidiary, an entity recognizes a gain or loss on the transaction and measures any retained investment in the subsidiary at fair value. The gain or loss includes any gain or loss associated with the difference between the fair value of the retained investment in the subsidiary and its carrying amount at the date the subsidiary is deconsolidated. In contrast, an entity is required to account for a decrease in its ownership interest of a subsidiary that does not result in a change of control of the subsidiary as an equity transaction. The adoption of these changes had no impact on the Company’s consolidated financial statements.

Effective January 1, 2010, the Company adopted changes issued by the FASB on January 21, 2010, to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. The changes also clarify existing disclosure requirements related to how assets and liabilities should be grouped by class and valuation techniques used for recurring and nonrecurring fair value measurements. The adoption of these changes had no impact on the Company’s consolidated financial statements.

Effective January 1, 2010, the Company adopted changes issued by the FASB on February 24, 2010, to accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued, otherwise known as “subsequent events.” Specifically, these changes clarified that an entity that is required to file or furnish its financial statements with the SEC is not required to disclose the date through which subsequent events have been evaluated. Other than the elimination of disclosing the date through which management has performed its evaluation for subsequent events, the adoption of these changes had no impact on the Company’s consolidated financial statements.

 

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Issued Guidance

In September 2011, the FASB issued changes to the testing of goodwill for impairment. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of a reporting unit is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, go directly to the two-step quantitative impairment test. These changes become effective for the Company for any goodwill impairment test performed on January 1, 2012 or later, although early adoption is permitted. The adoption of these changes is not expected to have a material impact on the Company’s consolidated financial statements.

In July 2011, the FASB issued “Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities” (ASU 2011-07), which requires healthcare organizations that perform services for patients for which the ultimate collection of all or a portion of the amounts billed or billable cannot be determined at the time services are rendered to present all bad debt expense associated with patient service revenue as an offset to the patient service revenue line item in the statement of operations. The ASU also requires qualitative disclosures about the Company’s policy for recognizing revenue and bad debt expense for patient service transactions and quantitative information about the effects of changes in the assessment of collectability of patient service revenue. This ASU is effective for fiscal years beginning after December 15, 2011, and will be adopted by the Company in the first quarter of 2012. The Company is currently assessing the potential impact the adoption of this ASU will have on its consolidated results of operations and consolidated financial position.

Note 4 – Change in Accounting Method and Accounting Estimate

On January 1, 2010, the Company elected to change its method of revenue recognition for sleep therapy equipment sales that are paid for over time (“rental equipment”) to recognize the revenue for rental equipment over the life of the rental period which typically ranges from 10 to 13 months. Prior to the acquisitions of somniTech, Inc., somniCare, Inc. and Avastra Eastern Sleep Centers, Inc. in the third quarter of 2009, the Company recognized the total amount of revenue for entire rental equipment period at the inception of the rental period with an offsetting entry for estimated returns. The entities that were acquired in 2009 recorded revenue for rental equipment consistent with method being adopted by the Company. Recording revenue for rental equipment over the life of the rental period will provide more accurate interim information as this method relies less on estimates than the previous method in which potential rental returns had to be estimated.

The Company has determined that it is impracticable to determine the cumulative effect of applying this change retrospectively because historical transactional level records are no longer available in a manner that would allow for the appropriate calculations for the historical periods presented. As a result, the Company will apply the change in revenue recognition for rental equipment on a prospective basis. As a result of the accounting change, the Company’s accumulated deficit increased $213,500, as of January 1, 2010, from $9,869,471, as originally reported, to $10,082,971. In addition, the accounts receivable and the related allowance for doubtful accounts associated with the outstanding rental equipment were removed and the cost of outstanding rental equipment was established as rental inventory as detailed below:

 

Accounts receivable

   $ 796,768   

Allowance for doubtful accounts

     (512,891

Less: Rental inventory established

     70,377   
  

 

 

 

Adjustment to accumulated deficit

   $ 213,500   
  

 

 

 

 

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Note 5 – Acquisitions

On December 12, 2011, the Company acquired 80% of the Village Sleep Center (“Village”), located in Plano, Texas, for a purchase price of up to $960,000. Under the purchase agreement, the Company paid $596,000 in cash and withheld $364,000 of the purchase price (“Withheld Funds”) as collateral to secure any obligations the sellers have pursuant to the indemnification clauses of the purchase agreement. The Withheld Funds, less any amounts deducted, shall be paid in two equal installments, not to exceed $182,000. In order to receive the maximum installment payment, the trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) for Village for the years ended December 31, 2012 and 2013 must be at least $200,000, respectively. If the EBITDA for 2012 and or 2013 is less than $200,000, the payment of Withheld Funds will be reduced by the ratio of actual EBITDA to the required EBITDA of $200,000. The Company determined the fair value of the contingent consideration or Withheld Funds to be $234,565. The Company will revalue the contingent consideration on a recurring basis at each reporting period. During the twelve months after the date of the acquisition, any difference between the $234,565 of contingent consideration recorded and the actual payment for Withheld Funds will be recorded as an adjustment to the original purchase accounting. Any adjustments recorded after one year will be recorded as an adjustment to earnings.

The acquisition of Village was based on management’s belief that the Village location will solidify the Company’s market presence in the Plano area.

The Village acquisition was recorded by allocating the cost of the acquisition to the assets acquired, including intangible assets and liabilities assumed based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is tax deductible. As of December 31, 2011, management has completed a preliminary valuation of the fair value of the assets acquired and liabilities assumed in the Village acquisition. Management expects that the final appraisal of Village could result in changes, however it is not expected that the final appraisal amounts will be materially different from those reflected at December 31, 2011. The preliminary purchase allocation for the Village acquisition was as follows:

 

     Village  

Property and equipment

   $ 102,859   

Intangible assets

     50,000   

Goodwill

     885,348   
  

 

 

 

Total assets acquired

     1,038,207   
  

 

 

 

Liabilities assumed:

  

Contingent consideration

     234,565   
  

 

 

 

Noncontrolling interests

     207,642   
  

 

 

 

Net assets acquired

   $ 596,000   
  

 

 

 

During 2011, the Company recorded expenses of approximately $69,000 related to costs incurred in the acquisition of Village. The acquisition costs were primarily related to legal and professional fees and other costs incurred in performing due diligence.

The amounts of Village’s revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2011, were approximately $27,000 and $12,000, respectively. It was impracticable for Company to obtain adequate financial information, from Village’s previous facility manager, to prepare pro forma revenue and earnings information for Village for 2011 and 2010.

Note 6 – Discontinued Operations

On May 10, 2011, the Company executed an Asset Purchase Agreement (“Agreement”) with Daniel I. Rifkin, M.D., P.C. pursuant to which the Company sold substantially all of the assets of the Company’s subsidiary, Nocturna East, Inc. (“East”) for $2,500,000. In conjunction with the sale of East assets, the Management Services Agreement (“MSA”) under which the Company provided certain services to the sleep centers owned by Independent Medical Practices (“IMA”) including billing and collections, trademark rights, non-clinical sleep center management services, equipment rental fees, general management services, legal support and accounting and bookkeeping services was terminated. The Company’s decision to sell the assets of East was primarily based on management’s determination that the operations of East no longer fit into the Company’s strategic plan of providing a full continuum of care to patients due to significant regulatory barriers that limit the Company’s ability to sell CPAP devices and other supplies at the East locations. As a result of the sale of East, the related assets, liabilities, results of operations and cash flows of East have been classified as discontinued operations in the accompanying consolidated financial statements.

 

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On September 1, 2010, the Company executed an Asset Purchase Agreement, which was subsequently amended on October 29, 2010, (as amended, the “Agreement”) providing for the sale of substantially all of the assets of the Company’s subsidiary, ApothecaryRx (the “ApothecaryRx Sale”). ApothecaryRx operated 18 retail pharmacy stores selling prescription drugs and a small assortment of general merchandise, including diabetic merchandise, non-prescription drugs, beauty products and cosmetics, seasonal merchandise, greeting cards and convenience foods. The final closing of the sale of ApothecaryRx assets occurred in December 2010. As a result of the sale of ApothecaryRx, the related assets, liabilities, results of operations and cash flows of ApothecaryRx have been classified as discontinued operations in the accompanying consolidated financial statements.

Under the Agreement, the consideration for the ApothecaryRx assets purchased and liabilities assumed is $25,500,000 plus up to $7,000,000 for inventory (“Inventory Amount”), but less any payments remaining under goodwill protection agreements and any amounts due under promissory notes which are assumed by buyer (the “Purchase Price”). For purposes of determining the Inventory Amount, the parties agreed to hire an independent valuator to perform a review and valuation of inventory being purchased from each pharmacy location; the independent valuator valued the Inventory Amount at approximately $3.8 million. The resulting total Purchase Price was $29.3 million. Of the Purchase Price, $2,000,000 was deposited in an escrow fund (the “Indemnity Escrow Fund”) pursuant to the terms of an indemnity escrow agreement. All proceeds from the sale of ApothecaryRx were deposited in a restricted account at Arvest Bank. Of the proceeds, $22,000,000 was used to reduce outstanding obligations under the Company’s credit facility with Arvest Bank.

In December 2011 (the 12-month anniversary of the final closing date of the sale of ApothecaryRx), 50% of the remaining funds ($1,000,000) held in the Indemnity Escrow Fund were released, without deduction for any pending claims for indemnification. All remaining funds held in the Indemnity Escrow Fund, if any, will be released in June 2012 (the 18-month anniversary of the final closing date of the sale), subject to any pending claims for indemnification.

During 2010, the Company recorded a special charge of approximately $6.5 million ($0.90 per share) related to certain estimated costs resulting from the ApothecaryRx Sale. The components of the special charge are as follows:

 

Loss on liquidation of inventory

   $
2,041,051
  

Bad debt expense on remaining accounts receivable

     3,003,190   

Lease termination costs

     859,580   

Severance and payroll costs

     493,303   

Equipment removal and lease termination costs

     119,489   
  

 

 

 

Total charge

   $ 6,516,613   
  

 

 

 

The charges noted above were incurred as a result of the following:

 

  The Company did not sell certain of the front-end merchandise and private-label and other over the counter drugs as part of the ApothecaryRx Sale. The loss on liquidation of inventory represents the loss on items that have been liquidated and the write-down of remaining inventory to expected liquidated values.

 

  The Company recorded a reserve for substantially all outstanding accounts receivable that had not been collected as of January 31, 2011. Historically, the Company collected accounts receivable within 30 days, but after the ApothecaryRx sale, the Company saw a significant delay from third-party payers. During 2011, the Company collected approximately $427,000 from the accounts that were outstanding at January 31, 2011. This amount was recorded as a bad debt recovery in 2011. The Company does not anticipate any future collections from the remaining ARx accounts receivable.

 

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  The Company incurred certain severance and payroll costs, lease termination costs and equipment removal costs related to the pharmacy locations which were not assumed by the buyer.

The operating results of East, ApothecaryRx and the Company’s other discontinued operations (discontinued internet sales division and discontinued film operations) are summarized below:

 

     2011     2010  

Revenues

    

East

   $ 566,874      $ 2,242,718   

ApothecaryRx

     (155,007     79,038,856   

Other

     (1,184     18,126   
  

 

 

   

 

 

 

Total revenues

   $ 410,683      $ 81,299,700   
  

 

 

   

 

 

 

Income (loss) from discontinued operations, before taxes

    

East

   $ 25,796      $ (2,163,854

ApothecaryRx

     (426,067     (324,092

Other

     (43,298     (220,258

Gain recorded on sale of East

     734,724        —     

Gain recorded on sale of ApothecaryRx

     —          5,644,880   

Special (charges) incurred on sale

     —          (6,516,613

Income tax (provision)

     —          —     
  

 

 

   

 

 

 

Income (loss) from discontinued operations

   $ 291,155      $ (3,579,937
  

 

 

   

 

 

 

As noted above, the Company’s other discontinued operations generated net loss of ($43,298) and ($220,258) during the years ended December 31, 2011 and 2010, respectively. During the year ended December 31, 2011, other discontinued operations included a loss from the Company’s discontinued internet sales channel of ($44,430) which was offset by income from the Company’s discontinued film operations of $1,132. During the year ended December 31, 2010, other discontinued operations included a loss from the Company’s discontinued internet sales channel of ($225,948) which was offset by income from the Company’s discontinued film operations of $5,690.

The balance sheet items for East, ApothecaryRx and the Company’s other discontinued operations as of December 31, 2011 and 2010 are summarized below:

 

     2011      2010  

Cash and cash equivalents

   $ 1,099       $ 931,402   

Accounts receivable, net of allowances

     —           969,924   

Inventories

     34,219         68,267   

Indemnity Escrow Fund

     1,000,000         1,000,000   

Other current assets

     23,705         379,974   
  

 

 

    

 

 

 

Total current assets

     1,059,023         3,349,567   
  

 

 

    

 

 

 

Fixed assets, net

     54,255         328,680   

Indemnity Escrow Fund

     —           1,000,000   

Intangible assets, net

     —           1,087,000   

Goodwill

     —           163,730   
  

 

 

    

 

 

 

Total noncurrent assets

     54,255         2,579,410   
  

 

 

    

 

 

 

Total assets

   $ 1,113,278       $ 5,928,977   
  

 

 

    

 

 

 

 

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     2011      2010  

Payables and accrued liabilities

   $ 723,274       $ 2,140,602   
  

 

 

    

 

 

 

Total liabilities

   $ 723,274       $ 2,140,602   
  

 

 

    

 

 

 

Note 7 – Property and Equipment

Following are the components of property and equipment included in the accompanying consolidated balance sheets as of December 31, 2011 and 2010:

 

     2011     2010  

Equipment

   $ 2,694,547      $ 2,640,178   

Furniture and fixtures

     555,423        542,096   

Software

     793,416        815,287   

Vehicles

     161,990        144,410   

Leasehold improvements

     1,663,355        1,492,998   
  

 

 

   

 

 

 
     5,868,731        5,634,969   

Accumulated depreciation

     (2,932,739     (1,992,122
  

 

 

   

 

 

 
   $ 2,935,992      $ 3,642,847   
  

 

 

   

 

 

 

Depreciation expense for the years ended December 31, 2011 and 2010 was $961,612 and $1,019,657, respectively.

During 2010, the Company identified impairment indicators relating to property and equipment at certain sleep diagnostic facilities and certain administrative facilities. The impairment indicators related primarily to sleep diagnostic systems that were no longer compatible with current systems and assets associated with sleep diagnostic and office facilities that were closed or consolidated into other locations. Accordingly, the Company performed a recoverability test and an impairment test on these locations and determined, based on the results of an undiscounted cash flow analysis (level 3 in the fair value hierarchy), that the fair value of the identified assets was less than their carrying value. As a result, an impairment charge of $762,224 for the year ended December 31, 2010 was recorded as a component of operating expenses in the accompanying consolidated financial statements. There was no impairment charge recorded in 2011.

Note 8 – Goodwill and Other Intangibles

Changes in the carrying amount of goodwill during the years ended December 31, 2011 and 2010 were as follows:

 

     Gross
Amount
     Accumulated
Impairment
Losses
    Net
Carrying
Value
 

January 1, 2010

   $ 20,353,164       $ —        $ 20,353,164   

Impairment charge

     —           (7,508,941     (7,508,941
  

 

 

    

 

 

   

 

 

 

December 31, 2010

     20,353,164         (7,508,941     12,844,223   

Business acquisition

     885,348         —          885,348   
  

 

 

    

 

 

   

 

 

 

December 31, 2011

   $ 21,238,512       $ (7,508,941   $ 13,729,571   
  

 

 

    

 

 

   

 

 

 

As of December 31, 2011, the Company had approximately $13.7 million of goodwill resulting from business acquisitions. Goodwill and intangibles assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill and indefinite-lived intangible assets for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the impairment test to determine the amount of impairment loss on goodwill and all related intangible assets. The second step of the impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

 

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Based on the Company’s (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing the Company’s business units, the Company determined that the carrying value of goodwill related to the Company’s sleep centers located in Oklahoma, Nevada and Texas exceeded their fair value. In addition, the Company determined the carrying value of the Company’s intangible assets exceeded their fair value. Accordingly, the Company recorded a noncash impairment charge, in December 2010, of $7.5 million and $0.4 million, respectively, on goodwill and other intangible assets. The Company’s evaluation of goodwill and indefinite lived intangible assets completed during 2011 resulted in no impairment losses.

Changes in the carrying amount of intangible assets during the years ended December 31, 2011 and 2010 were as follows:

 

     Gross
Amount
     Accumulated
Impairment
Losses
    Accumulated
Amortization
    Net  

January 1, 2010

   $ 2,085,000       $ —        $ (197,699   $ 1,887,301   

Amortization

     —           —          (207,600     (207,600

Impairment charge

     —           (365,945     —          (365,945
  

 

 

    

 

 

   

 

 

   

 

 

 

December 31, 2010

     2,085,000         (365,945     (405,299     1,313,756   

Business acquisition

     50,000         —          —          50,000   

Amortization

     —           —          (149,123     (149,123
  

 

 

    

 

 

   

 

 

   

 

 

 

December 31, 2011

   $ 2,135,000       $ (365,945   $ (554,422   $ 1,214,633   
  

 

 

    

 

 

   

 

 

   

 

 

 

At December 31, 2010, the Company also had intangible assets of $1,087,000 included in other assets from discontinued operations. These intangible assets were applicable to customer relationships at East which was sold in May 2011.

Intangible assets as of December 31, 2011 and 2010 include the following:

 

            2011      2010  
     Useful
Life
(Years)
     Carrying
Value(1)
     Accumulated
Amortization
    Net      Carrying
Value(1)
     Accumulated
Amortization
    Net  

Customer relationships

     5 -15       $ 1,139,333       $ (319,634   $ 819,699       $ 1,139,333       $ (231,333   $ 908,000   

Covenants not to compete

     3 -15         210,111         (145,056     65,055         160,111         (119,000     41,111   

Trademark

     10         229,611         (60,177     169,434         229,611         (38,078     191,533   

Payor contracts

     15         190,000         (29,555     160,445         190,000         (16,888     173,112   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total

      $ 1,769,055       $ (554,422   $ 1,214,633       $ 1,719,055       $ (405,299   $ 1,313,756   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) The carrying value is net of accumulated impairment charges.

Amortization expense for the years ended December 31, 2011 and 2010 was $149,123 and $207,600, respectively. Amortization expense for the next five years related to these intangible assets is expected to be as follows:

 

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2012

   $ 156,178   

2013

     139,734   

2014

     138,344   

2015

     123,067   

2016

     109,200   

Note 9 – Other Assets:

Deferred Offering Costs

As of December 31, 2010, the Company had deferred offering costs of approximately $435,000. The costs were incurred in conjunction with a public stock offering that the Company completed in 2011. See Note 13 – Capital Structure.

Equity Investment in Non-Controlled Entity

In December 2008, the Company invested in a non-controlled entity (the “Fund”) whose purpose is to invest in Oklahoma based small or rural small business ventures. Such investment generates tax credits which will be allocated to investors and can be used to offset Oklahoma state income tax. The tax credits are available through a rural economic development fund established by the state of Oklahoma.

The Company invested $200,000 and signed a non-recourse debt agreement for approximately $1,537,000. The debt agreement is completely non-recourse to the Company for any amount in excess of the pledged capital investment of $200,000. As the debt agreement is non-recourse and has been guaranteed by other parties, it has not been reflected in the accompanying consolidated balance sheet.

The Company has provided with documentation from the Fund referencing tax credits which are available to the Company in the amount of approximately $400,000. The tax credits expired in 2010. Given the Company’s historical operating losses, management determined in the 4th quarter of 2010 that realization of the Company’s $200,000 investment from proceeds other than utilization of the tax credit was remote and as a result an impairment charge of $200,000 was recorded.

Note 10 – Borrowings

The Company’s borrowings as of December 31, 2011 and 2010 are as follows:

 

     Rate (1)     Maturity
Date
     2011     2010  

Bank line of credit

     6     June 2014 - Aug. 2015       $ 14,114,145      $ 14,396,935   

Senior bank debt

     6     May 2014         4,708,984        8,000,000   

Notes payable on equipment

     6 - 14     Apr. 2012 - Dec. 2013         282,872        417,249   

Sleep center working capital notes payable

     3.25 - 6     Mar. 2012 - Jan. 2015         90,247        225,124   

Seller financing

     7.6     Sep. 2012         40,317        90,662   

Notes payable on vehicles

     2.9 - 3.9     Nov. 2012 - Dec. 2013         38,723        63,586   

Insurance premium financing

     2.97        Nov. 2011         —          12,075   
       

 

 

   

 

 

 

Total borrowings

          19,275,288        23,205,631   

Less: Current portion of long-term debt

          (2,071,597     (22,768,781
       

 

 

   

 

 

 

Long-term debt

        $ 17,203,691      $ 436,850   
       

 

 

   

 

 

 

 

(1) Effective rate as of December 31, 2011

 

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In May 2008 and as amended in May 2009, July 2010, December 2010 and March 2012, the Company entered into a loan agreement with Arvest Bank consisting of a $30 million term loan (the “Term Loan”) and a $15 million line of credit to be used for future acquisitions (the “Acquisition Line”); collectively referred to as the “Credit Facility”. The Term Loan was used by the Company to consolidate certain prior loans to the Company’s subsidiaries SDC Holdings LLC (“SDC Holdings”) and ApothecaryRx LLC. The Term Loan and the Acquisition Line bear interest at the greater of the prime rate as reported in the Wall Street Journal or the floor rate of 6%. Prior to June 30, 2010, the floor rate was 5%. The rate on the Term Loan is adjusted annually on May 21. The rate on the Acquisition Line is adjusted on the anniversary date of each advance or tranche. The Term Loan matures on May 21, 2014 and requires quarterly payments of interest only. Commencing on September 1, 2011, the Company is obligated to make quarterly payments of principal and interest calculated on a seven-year amortization based on the unpaid principal balance on the Term Loan as of June 1, 2011. Each advance or tranche of the Acquisition Line will become due on the sixth anniversary of the first day of the month following the date of the advance or tranche. Each advance or tranche is repaid in quarterly payments of interest only for three years and thereafter, quarterly principal and interest payments based on a seven-year amortization until the balloon payment on the maturity date of the advance or tranche. The Credit Facility is collateralized by substantially all of the Company’s assets and is personally guaranteed by various individual shareholders of the Company. The Company has also agreed to maintain certain financial covenants including a Debt Service Coverage Ratio of not less than 1.25 to 1 and Minimum Net Worth, as defined.

As of December 31, 2011, the Company’s Debt Service Coverage Ratio is less than 1.25 to 1. Arvest Bank has waived the Debt Service Coverage Ratio and Minimum Net Worth requirements until March 31, 2013. In April 2012 and as a condition of obtaining the waiver, the Company agreed to the following conditions:

 

   

The Company paid all principal and interest due on the Arvest Debt through June 30, 2012.

 

   

The Company will pay on or before June 30, 2012, all principal and interest due on the Arvest Debt through December 31, 2012.

 

   

Beginning on April 1, 2012, and continuing through June 4, 2012, the Company must have $1.75 million in cash on hand and beginning June 5, 2012 and ending on June 30, 2012, the Company must have $2.5 million in cash prior to making the required principal and interest prepayment due on June 30, 2012.

 

   

Beginning on September 30, 2012, and on the last day of each quarter thereafter, the Company’s EBITDA must be positive for the immediately prior quarter. EBITDA is defined as net income plus: (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense and (iv) non-cash charges including impairment charges and stock compensation.

There is no assurance that Arvest Bank will waive any future violations of the Debt Service Coverage Ratio covenant. However, management has historically been successful in obtaining waivers from Arvest Bank.

The Company has entered into various notes payable for the purchase of sleep diagnostic equipment. The balance owed at December 31, 2011 of $282,872 is comprised of two notes with principal balances at December 31, 2011 of $274,872 and $8,000, respectively, and that bear interest at fixed rates of 6% and 14%, respectively. The Company is required to make monthly payments of principal and interest totaling $15,449. The notes mature in December 2013 and April 2012, respectively.

The Company has entered into various notes payable to banks to supplement the working capital needs of its individual sleep centers. The amount owed under these notes at December 31, 2011 of $90,247 bear interest at variable rates ranging from 0.0% to 1.5% above the prime rate as published in the Wall Street Journal except for one note which bears interest at a fixed rate of 6.0%. The Company is required to make monthly payments of principal and interest totaling $4,743. The notes mature on varying dates from March 2012 to January 2015.

As part of the sale of ApothecaryRx assets, the Company retained one seller financing note payable. The note bears interest at a fixed rate of 7.6% and matures in September 2012. The Company is required to make monthly payments of principal and interest of $4,627.

 

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The Company has entered various notes payable for the purchase of vehicles. Under the terms of the notes, the Company is required to make monthly principal and interest payments totaling $2,221. The notes mature on various dates from November 2012 to December 2013.

At December 31, 2011, future maturities of long-term debt were as follows:

 

2012

   $ 2,071,597   

2013

     2,548,585   

2014

     11,052,339   

2015

     3,602,767   

2016

     —     

Thereafter

     —     

Note 11 – Commitments and Contingencies

Legal Issues

The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. During the year ended December 31, 2011, the Company incurred $160,000 in settlement expenses related to its ongoing asserted and unasserted legal claims. During the year ended December 31, 2010, the Company did not incur any costs in settlement expenses related to its ongoing asserted and unasserted legal claims.

Operating Leases

The Company leases all of the real property used in its business for office space, retail pharmacy locations and sleep testing facilities under operating lease agreements. Rent is expensed consistent with the terms of each lease agreement over the term of each lease. In addition to minimum lease payments, certain leases require reimbursement for common area maintenance and insurance, which are expensed when incurred.

The Company’s rental expense for operating leases in 2011 and 2010 was $1,605,474 and $1,908,322, respectively.

Following is a summary of the future minimum lease payments under operating leases as of December 31, 2011:

 

2012

   $ 1,257,709   

2013

     1,146,921   

2014

     807,079   

2015

     479,190   

2016

     332,821   

Thereafter

     2,103,253   
  

 

 

 

Total

   $ 6,126,973   
  

 

 

 

Significant Supplier

The Company is dependent on merchandise vendors to provide sleep disorder related products for resale. The Company’s largest sleep product suppliesr are Fisher & Paykel Healthcare, which supplied approximately 38% and 39% of the Company’s sleep supplies in the years ended December 31, 2011 and 2010, respectively, and ResMed, Inc., which supplied approximately 32% and 30% of the Company’s sleep supplies in the years ended December 31, 2011 and 2010, respectively. In management’s opinion, if any of these relationships were terminated or if any contracting party were to experience events precluding fulfillment of the Company’s needs, the Company would be able to find a suitable alternative supplier, but possibly not without significant disruption to the Company’s business. This could take a significant amount of time and result in a loss of customers and revenue, operating and cash flow losses and may deplete working capital reserves.

 

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Note 12 – Income Taxes

The income tax provision for the years ended December 31, 2011 and 2010 consists of:

 

     2011     2010  

Current provision

   $ 13,992      $ 118,000   

Deferred provision (benefit)

     (2,168,000     998,000   

Change in beginning of year valuation allowance

     2,168,000        (998,000
  

 

 

   

 

 

 

Total

   $ 13,992      $ 118,000   
  

 

 

   

 

 

 

Current provision, discontinued operations

   $ —        $ 48,795   
  

 

 

   

 

 

 

The Company expensed $110,000 during the year ended December 31, 2010 for estimated penalties incurred for filing certain Federal tax returns late. The amount expensed is included in the income tax provision. There were no estimated penalties expensed during the year ended December 31, 2011. The Company has accrued interest and penalties of approximately $159,000 at December 31, 2011 and 2010 related to the late filing of certain tax returns. The accrued interest and penalties are included in accrued liabilities in the accompanying consolidated balance sheets.

Deferred income tax assets and liabilities as of December 31, 2011 and 2010 are comprised of:

 

     2011     2010  

Deferred income tax assets:

    

Current:

    

Accounts receivable

   $ 538,000      $ 1,664,000   

Accrued liabilities

     87,000        106,000   
  

 

 

   

 

 

 
     625,000        1,770,000   

Valuation allowance

     (625,000     (1,770,000
  

 

 

   

 

 

 

Total current deferred tax assets

     —          —     
  

 

 

   

 

 

 

Long-term:

    

Goodwill

     3,249,000        4,839,000   

Net operating loss carryforwards

     10,025,000        4,725,000   

State tax credit carryforwards

     —          400,000   

Intangible assets

     77,000        154,000   

Acquisition costs

     63,000        38,000   

Stock awards

     50,000        69,000   
  

 

 

   

 

 

 
     13,464,000        10,225,000   

Valuation allowance

     (13,162,000     (9,849,000
  

 

 

   

 

 

 

Total long-term deferred tax assets

     302,000        376,000   

Deferred income tax liabilities:

    

Long-term:

    

Fixed assets, net

     302,000        376,000   
  

 

 

   

 

 

 

Deferred tax asset, net

   $ —        $ —     
  

 

 

   

 

 

 

The change in the Company’s valuation allowance on deferred tax assets during the years ended December 31, 2011 and 2010 follows:

 

     2011      2010  

Beginning valuation allowance

   $ 11,619,000       $ 12,617,000   

Change in valuation allowance

     2,168,000         (998,000
  

 

 

    

 

 

 

Ending valuation allowance

   $ 13,787,000       $ 11,619,000   
  

 

 

    

 

 

 

 

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The Company’s effective income tax rate for continuing operations differs from the U.S. Federal statutory rate as follows:

 

     2011     2010  

Federal statutory rate

     35.0     35.0

Change in valuation allowance

     -35.5        5.2   

Nondeductible impairment charges

     —          -29.6   

Other

     0.3        -11.5   
  

 

 

   

 

 

 

Effective income tax rate

     -0.2