This management’s discussion and analysis of results of operations and financial condition contains forward-looking statements that involve risks and uncertainties. In some cases, you can identify these statements by forward-looking words such as “may,” “might,” “will,” “should,” “expect(s),” “plan(s),” “anticipate(s),” “believe(s),” “estimate(s),” “predict(s),” “intend(s),” “potential” and similar expressions. All of the forward-looking statements contained in this registration statement are based on estimates and assumptions made by our management. These estimates and assumptions reflect our best judgment based on currently known market and other factors. Although we believe such estimates and assumptions are reasonable, they are inherently uncertain and involve risks and uncertainties. In addition, management’s assumptions about future events may prove to be inaccurate. We caution you that the forward-looking statements contained in this registration statement are not guarantees of future performance and we cannot assure you that such statements will be realized. In all likelihood, actual results will differ from those contemplated by such forward-looking statements as a result of a variety of factors. Except as required by law, we undertake no obligation to update any of these forward-looking statements.
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The following discussion of our consolidated financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes attached hereto included in the Annual Report on Form 10-K for the years ended December 31, 2008 filed on March 27, 2009 and subsequently amended on June 11, 2009 and July 20, 2009 on form 10K/A.
HC Innovations, Inc. (the “Company”, “We”, “Us”, or “Our”) is a holding company incorporated in Delaware that, through its subsidiaries, provides specialty care management products and services.
Our wholly owned subsidiary and operating company is Enhanced Care Initiatives, Inc. (“ECI”). ECI is a specialty care management company comprised of several divisions each with a specific focus and intervention. Our mission is to identify subgroups of people with high costs and disability and to create and implement systems that improve their health, resulting in dramatic reductions in the cost of their care. As a specialty care management company, we bring to our clients the ability to impact the health and cost of their sickest, costliest subsets of patients. We combine our proprietary state of the art information systems with highly trained nurses and nurse practitioners. We provide intense, hands-on involvement with call center backup and biometric monitoring. We connect care around the patient and around the clock, providing care support if the patient requires hospitalization or rehabilitation in a nursing home — always working to bring the patient safely home. We connect directly with the patient’s physician by going with the patient to doctor visits. The applications for our unique systems are numerous, complex populations that require complex solutions. We combine best practices, state of the art Electronic Health Record (EHR), communication tools, calls center support and biometrics, with community-based, hands-on, high-touch care.
The Company’s focus for the past five years was to invest in the areas of IT/Systems building, clinical protocol training and development, human resource recruiting, training and development as well as marketing and business development expense. The Company has invested heavily in the development of its proprietary software systems for fully integrated electronic health records for its principal divisions: Easy Care and NP Care. During the past three years the Company has also invested in additions to its management and systems infrastructure in anticipation of rapid growth of its programs.
Management believes that these investments in building the management infrastructure and systems is critical, both to ensure effective execution of its business model(s) in each market area, and to sustain high levels of revenue growth and margin enhancement over time. Management believes its model for Easy Care is scalable, however there are significant start-up costs associated with scaling to new markets and there can be no assurance that the Company will be successful in securing new contracts and growing these new markets profitably.
We identify subgroups of people with common needs and create programs to fill the gaps in care, stabilizing the health of the individual. These are highly complex populations that require complex solutions. We combine best practices, state of the art (EHR), communication tools, calls center support and biometrics, with community-based, hands-on, high-touch care.
CORPORATE STRATEGY
We create scalable interventions which result in significant healthcare cost savings which drive our growth visibility and profitability.
As is typical with early stage, growth companies, fiscal year 2007, 2008 and first quarter 2009 losses are largely a result of business development expenses as well as significant investment in building infrastructure for growing our divisions, business and clinical systems and programs. During the first quarter of 2008 we opened Easy Care operations in the state of Alabama bringing the total number of Easy Care operations to five at June 30, 2009.
In addition to the new operations opened during 2008 we experienced growth in the number of members under care within the Easy Care Operations. As of June 30, 2009 we had approximately 6,800 members under care throughout the Easy Care operations representing a 13% increase from members under care as of December 31, 2008.
RESULTS OF OPERATIONS
Our focus through the first two quarters of 2009 was to invest in the areas of IT/Systems, clinical protocol training and development, human resource recruiting, training and development as well as marketing and business development expense. We have invested heavily in the development of proprietary software systems for fully integrated electronic health records for its principal divisions: Easy Care and NP Care. During 2008 and 2009 to date, we have also invested in management and systems infrastructure in anticipation of rapid growth.
Management believes that these investments in building the management infrastructure and systems is critical, both to ensure effective execution of its business model(s) in each market area, and to sustain high levels of revenue growth and margin enhancement over time. Management believes its models are highly scalable, however there are significant start-up costs associated with scaling to new markets and there can be no assurance that we will be successful in securing new contracts and growing these new markets profitably.
THREE AND SIX - MONTHS ENDED JUNE 30, 2009 AND 2008
Revenues
For the three months ended June 30, 2009, net revenue was $7,012,831, representing an increase of $179,398 (3%), as compared to the net revenue of $6,833,433 for the three months ended June 30, 2008. The increase is a result of membership growth from existing customers. For the six months ended June 30, 2009, net revenue was $14,636,570, representing an increase of $2,484,787 (20%), as compared to the net revenue of $12,151,783 for the six months ended June 20, 2008, primarily a result of membership growth from existing customers.
Cost of Net Revenue and Gross Profit
For the three months ended June 30, 2009, cost of net revenue was $3,886,207, representing a decrease of ($875,679) (18%), as compared to the cost of net revenue of $4,761,886 for the three months ended June 30, 2008. The decrease is a result of exiting select markets in our Medical Management segment and continued focus on cost containment strategies. For the six months ended June 30, 2009, cost of net revenue was $8,004,696, representing a decrease of ($871,920) (10%), as compared to the cost of net revenue of $8,876,616 for the six months ended June 30, 2008. The decrease is a result of exiting select markets in our Medical Management segment and continued focus on cost containment strategies.
For the three months ended June 30, 2009, gross margin was $3,126,624 or 51% as compared to the gross margin of $2,071,547 or 30% of net revenue for the three months ended June 30, 2008. For the six months ended June 30, 2009, gross margin was $6,631,874 or 45% of net revenue representing an increase of $3,356,707, or 103% as compared to the gross margin of $3,275,167, or 27% of net revenue for the six months ended June 30, 2008. The margin improvement for both the three month and six month periods of 2009 as compared to the comparable periods of 2008 are a result primarily of the Company’s membership growth combined with improved efficiencies in operations and cost containment strategies.
Selling, General and Administrative Expense (“SG&A Expenses”)
SG&A expenses include the wages and salaries of administrative and business development personnel, as well as other general and corporate overhead costs not directly related to generation of net revenue. For the three months ended June 30, 2009, total SG&A Expenses were $3,189,180, representing a decrease of $938,496 or 23% as compared to the total SG&A Expenses of $4,127,676 for the three months ended June 30, 2008. For the six months ended June 30, 2009, total SG&A expenses were $6,752,526, representing a decrease of $845,410 (11%) as compared to the total SG&A expenses of $7,597,936 for the six months ended June 30, 2008. The decreases in both the three and six month periods of 2009 as compared to the comparable periods of 2008 are results of the Company’s continuing focus on operational efficiencies and cost containment strategies.
Depreciation and amortization expense are calculated using the straight line method over the estimated useful lives of the assets, or, in the case of leasehold improvements over the remaining term of the related lease, whichever is shorter. For the three months ended
June 30, 2009, depreciation and amortization expense included in operating expenses was $144,040, representing an increase of $2,288 or (2%), as compared to the total depreciation and amortization expense of $141,752 included in SG&A for the three months ended June 30, 2008. For the six months ended June 30, 2009, depreciation and amortization expense included in operating expenses is $282,144, representing an increase of $9,870 (4%), as compared to the total depreciation and amortization expense of $272,274 for the six months ended June 30, 2008.
Income (Loss) from operations
For the three months ended June 30, 2009, we incurred a loss from operations of ($206,596) representing an improvement of $1,991,285 or 91%, compared to ($2,197,881) for the three months ended June 30, 2008. For the six months ended June 30, 2009, we incurred a loss from operations of ($402,796), representing an improvement of $4,192,247 (91%) compared to a loss from operations of $4,595,043 for the six months ended June 30, 2008. We expect further improvement in our results of operations as revenues increase and we begin to absorb the incremental fixed costs associated with our expansion. Revenues and operating results are expected to fluctuate from period to period as a result of the timing of new contracts and additional start-up costs associated with additional planned new markets.
Other Income (Expense)
Other income (expense) includes interest income/expense, amortization of net discounts as well as income from derivative instruments in accordance with Statement of Financial Accounts Standards. For the three months ended June 30, 2009, Other Income was $7,281,349 representing an improvement of $8,616,542 or 845% compared to Other Expense of $1,335,194 for the three months ended June 30, 2008. The change is due to the decrease in interest expense due to the senior secured Noteholders which was capitalized as convertible debentures offset by an increase in amortization expense related to the derivative liabilities and combined with the income derived from the change in fair value of derivative liabilities. For the six months ended June 30, 2009, other income was $955,364, representing an improvement of $3,500,448 or 338% compared to Other Expense of $2,545,084 for the six months ended June 30, 2008. The year to date change in Other Income is due to the decrease in interest expense, offset by additional amortization expense as well as year to date profit on the change in fair value of derivative instruments.
Income Tax Expense
We have incurred net operating losses (NOLs) since inception. At June 30, 2009, we had net operating loss carry forwards for federal income tax purposes of approximately $24.0 million, which is available to offset future federal taxable income, if any, ratably through 2028. These net operating losses are subject to review by federal and state tax authorities.
PLAN OF OPERATIONS - EASY CARE
Primary Strategy
Our primary strategy consists of the following:
1. MANAGED MEDICARE MARKET - Currently over five million enrolled — 150,000 Easy Care(SM) eligible. We are focusing on small to medium sized Medicare Advantage programs with Medicare enrollment between 10,000 and 60,000. These plans are independent and not part of large networks; they are growing their Medicare membership, and are less likely to have their own disease management programs. Most of these plans are well established, though some are relatively new to Medicare. We believe we are well positioned to grow with the enrollment of these companies.
2. SUBCONTRACTING WITH POPULATION BASED-SINGLE DISEASE ORIENTED DISEASE MANAGEMENT COMPANIES — many of these companies either have large Medicare populations, are partnering with an HMO in a CCI (Medicare demonstration project), or seeking contracts with the states for Medicaid populations which include the disabled. In these cases we subcontract with the company and enable them to provide a complete spectrum of care which includes hands-on and presence in the community for the medically complex and frail.
3. DUAL ELIGIBLE MEDICARE/MEDICAID PLANS - these are relatively new entities but a number of companies who are already in the Medicaid market are seeking to enroll Medicare members who have both insurances since the reimbursement incentives are favorable. Most of these companies do not have experience with the medically complex and frail patients and are seeking partners to help them.
4. MEDICAID CONTRACTS —although this is a population which could benefit from our programs, the sales cycle is very long (up to two years) and the RFP (Request for Proposal) process too distracting for EASY CARE(SM) at this time. Our approach in this context is to partner with other Disease Management and Managed Care Organizations as part of their Request for Proposal responses.
PLAN OF OPERATIONS - NP CARE
NP Care’s fundamental tools and processes include:
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| • | Problem-oriented nurse documentation tools that guide the nurse through appropriate, efficient patient evaluation and interventions. |
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| • | On-site nurse practitioner providing support and care. |
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| • | Integration with the physician, staff and family. |
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| • | Patient risk assessments of adverse events, such as falls, fractures, and dehydration drive our Risk Avoidance Program and allows the nursing home to put in place safeguards to reduce these events, while allowing us to notify the family of the risks involved, thereby mitigating potential lawsuits. |
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NP Care has two revenue models: |
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| • | Fee for service |
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| | – | Where our Nurse Practitioners visit patients for acute care needs and bill the patients’ insurance company. Medicare and Medicaid comprise 84% of our fee for service revenue. |
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| • | Managed Care |
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| | – | Institutional Specialty Needs Programs – Currently contracted with Health Spring of Tennessee and explanation of the Institutional Specialty Needs Program is below. |
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| | – | Medicaid Managed Care – Caring for all residents living in nursing homes who have Medicaid as their primary insurance. We have a contract with McKesson Health Services to provide this care for residents in the State of Illinois. |
In March of 2009, the Company exited select markets related to its NP Care business. Those specific markets were Connecticut, Massachusetts, and Florida. In July of 2009, the Company exited the Illinois market related to its NP Care business. The Company maintains NP Care business in Tennessee. The Company will continue to evaluate these markets as well as entry into other possible markets as appropriate.
LIQUIDITY AND CAPITAL RESOURCES
We have historically financed our liquidity needs through a variety of sources including proceeds from the sale of common stock, borrowing from banks, loans from our stockholders, issuance of convertible notes and cash flows from operations. At June 30, 2009 and December 31, 2008, we had $198,779 and $393,982, respectively, in cash and cash equivalents. Operating activities for the six months ended June 30, 2009 used $489,665, representing an improvement of $3,585,748 when compared to the cash used in operating activities of $4,075,413 for the six months ended June 30, 2008. This change is primarily due to the increased membership and growth in the business.
Accounts Receivable
As of June 30, 2009 and December 31, 2008, our accounts receivable aging by major payers was as follows:
June 30, 2009
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Medicare | | $ | 8,851 | | $ | 1,548 | | $ | 920 | | $ | 729 | | $ | 12,048 | |
Medicaid | | | 2,988 | | | 2,898 | | | 3,325 | | | 7,293 | | | 16,504 | |
Blue Cross | | | 363 | | | 218 | | | 278 | | | 280 | | | 1,139 | |
Other Private | | | 2,215,550 | | | 153,028 | | | 5,765 | | | 15,585 | | | 2,389,928 | |
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| | $ | 2,227,752 | | $ | 157,692 | | $ | 10,288 | | $ | 23,887 | | $ | 2,419,619 | |
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December 31, 2008
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| | 0-30 | | 31-60 | | 61-90 | | > 90 | | Total | |
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Medicare | | $ | 292,101 | | $ | 18,145 | | $ | 0 | | $ | 0 | | $ | 310,246 | |
Medicaid | | | 9,648 | | | 2,394 | | | 0 | | | 0 | | | 12,042 | |
Healthnet | | | 15,686 | | | 3,572 | | | 0 | | | 0 | | | 19,258 | |
Blue Cross | | | 13,859 | | | 3,763 | | | 0 | | | 0 | | | 17,622 | |
Other Private | | | 1,974,095 | | | 494,495 | | | 84,540 | | | 12,337 | | | 2,565,467 | |
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| | $ | 2,305,389 | | $ | 522,369 | | $ | 84,540 | | $ | 12,337 | | $ | 2,924,635 | |
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Receivables recorded at June 30, 2009 and December 31, 2008 consists primarily of capitated contracts and to a lesser extent patient service fees to be reimbursed by Medicare, Medicaid and other private insurance payers. Self pay accounts are not material. These accounts are actively monitored by management and a third party billing company responsible for collecting amounts due.
A significant portion of our patient services revenues have been reimbursed by federal Medicare and, to a lesser extent, state Medicaid programs. Payments for services rendered to patients covered by these programs are generally less than billed charges. We monitor our revenues and receivables from these reimbursement sources, as well as other third-party insurance payers, and records an estimated contractual allowance for certain service revenues and receivable balances in the month of revenue recognition, to properly account for anticipated differences between billed and reimbursed amounts. Reimbursement is determined based on historical payment trends as well as current contract terms. Accordingly, a substantial portion of the total net revenues and receivables reported in our condensed consolidated financial statements for the six and three months ended June 30, 2009 and the year ended December 31, 2008 are recorded at the amount ultimately expected to be received from these payers. For the six months ended June 30, 2009 and the year ended December 31, 2008, there were $988,346 and $5,315,186, respectively, recorded as contractual allowances.
Management has provided for uncollectible accounts receivable through direct write-offs and such write-offs have been within management’s expectations. Historical experience indicates that after such write-offs have been made, potential collection losses are considered minimal and, therefore, no allowance for doubtful accounts is considered necessary by management. On a monthly basis, management reviews the accounts receivable aging by payer and rejected claims to determine which receivables, if any are to be written off. For the six and three months ended June 30, 2009 and 2008, there were no bad debt direct write-offs recorded in our results of operations.
During the six months ended ending June 30, 2009 the Company reduced its accounts receivables due to accelerated cash collection on its customer billings. The Company also reduced its accounts payables by focusing on paying down several of the Company’s older obligations. The Company, in connection with meeting specific contract metrics, also recognized revenue that was previously deferred.
Based on our current financial resources we will require additional working capital to fund our ongoing business and to implement our current business strategy, including acquisitions and further development of our proprietary software systems. The Company intends to do this through capital raising efforts. To this end, the Company’s management will work with the Board of Directors to evaluate our current capital raising efforts.
In addition to the above, the Company intends to re-evaluate its current operations in order to determine which markets and products the Company should consider exiting in order that our capital and resources are re-deployed to areas which align to our business strategy and will generate appropriate returns on capital. We also anticipate working on growth opportunities with our current customers and entering into new contracts with other health care providers. Currently, the Company generates adequate cash flow to sustain day to day operations to provide services to its constituents and pay its current obligations. In addition, the Company generates adequate cash flow to pay for some past service obligations that have been accrued for but not settled. The Company will continue to focus on membership growth as well as cost savings and efficiencies through technology deployment and operational scale to improve its cash flow and liquidity position.
On August 4, 2009, the Company entered into two agreements with Brahma Finance (BVI) Limited, a company organized under the laws of the British Virgin Islands (the “Purchaser”): (i) a Stock Purchase Agreement (the “Stock Purchase Agreement”); and (ii) a Standby Purchase Agreement (the “Standby Purchase Agreement” and, together with the Stock Purchase Agreement the “Agreements”). Pursuant to the Agreements, the Company has agreed to sell to the Purchaser and the Purchaser has agreed to purchase from the Company, shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”) in two separate transactions.
The first transaction, which is pursuant to the Stock Purchase Agreement, includes an initial purchase by the Purchaser of 60,000,000 shares of the Common Stock at a purchase price of $0.01 per share (the “Initial Purchase”), for an aggregate purchase price of $600,000. The Purchaser’s Initial Purchase obligation is subject to satisfaction or waiver by the Purchaser of certain conditions precedent including, but not limited to, the following: (i) the Company entering into an amendment to the Line of Credit Agreement, dated March 12, 2009, extending the availability to December 31, 2009 of the line of credit previously granted to the Company by certain lenders named therein in the maximum amount of $510,000; (ii) the Company and the Purchaser entering into the Standby
Purchase Agreement; (iii) the undertaking by the Senior Secured Noteholders (the “Noteholders”) to convert all of the Amended Notes held by them pursuant to that certain Securities Amendment and Purchase Agreement dated December 23, 2008 into shares of the Company’s Common Stock at the adjusted conversion price provided for therein; and (iv) the undertaking of the Noteholders to transfer all of their New Warrants to the Purchaser.
The second transaction is pursuant to the Standby Purchase Agreement, whereby the Company will agree, by means of a rights offering (the “Rights Offering”), to offer to the existing holders of its Common Stock and holders of securities issued by the Company that are convertible into or exercisable or exchangeable for its Common Stock, an aggregate of 240,000,000 shares of Common Stock at a purchase price of $0.01 per share The Purchaser has agreed to provide a standby commitment to purchase, on the terms and conditions set forth in the Standby Purchase Agreement, all of the shares of Common Stock offered but not purchased pursuant to the Rights Offering. The Company will also be required to increase the number of authorized shares in connection with the second transaction. In consideration for its obligations under the Standby Purchase Agreement, the Purchaser will receive a fee of $600,000, payable by the issuance of further shares of Common Stock at a price of $0.01 per share.
The Purchaser’s obligations under the Standby Purchase Agreement are subject to certain conditions precedent being met including, but are not limited to, the following: (i) the completion of the Rights Offering in accordance with the terms of the Standby Purchase Agreement; (ii) the Noteholders converting all of the Amended Notes and transferring all of the New Warrants as described above; (iii) the termination and repayment of all the outstanding debt by the Company in connection with the Line of Credit Agreement, dated March 12, 2009; and (iv) each of the Noteholders having made certain investments in shares of Common Stock as therein set forth.
Although the Company has entered into the above transaction, the Company continues to evaluate its capital raising opportunities, and there can be no assurance that additional financing will be available, or if available, that such financing will be on favorable terms. Any such failure to secure additional financing could impair our ability to achieve our business strategy. Further, there can be no assurance that we will be able to take advantage of any growth opportunities with our current customers, that we will be able to enter into new contracts with our existing clients, or that we will be able to execute on any of our planned methods of generating cash flow. We cannot give any assurance that we will have sufficient funds or successfully achieve our plans to a level that will have a positive effect on our results of operations or financial condition. Our ability to execute our growth strategy is contingent upon sufficient capital as well as other factors, including, but not limited to, our ability to further increase awareness of our programs, our ability to consummate acquisitions of complementary businesses, general economic and industry conditions, our ability to recruit, train and retain a qualified sales and nursing staff, and other factors, many of which are beyond our control. Even if our revenues and earnings grow rapidly, such growth may significantly strain our management and our operational and technical resources. If we are successful in obtaining greater market penetration with our programs, we will be required to deliver increasing outcomes to our customers on a timely basis at a reasonable cost to us. No assurance can be given that we can meet increased program demand or that we will be able to execute our programs on a timely and cost-effective basis.
COMMITMENTS, CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
There are no guarantees, commitments, lease and debt agreements or other agreements that would trigger adverse changes in our credit rating, earnings, or cash flows, including requirements to perform under stand-by agreements.
We are obligated under various operating leases for the rental of office space and office equipment. Future minimum rental commitments with a remaining term in excess of one year as of June 30, 2009 are as follows:
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PERIODS ENDING DECEMBER 31, | | | | |
2009 | | $ | 297,066 | |
2010 | | | 372,720 | �� |
2011 | | | 137,451 | |
2012 | | | 98,784 | |
2013 | | | 91,402 | |
2014 | | | 13,888 | |
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Total minimum lease payments | | $ | 1,011,310 | |
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
We believe that the following critical policies affect our more significant judgments and estimates used in preparation of our consolidated financial statements.
REVENUE RECOGNITION
A portion of our patient services revenues have been reimbursed by federal Medicare and, to a lesser extent, state Medicaid programs. Payments for services rendered to patients covered by these programs are generally less than billed charges. We monitor our revenues and receivables from these reimbursement sources, as well as other third-party insurance payers, and record an estimated contractual allowance for certain service revenues and receivable balances in the month of revenue recognition, to properly account for anticipated differences between billed and reimbursed amounts. Accordingly, a portion of the total net revenues and receivables reported in our consolidated financial statements are recorded at the amount ultimately expected to be received from these payers.
We evaluate several criteria in developing the estimated contractual allowances for unbilled and/or initially rejected claims on a monthly basis, including historical trends based on actual claims paid, current contract and reimbursement terms, and changes in patient base and payer/service mix. Contractual allowance estimates are adjusted to actual amounts as cash is received and claims are settled. Further, we do not expect the reasonably possible effects of a change in estimate related to unsettled contractual allowance amounts from Medicaid and third-party payers to be significant to its future operating results and consolidated financial position.
CAPITALIZED SOFTWARE DEVELOPMENT COSTS
We have capitalized costs related to the development of software for internal use. Capitalized costs include external costs of materials and services and consulting fees devoted to the specific software development. These costs have been capitalized based upon Statement of Position (SOP) No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” In accordance with SOP No. 98-1, internal-use software development costs are capitalized once (i) the preliminary project stage is completed, (ii) management authorizes and commits to funding a computer software project, and (iii) it is probable that the project will be completed, and the software will be used to perform the function intended. Costs incurred prior to meeting these qualifications are expensed as incurred. Capitalization of costs ceases when the project is substantially complete and ready for its intended use. Internal-use software development costs are amortized using the straight-line method over estimated useful lives approximating five years.
The capitalization and ongoing assessment of recoverability of development costs requires considerable judgment by us with respect to certain external factors, including, but not limited to, technological and economic feasibility, and estimated economic life.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company measures fair value in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions there exists a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:
Level 1 - unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date.
Level 2 - inputs other than quoted prices included within Level 1 that are directly observable for the asset or liability or indirectly observable through corroboration with observable market data.
Level 3 - unobservable inputs for the asset or liability only used when there is little, if any, market activity for the asset or liability at the measurement date.
This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.
FIXED ASSETS
Fixed assets are stated at cost, less accumulated depreciation and amortization. Major improvements and betterments to the fixed assets are capitalized. Expenditures for maintenance and repairs which do not extend the estimated useful lives of the applicable assets are charged to expense as incurred. When fixed assets are retired or otherwise disposed of, the assets and the related accumulated depreciation are removed from the accounts and any resulting profit or loss is recognized in operations.
We provide for depreciation and amortization using the straight-line method over the estimated useful lives of the assets, or, in the case of leasehold improvements, over the remaining term of the related lease, whichever is shorter.
NEWLY ADOPTED ACCOUNTING STANDARDS
In January 2009, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”), which changes the disclosure requirements for derivative instruments and hedging activities. SFAS 161 requires enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The adoption of SFAS 161 did not have a material impact on the condensed consolidated financial statements.
In January 2009, the Company adopted Emerging Issues Task Force Issue No. 07-5,Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (EITF 07-5) effective January 1, 2009. The adoption of EITF 07-5’s requirements can affect the accounting for warrants and many convertible instruments with provisions that protect holders from a decline in the stock price (or “down-round” provisions). Warrants and convertible instruments with such provisions will no longer be recorded in equity. The Company evaluated whether the warrants to acquire stock of the Company and the conversion feature in its convertible notes contain provisions that protect holders from declines in the stock price or otherwise could result in modification of the exercise price and/or shares to be issued under the respective agreements based on a variable that is not an input to the fair value of a fixed-for-fixed option. The Company determined that the warrants issued under the Securities Amendment and Purchase Agreement dated December 23, 2008 and the contingent conversion option in the notes issued under the same Agreement contained such provisions.
In accordance with EITF 07-5, the Company, beginning on January 1, 2009, recognizes these warrants and the embedded contingent conversion option as liabilities at their respective fair values on each reporting date. The cumulative effect of the change in accounting for these instruments of $5,658 was recognized as an adjustment to the opening balance of accumulated deficit at January 1, 2009. The cumulative effect adjustment was the difference between the amounts recognized in the balance sheet before initial adoption of EITF 07-5 and the amounts recognized in the consolidated balance sheet upon the initial application of EITF 07-5. The amounts recognized in the balance sheet as a result of the initial application of EITF 07-5 on January 1, 2009 were determined based on the amounts that would have been recognized if EITF 07-5 had been applied from the issuance date of the warrants and contingent conversion option.
Accounting Standards Not Yet Adopted
There are no new accounting standards that are expected to have a significant impact on the Company.
ITEM 3. QUANTITIVE AND QUALTITIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 4. CONTROLS AND PROCEDURES
Pursuant to Rule 13a-15(b) of the Exchange Act, the Company has reevaluated the effectiveness of the design and operation of its disclosure controls and procedures to allow timely decisions regarding required disclosure as of the period covered by this report. This reevaluation was done under the supervision and with the participation of management, including the Company’s Interim Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate. Based on this evaluation, the Company concluded that because of material weakness in our internal controls over financial reporting, our disclosure controls and procedures as defined in Rule 13a-15(e) are not effective in timely alerting them to material information relating to the Company required to be included in its periodic Securities and Exchange Commission filings and to ensure information required to be included by the Company in reports we file or submit under the Securities Exchange Act is (i) recorded, processed, summarized and reported, within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to management including the Company’s Interim CEO and CFO, as appropriate, to allow timely decisions regarding disclosure as of the end of the period covered by this report. The audit adjustments recorded for 2008 and 2007 are indicative of a lack of effective controls over the application of generally accepted accounting principles commensurate with the Company’s financial reporting requirements. Management has engaged in remediation efforts to address the material weakness identified in the Company’s disclosure controls and procedures and to improve and strengthen our overall control environment. Notwithstanding weakness in the Company’s internal control over financial reporting as of June 30, 2009, the Company believes that the condensed consolidated financial statements contained in this report present fairly its financial condition, the results of our operations and cash flows for the periods covered thereby in all material respects in accordance with accounting principles generally accepted in the United States.
CHANGES IN INTERNAL CONTROLS
As stated herein, the Company is currently working on changes to its internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) and expects to have these changes fully implemented by the end of the third quarter of 2009. As the Company has experienced growth in its business, it has continued to evaluate its overall control environment and enhance controls. These enhancements are not being done as a direct result of any identified control weakness but as a way to ensure enhanced controls continue to operate effectively as the business continues to grow. The changes that the Company has undertaken to date are as follows:
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| 1. | Created a detailed budget and forecasting process for the year 2009; |
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| 2. | Defined and detailed the job description for each key finance and accounting personnel; |
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| 3. | Developed process flows and narratives around the Company’s policy and procedures; and |
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| 4. | Developed a policy for Procurement and Vendor Management. |
LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS
The Company’s management, including its Interim CEO and CFO, does not expect that our disclosure controls and procedures and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management or board override of the control.
The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are not a party to any material legal proceedings, nor to our knowledge, is there any proceeding threatened against us.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
A. Exhibits:
10.1 Stock Purchase Agreement, dated August 4, 2009 included as Exhibit 1.01 of the Company’s Form 8-K filed with the SEC on August 10, 2009.
10.2 Standby Agreement, dated August 4, 2009 included as Exhibit 1.02 of the Company’s Form 8-K filed with the SEC on August 10, 2009.
10.3 Securities Amendment and Purchase Agreement, dated December 23, 2008*
10.4 Guarantee and Amended and Restated Security Agreement, dated December 23, 2008*
10.5 Registration Rights Agreement, dated December 23, 2008*
10.6 Line of Credit Agreement, dated March 12, 2009*
31.1 Certification of the Interim Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.*
31.2 Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.*
32.1 Certifications of the Interim Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.*
32.2 Certifications of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.*
*Filed herewith.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| HC Innovation, Inc. |
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Date: August 14, 2009 | By: | /S/ JOHN RANDAZZO |
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|
| | John Randazzo |
| | Interim Chief Executive Officer |
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| HC Innovation, Inc. |
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Date: August 14, 2009 | By: | /S/ R. SCOTT WALKER |
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| | R. Scott Walker |
| | Chief Financial Officer |
EXHIBIT INDEX
Exhibit Number and Description
10.1 Stock Purchase Agreement, dated August 4, 2009 included as Exhibit 1.01 of the Company’s Form 8-K filed with the SEC on August 10, 2009.
10.2 Standby Agreement, dated August 4, 2009 as Exhibit 1.02 of the Company’s Form 8-K filed with the SEC on August 10, 2009.
10.3 Securities Amended and Purchase Agreement, dated December 23, 2008*
10.4 Guarantu and Amended and Restated Security Agreement, dated Dec. 23, 2008*
10.5 Registration Rights Agreement, dated Dec. 23, 2008*
10.6 Line of Credit Agreement dated March 12, 2008*
31.1 Certification of the Interim Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.*
31.2 Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.*
32.1 Certifications of the Interim Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.*
32.2 Certifications of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act.*
*Filed herewith.
