1 Filed Pursuant to Rule 424B1 Registration No. 333-35071 [NOVACARE EMPLOYEE SERVICES LOGO] 5,000,000 SHARES COMMON STOCK ALL OF THE 5,000,000 SHARES OF COMMON STOCK OFFERED HEREBY ARE BEING SOLD BY NOVACARE EMPLOYEE SERVICES, INC. (THE "COMPANY"). PRIOR TO THIS OFFERING, THERE HAS BEEN NO PUBLIC MARKET FOR THE COMMON STOCK OF THE COMPANY. SEE "UNDERWRITING" FOR INFORMATION RELATING TO THE METHOD OF DETERMINING THE INITIAL PUBLIC OFFERING PRICE. THE COMMON STOCK HAS BEEN APPROVED FOR QUOTATION ON THE NASDAQ STOCK MARKET'S NATIONAL MARKET UNDER THE SYMBOL "NCES." AFTER THE OFFERING, NOVACARE, INC. (THE "PARENT") WILL OWN 75.7% OF THE COMPANY'S OUTSTANDING COMMON STOCK. --------------------- THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" COMMENCING ON PAGE 8. --------------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. ================================================================================================ UNDERWRITING PRICE TO DISCOUNTS AND PROCEEDS TO PUBLIC COMMISSIONS(1) COMPANY(2) - ------------------------------------------------------------------------------------------------ Per Share........................ $9.00 $0.63 $8.37 - ------------------------------------------------------------------------------------------------ Total(3)......................... $45,000,000 $3,150,000 $41,850,000 ================================================================================================ (1) The Company has agreed to indemnify the Underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the "Securities Act"). See "Underwriting." (2) Before deducting expenses of the Offering payable by the Company estimated at $1,220,000. Of the proceeds, approximately $23,707,000 will be used to repay a portion of the $28,382,000 loan from the Parent and $1,000,000 will be paid to an affiliate of the Company who is a former owner of a business acquired by the Company. (3) The Company has granted the Underwriters a 30-day option to purchase up to an additional 750,000 shares of Common Stock solely to cover over-allotments, if any. See "Underwriting." If such option is exercised in full, the total Price to Public, Underwriting Discounts and Commissions and Proceeds to Company will be $51,750,000, $3,622,500 and $48,127,500, respectively. --------------------- The Common Stock is offered by the Underwriters, as stated herein, subject to receipt and acceptance by them and subject to their right to reject any order in whole or in part. It is expected that delivery of such shares will be made through the offices of BancAmerica Robertson Stephens, 555 California Street, Suite 2600, San Francisco, California 94104 on or about November 14, 1997. BANCAMERICA ROBERTSON STEPHENS SMITH BARNEY INC. The date of this Prospectus is November 11, 1997 2 [NOVACARE EMPLOYEE SERVICES PHOTO OF INDIVIDUALS] CARING FOR AND ABOUT PEOPLE IS OUR BUSINESS At NovaCare Employee Services, our fundamental goal is to handle all the administrative details and provide the peace of mind that comes from a company knowing its human resource needs are being handled by people with knowledge, experience and a commitment to caring. A BETTER WAY TO MANAGE HUMAN RESOURCES NovaCare Employee Services offers small and medium-sized businesses a better way to handle the management and administration of employee-related tasks. A way that's better for employers and better for employees. The idea is simple. NovaCare Employee Services allows small businesses to outsource time consuming tasks--such as managing employee benefits, payroll, and government compliance--to an organization with expertise in every facet of human resources. NOVACARE EMPLOYEE SERVICES' COMMITMENT TO INDUSTRY LEADERSHIP NovaCare Employee Services is one of the nation's largest (measured by revenues and number of worksite employees) professional employer organizations, providing administration and management services for over 35,000 employees in 45 states, across a wide array of industries. Our objective is to be the brand, service and performance leader in the highly fragmented PEO industry. An industry which currently has approximately $18 billion in annual revenues (according to a NAPEO estimate), a five year historical growth rate of approximately 30% per year and significant consolidation opportunities. [NOVACARE EMPLOYEE SERVICES LOGO] 3 NO DEALER, SALES REPRESENTATIVE OR ANY OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION IN CONNECTION WITH THIS OFFERING (THE "OFFERING") OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY UNDERWRITER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OTHER THAN THE REGISTERED SECURITIES TO WHICH IT RELATES OR AN OFFER TO, OR SOLICITATION OF, ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY DATE SUBSEQUENT TO THE DATE HEREOF. UNTIL DECEMBER 6, 1997 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE SHARES OF COMMON STOCK, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS DELIVERY REQUIREMENT IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. ------------------------ TABLE OF CONTENTS PAGE ---- Prospectus Summary.................................................................... 4 Risk Factors.......................................................................... 8 The Company........................................................................... 15 Use of Proceeds....................................................................... 16 Dividend Policy....................................................................... 16 Dilution.............................................................................. 17 Capitalization........................................................................ 18 Selected Financial and Statistical Data............................................... 19 Pro Forma Combined Statement of Operations............................................ 20 Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................................................... 24 Business.............................................................................. 33 Management............................................................................ 49 Principal Shareholders................................................................ 55 Certain Related Party Transactions.................................................... 56 Description of Capital Stock.......................................................... 56 Shares Eligible for Future Sale....................................................... 58 Underwriting.......................................................................... 59 Validity of Common Stock.............................................................. 60 Experts............................................................................... 60 Additional Information................................................................ 61 Index to Financial Statements......................................................... F-1 ------------------------ The Company intends to furnish to its stockholders annual reports containing audited consolidated financial statements examined by its independent public accountants and quarterly reports containing unaudited consolidated financial statements for each of the first three quarters of each fiscal year. CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK, INCLUDING BY ENTERING STABILIZING BIDS, EFFECTING SYNDICATE COVERING TRANSACTIONS OR IMPOSING PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING." 3 4 PROSPECTUS SUMMARY The following summary is qualified in its entirety by the more detailed information and financial statements and the notes thereto appearing elsewhere in this Prospectus. Unless otherwise indicated, information in this Prospectus assumes no exercise of the Underwriters' option to purchase from the Company up to 750,000 additional shares of the Company's common stock (the "Common Stock") to cover over-allotments, if any. This Prospectus contains forward-looking statements that are based on management's estimates, assumptions and projections. Important factors that could cause results to differ materially from those expected by management include the inability of the Company to carry out its growth strategy and the other factors discussed under "Risk Factors." Prospective investors should carefully consider the information set forth under "Risk Factors." THE COMPANY NovaCare Employee Services, Inc. (the "Company") is one of the largest (measured by revenues and number of worksite employees) professional employer organizations ("PEO"s) in the United States. The Company is an employee services company which provides small to medium-sized businesses with comprehensive, fully integrated outsourcing solutions to human resource issues, including payroll management, risk management, benefits administration, unemployment services and human resource consulting services. The Company believes its services enable small and medium-sized businesses to cost-effectively manage and enhance the employment relationship by: (i) controlling the risks and costs associated with workers' compensation, workplace safety and employee-related litigation; (ii) providing employees with high quality health care coverage and related benefits; (iii) managing the increasingly complex legal and regulatory environment affecting employment; and (iv) achieving scale advantages typically available to larger organizations. As of June 30, 1997, the Company served 1,742 clients and had 35,028 employees ("worksite employees") at over 3,000 worksites in 45 states, principally in 10 different industries. The Company was established in September 1996 by the Parent and began operations in October 1996 with the acquisition of Resource One, Inc. ("Resource One"), a PEO. Three additional PEO acquisitions were completed in February 1997. The Company's total remaining contingent and non-contingent obligations in connection with these acquisitions, if target levels are met but not exceeded, are approximately $22.2 million in cash and 466,063 shares of Common Stock. See Note 3 of Notes to the Company's Consolidated Financial Statements. On July 1, 1997, the Company acquired NovaPro, the rehabilitation temporary staffing business of the Parent. For the year ended June 30, 1997, the Company had pro forma revenues of over $878 million. See "Pro Forma Financial Information." The National Association of Professional Employer Organizations ("NAPEO") estimates the PEO industry has approximately $18 billion in annual revenues with an historical growth rate over the last five years of approximately 30% per year. The Company has had a relatively short operating history and has only managed the acquired companies for a short period of time. Accordingly, the Company does not have a meaningful historical growth rate and there can be no assurance that the Company's growth rate will equal or exceed that of the PEO industry. According to the U.S. Small Business Administration, there are nearly six million businesses in the United States with under 100 employees, employing over 52 million persons and with approximately $1.1 trillion in aggregate annual payroll. NAPEO estimates that the PEO industry has less than three million worksite employees. The Company believes, therefore, approximately 49 million of these employees are currently unserved by the PEO industry. The PEO industry is highly fragmented. NAPEO data suggest that there are at least 2,400 PEOs currently in operation and that the ten largest PEOs account for less than 10% of existing revenues in the industry. The Company believes that significant consolidation opportunities exist within the PEO industry due to increasing regulatory complexity and capital requirements associated with developing larger service delivery infrastructures, more diversified services and more sophisticated management information systems. The Company's objective is to be the brand, service and performance leader in the PEO industry by focusing on caring service, operational excellence and growth. In addition to emphasizing cost-effectiveness 4 5 and providing a breadth of services, the Company creates relationships with both its clients and worksite employees by contractually assuming certain administrative and financial employer responsibilities with respect to worksite employees in a "co-employment" relationship. By focusing on employee services, the Company believes that it helps create a more profitable, more productive and more satisfying relationship between clients and employees. After the Offering, the Parent will own approximately 75.7% of the outstanding Common Stock of the Company. In addition, the Company, under a five-year evergreen contract, co-employs most of the Parent's employees (amounting to 15,072 employees at June 30, 1997) for which the Parent pays the Company fees equaling approximately 117% of the wages of such co-employees. Under a management services agreement, the Parent provides information systems and regulatory, legal, accounting and other management services to the Company at the Parent's cost. Under a loan agreement, the Company has borrowed approximately $28.4 million from the Parent, of which $23.7 million will be repaid from the proceeds of the Offering. In addition to its interest in the Company, the Parent is in the business of providing medical rehabilitation services. The Company's operating and growth strategies are intended to leverage the capabilities and expertise of the Parent. Through its relationship with the Parent, the Company has access to: a large, stable and growing employee base; sophisticated infrastructure resulting from investments made by the Parent in human resource management and information technology; management control systems; and workers' compensation risk management experience. In addition to leveraging its relationship with the Parent, the Company plans to grow and operate its business by: (i) increasing its sales force and marketing efforts; (ii) implementing its sophisticated business model; (iii) focusing on geographic expansion; (iv) targeting high potential industries; and (v) acquiring PEOs and other employee service providers and entering into strategic alliances. The Company is a Delaware corporation with executive offices at 2621 Van Buren Avenue, Norristown, PA 19403, and its telephone number at that address is (610) 650-4700. The Company transacts business directly and through its subsidiaries. Unless the context otherwise requires, all references in this Prospectus to the Company include its subsidiaries. THE OFFERING Common Stock offered by the Company(1)...................... 5,000,000 shares Common Stock outstanding after the Offering(1)(2)........... 25,643,187 shares Use of proceeds............................................. To repay certain indebtedness Nasdaq National Market symbol............................... NCES - --------------- (1) Does not include up to 750,000 shares of Common Stock that may be sold pursuant to the Underwriters' over-allotment option. (2) Based on the 18,630,000 shares of Common Stock outstanding as of June 30, 1997, adjusted for (i) 1,200,000 shares issued to acquire the assets and liabilities of NovaPro effective July 1, 1997 (see Note 13 of Notes to the Company's Consolidated Financial Statements); (ii) 5,000,000 shares to be issued in connection with the Offering; and (iii) the conversion upon the Offering of 813,187 shares of mandatorily redeemable Common Stock (temporary equity) to 813,187 shares of Common Stock (permanent equity) (see Note 10 of Notes to the Company's Consolidated Financial Statements). Does not include 625,000 shares of Common Stock reserved for issuance under the Company's Stock Option Plan. See "Management -- Executive Compensation -- Stock Option Plan" and Note 11 of Notes to the Company's Consolidated Financial Statements. 5 6 SUMMARY FINANCIAL AND STATISTICAL DATA (IN THOUSANDS, EXCEPT PER SHARE AND STATISTICAL DATA) HISTORICAL PRO FORMA AS ------------------- ADJUSTED(2) PERIOD FROM ------------- OCTOBER 1, 1996 YEAR ENDED TO JUNE 30, 1997(1) JUNE 30, 1997 ------------------- ------------- OPERATING RESULTS: Revenues(3).............................................. $ 394,193 $ 878,097 Direct Costs: Salaries, wages and employment taxes of worksite employees........................................... 357,238 790,769 Health care, workers' compensation, state unemployment taxes and other..................................... 24,717 62,825 --------- --------- Gross profit........................................ 12,238 24,503 Selling, general and administrative expenses............. 8,273 21,295 Amortization of excess cost of net assets acquired....... 1,034 2,268 --------- --------- Income from operations.............................. 2,931 940 Interest expense, net.................................... (697) (327) --------- --------- Income before income taxes.......................... 2,234 613 Income taxes............................................. 1,542 1,244 --------- --------- Net income (loss)................................... $ 692 $ (631) ========= ========= Net (loss) attributable to common stock............. $ (341) ========= Net (loss) per share..................................... $ (.02) ========= Pro forma net income (loss) per share.................... $ .03 $ (.02) ========= ========= Weighted average number of shares outstanding............ 20,574 25,574 ========= ========= STATISTICAL DATA: EBITDA (in thousands)(4)................................. $ 4,217 $ 3,927 Number of clients at period end.......................... 1,742 1,742 Worksite employees paid at period end: Third parties......................................... 18,634 19,956 Related party......................................... 16,394 15,072 --------- --------- Total............................................ 35,028 35,028 ========= ========= Weighted average worksite employees paid during the period: Third parties......................................... 11,764 18,123 Related party......................................... 15,879 14,428 Weighted average................................. 18,582 32,551 Gross profit per weighted average worksite employee (in whole $'s): Third parties......................................... $ 665 $ 731 Related party......................................... 650 780 Weighted average................................. $ 659 $ 753 JUNE 30, 1997 ---------------------------------------------- PRO FORMA ACTUAL PRO FORMA(5) AS ADJUSTED(5)(6) ------- ------------ ----------------- BALANCE SHEET DATA: Current assets.................................. $39,879 $ 41,669 $ 41,669 Total assets.................................... 95,998 98,330 97,753 Current liabilities(7).......................... 88,721 91,178 49,971 Financing arrangements(7)....................... 1,366 1,366 1,366 Mandatorily redeemable common stock............. 2,731 2,731 -- Shareholders' equity............................ 301 176 43,537 6 7 SUMMARY QUARTERLY FINANCIAL AND STATISTICAL DATA (IN THOUSANDS, EXCEPT PER SHARE AND STATISTICAL DATA) (UNAUDITED) PRO FORMA AS ADJUSTED(2) FOR THE QUARTER ENDED --------------------------------------------------- SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30, 1996 1996 1997 1997 ------------- ------------ --------- -------- OPERATING RESULTS: Revenues(3)...................................................... $ 202,285 $219,367 $223,333 $233,112 Direct Costs: Salaries, wages and employment taxes of worksite employees..... 183,678 199,071 200,951 207,069 Health care, workers' compensation, state unemployment taxes and other.................................................... 13,813 14,875 15,507 18,630 --------- -------- -------- -------- Gross profit.............................................. 4,794 5,421 6,875 7,413 Selling, general and administrative expenses..................... 4,956 6,088 5,184 5,067 Amortization of excess cost of net assets acquired............... 529 556 616 567 --------- -------- -------- -------- (Loss) income from operations............................. (691) (1,223) 1,075 1,779 Interest (expense) income, net................................... (85) (111) (41) (89) --------- -------- -------- -------- (Loss) income before income taxes......................... (776) (1,334) 1,034 1,690 Income taxes..................................................... 45 37 298 865 --------- -------- -------- -------- Net (loss) income......................................... $ (821) $ (1,371) $ 736 $ 825 ========= ======== ======== ======== Pro forma net (loss) income per share............................ $ (.03) $ (.05) $ .03 $ .03 ========= ======== ======== ======== STATISTICAL DATA: EBITDA (in thousands)(4)......................................... $ (53) $ (418) $ 1,810 $ 2,482 Number of clients at period end.................................. 1,437 1,499 1,531 1,742 Worksite employees paid at period end: Third parties.................................................. 17,080 17,750 18,088 19,956 Related party.................................................. 13,340 14,049 14,557 15,072 --------- -------- -------- -------- Total..................................................... 30,420 31,799 32,645 35,028 ========= ======== ======== ======== Weighted average worksite employees paid during the period: Third parties.................................................. 16,685 17,415 17,919 19,022 Related party.................................................. 13,562 13,695 14,303 14,815 Weighted average.......................................... 30,247 31,110 32,222 33,837 Gross profit per weighted average worksite employee per quarter (in whole $'s): Third parties.................................................. $ 159 $ 164 $ 212 $ 208 Related party.................................................. 158 187 216 234 Weighted average.......................................... $ 159 $ 174 $ 213 $ 219 - --------------- (1) The Company commenced operations effective October 1, 1996, concurrent with the acquisition of Resource One, which was accounted for as a purchase. The computation of weighted average number of shares outstanding is consistent with the computation of weighted average number of shares outstanding for historical and pro forma net income per share described in Note 1 of Notes to the Company's Consolidated Financial Statements. (2) Adjusted on a pro forma basis to give effect to the acquisitions of Resource One, Inc., Employee Services of America, Inc., The TPI Group, Ltd., Prostaff Human Resources, Inc., NovaPro and the Company's contract with the Parent (the "NovaCare Contract") (see Note 2 of Notes to the Company's Consolidated Financial Statements) as if they occurred on July 1, 1996. NovaPro, formerly a business of the Parent, was acquired from the Parent effective July 1, 1997. The application of a portion of the net proceeds of the Offering is assumed to pay certain debt which reduces pro forma as adjusted interest expense. Additionally, the pro forma adjusted worksite employee statistical data reflect 1,322 worksite employees which became third party employees upon the consummation of the NovaPro acquisition. The as adjusted pro forma statement of operations does not purport to represent what the Company's actual results of operations would have been if such acquisitions, the NovaCare Contract and the Offering had occurred on July 1, 1996, or to project the Company's results of operations for any future period. See the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. The computation of weighted average numbers of shares outstanding is consistent with the computation of weighted average number of shares outstanding for supplemental pro forma net income per share described in Note 1 of Notes to the Company's Consolidated Financial Statements. (3) Revenues include all amounts billed to clients for gross salaries and wages, related employment taxes and health care and workers' compensation coverage of worksite employees. (4) EBITDA is defined as earnings before interest, income taxes, depreciation and amortization. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to incur and service debt. However, EBITDA should not be considered in isolation or as a substitute for net income or cash flow data prepared in accordance with generally accepted accounting principles or as a measure of a company's profitability or liquidity. Also, the EBITDA definition used herein may not be comparable to similarly titled measures reported by other companies. (5) Adjusted on a pro forma basis to include the assets and liabilities of NovaPro as of June 30, 1997. See the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. (6) Adjusted to give effect to the conversion of mandatorily redeemable Common Stock into stockholders' equity and the Offering and the application of the estimated net proceeds therefrom, as if each of the foregoing had occurred as of June 30, 1997. See "Use of Proceeds" and the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. (7) The current portion of financing arrangements amounting to $298 is included in current liabilities. 7 8 RISK FACTORS In addition to the other information contained elsewhere in this Prospectus, prospective investors should consider carefully the factors listed below before purchasing any of the Common Stock offered hereby. This Prospectus contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below as well as those discussed elsewhere in this Prospectus. SHORT OPERATING HISTORY; NO ASSURANCE OF PROFITABLE OPERATIONS The Company commenced operations in October 1996 with the acquisition of Resource One. Prior to the acquisition of Resource One, the Company conducted no significant operations. The Company has a limited operating history and is subject to various uncertainties and risks characteristic of development stage companies. In addition, there can be no assurance that the Company will be able to integrate successfully the operations of its recently completed acquisitions. The Company's success will depend, to a large degree, upon the successful implementation of its business strategy. There can be no assurance that this strategy will yield profitable operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 1 of Notes to the Company's Consolidated Financial Statements. LIMITS ON ABILITY TO PASS THROUGH CERTAIN COSTS Health insurance premiums, state unemployment taxes and workers' compensation rates are in part determined by the Company's claims experience and comprise a significant portion of the Company's direct costs. The Company employs risk management procedures in an attempt to control its claims incidences. However, should the Company experience a large increase in claims activity, its unemployment taxes, health insurance premiums or workers' compensation insurance rates may increase. The Company's ability to incorporate such increases into service fees to clients is constrained by contractual arrangements with clients and competitive factors. As a result, such increases could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. SHORT-TERM NATURE OF PEO SERVICES AGREEMENTS; CLIENT ATTRITION The Company's standard PEO services agreement provides for an initial one-year term; thereafter, the agreement is renewed periodically. The agreement is subject to termination without cause by the Company or the client upon 30 days' prior written notice. The Company experiences terminations and non-renewals every quarter and there can be no assurance that the Company can replace these clients. A significant number of terminations or non-renewals could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. See "Business -- Employee and Client Services." ADEQUACY OF RESERVES FOR WORKERS' COMPENSATION CLAIMS The maintenance of a workers' compensation insurance plan that covers worksite employees is a significant part of the Company's business. As part of its standard PEO services agreement with its clients, the Company assumes the financial obligations of its clients to pay workers' compensation claims of worksite employees. Through June 30, 1997, certain of the Company's worksite employees were covered by large deductible workers' compensation insurance policies and certain other worksite employees were covered by guaranteed cost or low deductible workers' compensation insurance policies. Consequently, the Company is financially liable for substantially all of the workers' compensation claims of these worksite employees that occurred on or before June 30, 1997 up to the applicable deductible. The Company maintains reserves for the pre-July 1, 1997 workers' compensation claims based on periodic reviews of open claims as well as past claims experience. The Company cannot predict with certainty the ultimate liability associated with open claims, and past claims experience may not be indicative of future results. Accordingly, if the ultimate liability with respect to these open claims proves to be greater than estimated reserve amounts, the Company's business, financial condition, results of operations and liquidity could be materially adversely affected. 8 9 Effective July 1, 1997, the Company and the Liberty Mutual Group ("Liberty Mutual") entered into a workers' compensation deductible program which will extend through June 30, 2000 containing an aggregate stop-loss that limits the liability of the Company to a capped percentage of the standard premium or a fixed aggregate deductible, whichever is greater. There can be no assurance that upon the expiration of the policies a replacement program will be secured on competitive terms without causing significant disruption to the Company's business. See "Business -- Workers' Compensation and Health Care Program" and Notes 1 and 6 of Notes to the Company's Consolidated Financial Statements. ADEQUACY OF RESERVES FOR HEALTH CARE CLAIMS As part of its standard PEO services agreement with its clients, the Company also assumes the financial obligation to provide health care coverage for worksite employees. While the Company has purchased certain insurance coverage to limit this exposure, it has not purchased such insurance for the worksite employees of the Parent, of which there were 15,072 at June 30, 1997. As a result, the Company is self-insured with respect to health care coverage for the Parent's worksite employees and, therefore, is financially liable for any health care claims of such worksite employees. The Company maintains reserves for health care claims based on periodic reviews of open claims as well as past claims experience. However, the Company cannot predict with certainty the ultimate liability associated with open claims, and past claims experience may not be indicative of future results. Accordingly, if the ultimate liability with respect to these open claims proves to be greater than estimated reserve amounts, the Company's business, financial condition, results of operations and liquidity could be materially adversely affected. See "Business -- Workers' Compensation and Health Care Program" and Notes 1 and 6 of Notes to the Company's Consolidated Financial Statements. REGULATION OF PEOS The Company's operations are affected by numerous federal, state and local laws relating to insurance, tax and employment matters. By entering into a co-employment relationship with clients, the Company assumes certain employer obligations and responsibilities under these laws. The Company's business model and services have been developed based on the premise that the Company is an employer for certain purposes under common law. However, because many of the laws related to the employment relationship were enacted prior to the development of alternative employment arrangements, such as those provided by PEOs and other staffing businesses, many of those laws do not specifically address the obligations and responsibilities of non-traditional employers. Interpretive issues concerning such relationships have arisen and remain unsettled. Uncertainties arising under the Internal Revenue Code of 1986, as amended (the "Code"), include, but are not limited to, the qualified tax status and favorable tax status of certain benefit plans provided by the Company and other alternative employers. See "Risk of Loss of Qualified Status for Certain Tax Purposes" below. The unfavorable resolution of these unsettled issues could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. There can be no assurance that existing laws and regulations which are not currently applicable to the Company will not be interpreted more broadly in the future so as to apply to the Company's existing activities, or that new laws and regulations will not be enacted with respect to the Company's activities, either of which could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. While many states do not explicitly regulate PEOs, approximately one-third of the states (including Florida) have adopted licensing or registration requirements for PEOs, and several additional states (including Pennsylvania) are considering implementation of such requirements. Such laws vary from state to state but generally provide for monitoring the fiscal responsibility of PEOs and specify the employer responsibilities assumed by PEOs. There can be no assurance that the Company will be able to comply with any licensing or registration requirements which may be imposed upon it in the future. In addition, there can be no assurance that states will not pass laws limiting the ability of PEOs to provide services which, if enacted, may impede the Company's growth. See "Business -- Regulation." 9 10 RISK OF LOSS OF QUALIFIED STATUS FOR CERTAIN TAX PURPOSES The Internal Revenue Service (the "IRS") is conducting a market segment study of the PEO industry (the "Market Segment Study") focusing on selected PEOs (not including the Company) in order to examine the relationship among PEOs, their clients, worksite employees and the owners of clients. The IRS has indicated that the Market Segment Study is expected to be completed in January 1998, although there can be no assurance that it will be completed by such time. If the IRS concludes that PEOs are not "employers" of certain worksite employees for purposes of the Code, the tax-qualified status of the Company's 401(k) plans could be revoked, its cafeteria plans may lose their favorable tax status, and the Company may no longer be able to assume the client company's federal employment tax withholding obligations. If the loss of qualified tax status for the Company's 401(k) plans or cafeteria plans is applied retroactively, employees' vested account balances would become taxable immediately to the employees, the Company would lose its tax deduction to the extent the contributions were not vested, the plans' trusts would become taxable trusts and penalties could be assessed. In such a case, the Company would face the risk of client dissatisfaction as well as potential litigation, and its business, financial condition, results of operations and liquidity could be materially adversely affected. In addition, if the Company is required to report and pay employment taxes for the separate accounts of its clients rather than for its own account as a single employer, the Company could incur increased administrative burdens. The Company is unable to predict the actual timing or nature of the findings of the Market Segment Study or the ultimate outcome of such findings. See "Business -- Regulation." LIABILITIES FOR CLIENT AND EMPLOYEE ACTIONS A number of legal issues remain unresolved with respect to the co-employment arrangements among PEOs, their clients and worksite employees, including questions concerning the ultimate liability for violations of employment and discrimination laws. The Company's standard PEO services agreement establishes a contractual division of responsibilities between the Company and each client for various human resource matters, including compliance with and liability under various governmental regulations. However, as a result of the Company's status as a co-employer, the Company may be subject to liability for violations of these or other laws despite such contractual provisions even if it does not participate in such violations. Although such PEO services agreements generally provide that the client is to indemnify the Company for any liability attributable to the client's failure to comply with its contractual obligations and the requirements imposed by law, the Company may not be able to collect on such a contractual indemnification claim and thus may be responsible for satisfying such liabilities. In addition, worksite employees may be deemed to be agents of the Company, subjecting the Company to liability for the actions of such worksite employees. See "Business -- Employee and Client Services" and "Business -- Regulation." RISKS OF ACQUISITIONS AND FAILURE TO INTEGRATE ACQUIRED BUSINESSES One of the Company's principal strategies is to increase its revenues and the markets it serves through the acquisition of PEOs and other employee services companies. There can be no assurance that the Company will be able to identify and acquire attractive acquisition candidates, profitably manage such acquired companies or successfully integrate such acquired companies into the Company without substantial costs, delays or other problems. Acquisitions may involve a number of special risks, including, but not limited to, adverse short-term effects on the Company's reported financial condition or results of operations, diversion of management's attention, dependence on retention, hiring and training of key personnel, risks associated with unanticipated problems or liabilities and amortization of acquired intangible assets, some or all of which could have a material adverse effect on the Company's business, financial condition, results of operations or liquidity. In addition, there can be no assurance that companies acquired in the future will be profitable at the time of acquisition or that the companies recently acquired or acquired in the future will achieve sales and profitability justifying the Company's investment therein or that the Company will recognize the synergies expected from such acquisitions; the failure to obtain any or all of which could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. See "Business -- Growth Strategy." 10 11 RISKS ASSOCIATED WITH FINANCIAL POSITION OF CLIENTS In providing its services, the Company enters into a co-employment relationship with worksite employees and assumes the obligations to pay the wages and related benefit costs and payroll taxes of such worksite employees. The Company's standard PEO services agreement with its clients obligates the client to reimburse the Company for these payments. The Company's obligations include responsibility for payroll for worksite employees and payment of payroll withholding taxes, federal and state unemployment taxes, and taxes due under the Federal Income Contribution Act ("FICA"). The Company assumes such obligations as a principal, not merely as an agent of the client, and is therefore liable for such obligations even if the client defaults in its payment to the Company. Although the Company retains the right to terminate immediately its PEO services agreement with the client, as well as its relationship with the worksite employees, due to nonpayment by the client, the Company remains liable to satisfy payroll obligations for services performed prior to such termination in the event of a client default. The Company may require the owners of its clients to guarantee personally the performance of the PEO services agreement. However, there can be no assurance that such owners would be financially able to satisfy such guarantee obligations. There can be no assurance that the Company's ultimate liability for worksite employee payroll and related tax costs will not have a material adverse effect on its business, financial condition, results of operations or liquidity. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." DEPENDENCE ON THE PARENT; POTENTIAL CONFLICTS WITH THE PARENT The Company was established in September 1996 by the Parent. See "The Company." Upon consummation of the Offering, the Parent will beneficially own approximately 75.7% of the Company's Common Stock (73.5% if the Underwriters' over-allotment option is exercised in full) and will, in effect, have the power to elect all the directors of the Company and to control the Company's policies. See "Principal Shareholders." In February 1997, the Parent and the Company entered into the NovaCare Contract whereby the Parent's employees are co-employed by the Company for a five-year term, ending on December 31, 2001. Under the NovaCare Contract, the Company provides traditional PEO services such as payroll administration, worksite safety evaluation, employment-related risk management and benefits consultation for substantially all of the Parent's employees. On a pro forma basis, the Parent accounted for approximately 67% of the Company's revenues during the quarter ended June 30, 1997 and approximately 65% of the Company's revenues for the year ended June 30, 1997. No other client accounted for more than 10% of the Company's revenues during that period or for calendar 1996 on a pro forma basis. Any material reduction in the Parent's workforce or adverse change in or termination of the NovaCare Contract would have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. See "Business -- Employee and Client Services," "Business -- Relationship with the Parent" and "Certain Related Party Transactions." Four directors of the Company are also directors of the Parent. One of these directors is also Chairman of the Company and two others are officers of the Parent. These directors may have conflicts of interest with respect to matters concerning the Company and its relationship with the Parent. The Company has not adopted any formal procedures regarding potential conflicts of interest with the Parent. Except as contemplated by this Prospectus, the Company does not currently intend to enter into material transactions with the Parent, but the Company may enter into transactions with the Parent which may be more favorable to the Parent than to the Company. See "Business -- Relationship with the Parent" and "Certain Related Party Transactions." The Company has entered into an agreement with the Parent pursuant to which the Company purchases certain services from the Parent, including information technology, finance, business development, regulatory and legal services. There can be no assurance that circumstances will not arise between the Company and the Parent as a result of which the Company would be required to obtain these services from other third parties at significantly higher prices or develop these capabilities internally. The unavailability of these services to the Company for any reason could have a material adverse effect on the Company's business, financial condition, 11 12 results of operations and liquidity. See "Business -- Relationship with the Parent" and "Certain Related Party Transactions." RISKS ASSOCIATED WITH INTANGIBLE ASSETS At June 30, 1997, the Company's total assets were approximately $96.0 million, of which approximately $53.7 million, or 56%, represented the excess of cost over fair market value of net assets acquired relating to the acquisition of businesses (intangible assets). The intangible assets consist of approximately $45.9 million in goodwill which is being amortized over 40 years, $5.2 million assigned to customer lists with an eight-year amortization period and $2.6 million assigned to noncompete and workforce agreements with a five-year and an eight-year amortization period, respectively. While the Company believes the value represented by intangible assets will be realized through the future contribution of the acquired businesses to earnings and cash flow of the Company, there can be no assurance that such projected contribution to earnings and cash flow will be realized. The amortization of such intangible assets, substantially all of which is not deductible for income tax purposes, will produce an annual charge to income from operations of approximately $2.2 million, which will adversely impact the Company's earnings. This charge could be greater in future years as the Company pursues additional acquisitions. The Company will evaluate on a regular basis whether events and circumstances have occurred that indicate that the carrying amount of the intangible assets may warrant revision or may not be recoverable. Any such future determination requiring the write-off of a significant portion of unamortized intangible assets could adversely affect the Company's financial position and results of operations for the period in which any such write-offs occur. OBLIGATIONS IN CONNECTION WITH ACQUISITIONS In connection with acquisitions of businesses by the Company, the Company is obligated to pay additional cash and stock consideration to sellers of businesses, certain of which are contingent upon achievement of certain operating objectives. The amount of cash to be paid and the number of shares of the Company's Common Stock to be issued with respect to the contingent payments cannot be determined until contingent payment periods terminate and achievement of certain criteria is established. As of July 1, 1997, if the criteria for the contingent payments with respect to each of the Company's acquisitions to date were achieved, but not exceeded, the Company would be obligated to make future cash payments of $2.5 million and issue 125,000 shares of its Common Stock over the next three years. A lesser amount of cash would be payable and a lesser number of shares of Common Stock would be issuable under certain acquisition agreements if the operating objectives were not met, and a greater amount of cash would be payable and a greater number of shares of Common Stock would be issuable under certain acquisition agreements if the operating objectives were exceeded. In certain of the acquisitions, there is no maximum as to the amount such sellers may receive. For example, as of July 1, 1997, if the operating objectives with respect to each of the acquisitions were to be exceeded by 20%, the Company would be obligated to make cash payments of $2.9 million and issue 150,000 shares of Common Stock over the next three years. If, in each case, the contingent payment goals were met, the acquired company would have achieved operating income which the Company believes should generate earnings significantly in excess of any incremental contingent payment due, although, there can be no assurance that it will do so. In addition to the contingent obligations, the Company is obligated in any event to make future cash payments of $1,797,000 and issue 341,063 shares of its Common Stock over the next three years as part of the deferred purchase price for certain of the acquisitions. The Company believes that it will be able to make such cash payments from internally generated funds and, if necessary, proceeds of future borrowings. However, there can be no assurance that the Company will generate or be able to borrow sufficient cash to fund such obligations. The Company expects to continue to enter into acquisition agreements providing for future contingent earn-out arrangements primarily based on the achievement of financial criteria. The Company believes that it will continue to be able to make such cash payments (as well as any payments to repurchase Common Stock as described below) from cash on hand and, if necessary, proceeds of future borrowings. However, there can be no assurance that the Company will generate sufficient cash or obtain debt financing to fund such payments or that future acquisitions will not adversely affect cash generated from operations. 12 13 In addition, in connection with certain acquisitions, the Company granted to the sellers the right to require the Company to repurchase, at prices of up to $16.00 per share, all shares of the Company's Common Stock received by such sellers (up to 1,279,250 shares in the aggregate), as consideration for the acquisitions, including those shares of the Company's Common Stock received pursuant to contingent payments, in the event that the Company's Common Stock is not, by specific dates, (i) listed or traded on a national securities exchange, (ii) listed on the Nasdaq National Market or (iii) traded in the Nasdaq SmallCap Market. Moreover, in the event that (i) a change in control of the Company occurs prior to an initial public offering of the Company's Common Stock and (ii) either (a) the Company has not effected an initial public offering of its Common Stock by specific dates at certain minimum offering prices, or (b) the closing price of the Company's Common Stock is less than $16.00 per share as of December 31, 1998, the Company may be required to repurchase all such shares of its Common Stock issued in connection with one acquisition (375,000 shares plus contingent shares) at a price of $16.00 per share. The repurchase of such shares would have a material adverse effect on the Company's financial condition and liquidity. In addition to cash payments, the Company expects that it will continue to issue shares of Common Stock in connection with future acquisitions both at the time of closing and as earn-out payments. No predictions can be made as to the timing or amount of any such future issuances of Common Stock. In addition to the above payments, the Company is obligated to make additional cash payments upon the consummation of the Offering to the sellers of certain of the businesses acquired by the Company. As of July 1, 1997, the Company is obligated to make cash payments of $17.5 million upon the consummation of the Offering. See "Use of Proceeds." UNCERTAINTY OF IMPACT OF HEALTH CARE AND WORKERS' COMPENSATION REFORM Regulation in the health care and workers' compensation fields continues to evolve, and the Company is unable to predict what additional government regulations, if any, that affect its business may be adopted in the future. In addition, health care reform and/or specific changes in laws or regulations may affect demand for the Company's services, require the Company to develop new or modified services to meet the demands of the marketplace, or modify the fees that the Company may charge for its services. See "Business -- Regulation." RISKS ASSOCIATED WITH GEOGRAPHIC MARKET CONCENTRATION AND EXPANSION INTO ADDITIONAL STATES The Company operates primarily in Florida, Pennsylvania, New York and California, with such states accounting for approximately 29%, 10%, 9% and 6%, respectively, of the Company's revenues for fiscal 1997 on a pro forma basis. As a result, for the foreseeable future, a significant portion of the Company's revenues will be subject to economic factors specific to those states. No other state accounted for more than 5% of the Company's revenues for fiscal 1997. Because the Company's expansion plans target markets in states with high existing worksite employee populations, growth is likely to increase the Company's exposure to market-specific economic risks in the near term. Future growth of the Company's operations depends, in part, on its ability to offer its services to prospective clients in additional states. Currently, approximately one-third of the states require the licensing or registration of PEOs. The Company is licensed in seven states and has begun the licensing process in eight states. In order to operate effectively in a new state that has licensing regulations, the Company must obtain all necessary regulatory approvals, achieve acceptance in the local market, adapt its procedures to that state's regulatory requirements and local market conditions and establish internal controls that enable it to conduct operations in several locations. The length of time required to obtain regulatory approval to begin operations will vary from state to state. There can be no assurance that the Company will be able to satisfy licensing requirements or other applicable regulations of any particular state, that it will be able to provide the full range of services currently offered in the states where it currently conducts business, or that it will be able to operate profitably within the regulatory environment of any state in which it does obtain regulatory approval. The absence of required licenses would require the Company to restrict the services it offers. See "Business -- Regulation." Moreover, as the Company expands into additional states, there can be no assurance that the Company will be able to duplicate in other markets the revenue growth and operating results experienced in its current markets. 13 14 QUARTERLY FLUCTUATIONS IN OPERATING RESULTS The Company's quarterly results of operations are subject to a number of seasonal variations, including seasonal variations in employment levels and patterns and the effect of employment tax limits, none of which can be predicted with any degree of certainty. COMPETITION The PEO industry is highly fragmented, with at least 2,400 companies (according to an estimate by NAPEO) providing PEO services. The Company encounters competition from other national and regional PEOs and single-service and "fee for service" companies such as payroll processing firms, insurance companies, workers' compensation safety consultants and human resource consultants. In addition, the Company may encounter substantial competition from new national market entrants. Some of the Company's current and future competitors may be significantly larger, have greater name recognition and have greater financial, marketing and other resources than the Company. There can be no assurance that the Company will be able to compete effectively against such competitors in the future. There are low barriers to entry into the PEO business in most states where the Company operates and competitive pricing may adversely affect growth and/or margins. See "Business -- Competition." DEPENDENCE ON KEY MANAGEMENT The success of the Company is highly dependent on the services of current management. The loss of key management personnel or an inability to attract, retain and motivate sufficiently experienced management could adversely affect the Company's operations. All executive officers of the Company are considered by the Company to be key management personnel, but no single individual is considered by the Company to be critical to the Company's success. All executive officers except Andrew W. Stith are covered by non-competition agreements. The Company does not carry key-man life insurance on any individual. SUBSTANTIAL AND IMMEDIATE DILUTION Investors in the Offering will experience immediate and substantial dilution in net tangible book value (deficit) per share of Common Stock. Based upon the public offering price of $9.00 per share, dilution to investors in the Offering will be $9.40 per share and the net tangible book value (deficit) of the shares held by all stockholders will be $(.40) per share. See "Dilution." ABSENCE OF PUBLIC MARKET; VOLATILITY OF STOCK PRICE Prior to the Offering, there has been no public market for the Company's Common Stock and there can be no assurance that an active trading market will develop or be sustained upon the completion of the Offering, or that the market price of the Common Stock will not decline below the initial offering price. The initial public offering price of the Company's Common Stock offered hereby has been determined by negotiations between the Company and the Underwriters. The market price for shares of the Company's Common Stock may be highly volatile depending on news announcements of the Company related to quarterly operating results or other matters, general trends in the Company's industry, changes in general market conditions and other factors. In recent years the stock market has experienced extreme price and volume fluctuations. SHARES ELIGIBLE FOR FUTURE SALE Upon consummation of the Offering, there will be outstanding 25,643,187 shares of Common Stock. The 5,000,000 shares sold in the Offering will be freely tradable without restriction under the Securities Act of 1933, as amended (the "Securities Act"), except to the extent acquired by affiliates of the Company. The Company, its officers and directors and substantially all other holders of Common Stock and securities convertible into or exercisable or exchangeable for Common Stock have agreed that for a period of 180 days after the date of this Prospectus (the "Lockup Period") they will not, without the prior written consent of BancAmerica Robertson Stephens, offer, sell, contract to sell or otherwise dispose of any Common Stock or 14 15 any securities convertible into or exercisable or exchangeable for Common Stock except in certain limited circumstances. Upon expiration of the 180-day period, at least 19,380,937 shares of Common Stock will be eligible for sale pursuant to Rule 144 under the Securities Act, subject in some cases to compliance with Rule 144 volume limitations, of which 287,008 shares are held by officers, directors and affiliates of the Company. Sales of a substantial amount of such shares could have a significant adverse effect on the market price of the Common Stock. See "Shares Eligible for Future Sale." NO DIVIDENDS The Company intends to retain all of its earnings to finance the expansion of its business and for general corporate purposes and does not anticipate paying any cash dividends on its Common Stock for the foreseeable future. See "Dividend Policy" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." THE COMPANY The Company was established by the Parent in September 1996 to enter the employee services business. It began operations as of October 1, 1996 with the acquisition of Resource One, a PEO based in Maitland, Florida. In February 1997, the Company acquired three additional PEOs -- Employee Services of America, Inc., The TPI Group, Ltd. and Prostaff Human Resources, Inc. -- and entered into the NovaCare Contract with the Parent to co-employ the Parent's workforce. On July 1, 1997, the Company acquired from the Parent the assets of the Parent's NovaPro rehabilitation temporary staffing business. 15 16 USE OF PROCEEDS The net proceeds to the Company from the sale of the 5,000,000 shares of Common Stock offered hereby, at the public offering price of $9.00 per share, and after deducting underwriting discounts and commissions and estimated offering expenses, are estimated to be $40.6 million ($46.9 million if the Underwriters' over-allotment option is exercised in full). The Company has paid approximately $0.6 million of offering expenses as of the date of this Prospectus, which amount is reflected in the historical June 30, 1997 balance sheet, thereby resulting in an actual $41.2 million of net proceeds from the Offering ($47.5 million if the Underwriters' overallotment option is exercised in full). See Notes 3 and 4 of Notes to the Company's Pro Forma Combined Balance Sheet. The Company intends to use the approximately $41.2 million of net proceeds from the Offering to retire certain outstanding indebtedness as follows: (i) to satisfy $17.5 million of deferred purchase price obligations incurred in connection with the Company's acquisitions and (ii) to repay $23.7 million borrowed under the Company's line of credit from the Parent, at an interest rate equal to the EuroDollar rate plus 0.5% to 1.125% depending on certain cash flow calculations, which was incurred to finance the Company's acquisitions and to provide the Company with working capital and which is due upon the earlier of November 28, 1999 or the consummation of the Offering. DIVIDEND POLICY The Company has never paid a cash dividend on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The payment of cash dividends in the future will depend on the Company's earnings, financial condition and capital needs and on other factors deemed pertinent by the Company's Board of Directors. It is the current policy of the Company's Board of Directors to retain earnings to finance the operations and expansion of the Company's business. 16 17 DILUTION The Company had a net tangible book value (deficit) of $(53,515,000), or $(2.70) per share of the Common Stock at June 30, 1997 assuming the acquisition of NovaPro as if it had occurred at June 30, 1997. Giving effect to the sale of the Common Stock offered hereby at the public offering price of $9.00 per share and the conversion of the mandatorily redeemable Common Stock, and after deducting underwriting discounts and commissions and estimated offering expenses, such net tangible book value (deficit) would have been ($10,154,000), or $(.40) per common share. This represents an immediate increase in net tangible book value of $2.17 per common share to existing stockholders attributable to new investors and $.13 per common share attributable to conversion of mandatorily redeemable Common Stock, and an immediate dilution of $9.40 per common share to purchasers of shares in the Offering. The following table illustrates this dilution: Public offering price per share of Common Stock(1)................. $ 9.00 Net tangible book value (deficit) per share of Common Stock before the Offering(2).................................................. $(2.70) Decrease in net tangible book value (deficit) attributable to the conversion of mandatorily redeemable Common Stock(3)............. .13 Decrease in net tangible book value (deficit) attributable to new investors........................................................ 2.17 ------ Net tangible book value (deficit) per share of Common Stock after the Offering..................................................... (.40) ------- Dilution of net tangible book value per share to new investors(4)..................................................... $(9.40) ======= - --------------- (1) Public offering price before deduction of underwriting discounts and commissions and estimated offering expenses. (2) Negative net tangible book value (deficit) per share of Common Stock without considering the purchase of shares of Common Stock by new investors is determined by dividing the 19,830,000 shares of Common Stock outstanding before conversion of the mandatorily redeemable Common Stock into the tangible net worth (deficit) of the Company (tangible assets less liabilities). Net tangible book value (deficit) per share of Common Stock excludes intangibles of $53,691,000, or $2.71 per share. (3) The effect of the conversion of the 813,187 shares of the mandatorily redeemable Common Stock upon consummation of this Offering represents a decrease in negative tangible net worth (deficit) of $2,731,000, or $.13 per share. (4) Dilution is determined by subtracting net tangible book value (deficit) per share of Common Stock after the Offering from the public offering price paid by new investors for a share of Common Stock. Based on the same assumptions utilized in the table set forth above, the following table summarizes, as of June 30, 1997, the difference between existing stockholders, including conversion of the mandatorily redeemable Common Stock, and new investors with respect to the number of shares of Common Stock purchased from the Company, the consideration paid and the average price paid per share. AVERAGE PRICE PER SHARE ------------- SHARES PURCHASED TOTAL CONSIDERATION ---------------------- ----------------------- NUMBER PERCENT AMOUNT PERCENT ---------- ------- ----------- ------- Existing Stockholders(1)......... 20,643,187 80.5% $ 7,851,000 14.9% $ .38 New Investors.................... 5,000,000 19.5 45,000,000 85.1% 9.00 ---------- ----- ----------- ----- Total............................ 25,643,187 100.0% $52,851,000 100.0% ========== ===== =========== ===== - --------------- (1) Includes 1,200,000 shares issued to a subsidiary of the Parent on July 1, 1997 in connection with the acquisition of NovaPro. See "Certain Related Party Transactions." 17 18 CAPITALIZATION The following table sets forth certain current debt obligations and the capitalization of the Company as of June 30, 1997, the pro forma capitalization of the Company at June 30, 1997 assuming the acquisition of NovaPro as if it had occurred at June 30, 1997 and pro forma as adjusted capitalization to reflect the issuance and sale by the Company of the 5,000,000 shares of Common Stock offered hereby, the conversion of the mandatorily redeemable Common Stock into stockholders' equity and the application by the Company of the estimated net proceeds therefrom as described under "Use of Proceeds." JUNE 30, 1997 (IN THOUSANDS) ---------------------------------------------- PRO FORMA ACTUAL PRO FORMA(1) AS ADJUSTED(1)(2) ------- ------------ ----------------- Current note payable, current portion of financing arrangements and deferred purchase price obligations(3)(4)........................ $47,585 $ 47,585 $ 6,378 ======= ======== ======= Financing arrangements, net of current portion(3)..................................... $ 1,068 $ 1,068 $ 1,068 Deferred purchase price obligations, net of current portion(4)............................. 856 856 856 Mandatorily redeemable Common Stock(5)........... 2,731 2,731 -- Shareholders' Equity Preferred stock, $.01 par value; authorized 1,000,000 shares; no shares issued or outstanding(6).............................. -- -- -- Common stock, $.01 par value; authorized 60,000,000 shares, issued 19,193,187 actual, 20,393,187 pro forma, and 26,206,374 pro forma as adjusted(7)........................ 192 204 262 Additional paid-in capital..................... 1,189 1,052 44,355 Retained earnings.............................. -- -- -- ------- -------- ------- 1,381 1,256 44,617 Less: Common stock in treasury (at cost) 562,500 shares.............................. (1,080) (1,080) (1,080) ------- -------- ------- Total shareholders' equity.................. 301 176 43,537 ------- -------- ------- Total capitalization................... $ 4,956 $ 4,831 $45,461 ======= ======== ======= - --------------- (1) Gives effect to the acquisition of NovaPro as if it had occurred at June 30, 1997. See "Certain Related Party Transactions" and Note 3 of Notes to the Company's Consolidated Financial Statements. (2) Gives effect to the conversion of the Common Stock, and adjusted for the sale of shares of Common Stock offered hereby and the application of the estimated net proceeds therefrom as described under "Use of Proceeds" based upon the public offering price of $9.00 per share. See "Pro Forma Financial Information." (3) See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 of Notes to the Company's Consolidated Financial Statements for information concerning the Company's long-term debt. (4) See Note 3 of Notes to the Company's Consolidated Financial Statements. (5) See "Description of Capital Stock" and Note 10 of Notes to the Company's Consolidated Financial Statements concerning the mandatorily redeemable Common Stock. (6) See "Description of Capital Stock" and Note 9 of Notes to the Company's Consolidated Financial Statements for information concerning the Preferred Stock. (7) Does not include 625,000 shares reserved for issuance under the Company's Stock Option Plan. See "Management -- Executive Compensation -- Stock Option Plan" and Note 11 of Notes to the Company's Consolidated Financial Statements. 18 19 SELECTED FINANCIAL AND STATISTICAL DATA (IN THOUSANDS, EXCEPT PER SHARE AND STATISTICAL DATA) The selected historical financial data presented below has been derived from the consolidated financial statements of the Company and of its predecessor company, Resource One, which financial statements are included elsewhere in this Prospectus. The reports of Price Waterhouse LLP, independent accountants, on the consolidated financial statements of the Company as of and for the period from inception to June 30, 1997 and of Brewer, Beemer, Kuehnhackl and Koon, P.A., independent accountants, on the consolidated financial statements of Resource One at December 31, 1994 and 1995 and at September 30, 1996 and the periods then ended appear elsewhere in this Prospectus. The selected pro forma financial data have been taken from the pro forma financial information appearing elsewhere in this Prospectus. Selected historical financial data of the Company and its predecessor should be read in conjunction with the Company's consolidated financial statements and related notes appearing elsewhere in this Prospectus. PREDECESSOR COMPANY THE COMPANY ------------------------------------------ --------------------------------- HISTORICAL PRO FORMA(2) FOR THE YEAR ENDED FOR THE NINE -------- ------------ DECEMBER 31, MONTHS ENDED PERIOD FROM YEAR ENDED -------------------------- SEPTEMBER 30, OCTOBER 1, 1996 TO JUNE 30, STATEMENT OF OPERATIONS DATA: 1993 1994 1995 1996 JUNE 30, 1997(1) 1997 ------ ------- ------- ------------- ------------------ ------------ Revenues(3).................................... $7,780 $11,987 $18,749 $23,465 $394,193 $878,097 Direct Costs: Salaries, wages and employment taxes of worksite employees......................... 5,283 9,427 16,118 21,224 357,238 790,769 Health care, workers' compensation, state unemployment taxes and other............... 654 555 535 403 24,717 62,825 ------ ------- ------- ------- -------- -------- Gross profit............................. 1,843 2,005 2,096 1,838 12,238 24,503 Selling, general and administrative expenses... 1,704 1,683 1,763 1,767 8,273 21,295 Amortization of excess cost of net assets acquired..................................... -- -- -- -- 1,034 2,268 ------ ------- ------- ------- -------- -------- Income from operations................... 139 322 333 71 2,931 940 Interest (expense) income, net................. (2) 1 (5) 6 (697) (1,627) ------ ------- ------- ------- -------- -------- Income (loss) before income taxes........ 137 323 328 77 2,234 (687) Income taxes................................... -- 94 64 21 1,542 734 ------ ------- ------- ------- -------- -------- Net income (loss)........................ $ 137 $ 229 $ 264 $ 56 $ 692 $ (1,421) ====== ======= ======= ======= ======== ======== Net (loss) attributable to common stock.................................. $ (341) ======== Net (loss) per share........................... $ (.02) ======== Unaudited pro forma net income (loss) per share........................................ $ .03 $ (.07) ======== ======== Unaudited pro forma weighted average number of shares outstanding........................... 20,574 20,574 ======== ======== THE COMPANY PREDECESSOR COMPANY ------------------------------------- -------------------------------------- AS OF JUNE 30, 1997 AS OF DECEMBER 31, AS OF ------------------------------------- ---------------------- SEPTEMBER 30, PRO FORMA AS 1993 1994 1995 1996 ACTUAL PRO FORMA(4) ADJUSTED(4)(5) ---- ------ ------ ------------- ------- ------------ ------------ BALANCE SHEET DATA: Current assets................................... $573 $ 821 $ 986 $ 1,320 $39,879 $ 41,669 $ 41,669 Total assets..................................... 828 1,006 1,241 1,544 95,998 98,330 97,753 Current liabilities(6)........................... 285 591 748 1,087 88,721 91,178 49,971 Financing arrangements(6)........................ 18 164 101 8 1,366 1,366 1,366 Mandatorily redeemable common stock.............. -- -- -- -- 2,731 2,731 -- Shareholders' equity............................. 530 345 393 449 301 176 43,537 - --------------- (1) The Company commenced operations effective October 1, 1996, concurrent with the acquisition of Resource One, which was accounted for as a purchase. The computation of historical and unaudited pro forma weighted average number of shares outstanding is consistent with the computation of weighted average number of shares outstanding for historical and unaudited pro forma net income per share described in Note 1 of Notes to the Company's Consolidated Financial Statements. (2) Adjusted on a pro forma basis to give effect to the acquisitions of Resource One, Inc., Employee Services of America, Inc., The TPI Group, Ltd., Prostaff Human Resources, Inc., NovaPro and the NovaCare Contract (see Note 2 of Notes to the Company's Consolidated Financial Statements) as if they occurred on July 1, 1996. NovaPro, formerly a business of the Parent, was acquired from the Parent effective July 1, 1997. The pro forma statement of operations does not purport to represent what the Company's actual results of operations would have been if such acquisitions and the NovaCare Contract occurred on July 1, 1996, or to project the Company's results of operations for any future period. See the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. The computation of unaudited pro forma weighted average numbers of shares outstanding is consistent with the computation of unaudited pro forma weighted average number of shares outstanding for unaudited pro forma net income per share described in Note 1 of Notes to the Company's Consolidated Financial Statements. (3) Revenues include all amounts billed to clients for gross salaries and wages, related employment taxes and health care and workers' compensation coverage of worksite employees. (4) Adjusted on a pro forma basis to include the assets and liabilities of NovaPro as of June 30, 1997. See the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. (5) Adjusted to give effect to the conversion of mandatorily redeemable Common Stock into stockholders' equity and the Offering and the application of the estimated net proceeds therefrom, as if each of the foregoing had occurred as of June 30, 1997. See "Use of Proceeds" and the Consolidated Pro Forma Financial Statements and the Notes thereto appearing elsewhere in this Prospectus. (6) The current portion of financing arrangements is included in current liabilities. 19 20 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES PRO FORMA COMBINED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) The unaudited pro forma Combined Statement of Operations for the year ended June 30, 1997 appearing on the following page is based on the historical consolidated financial statements of NovaCare Employee Services, Inc. (the "Company") for the period from October 1, 1996 (commencement of operations) to June 30, 1997, adjusted to give effect to the acquisition of Resource One, Inc. ("Resource One"), the predecessor company, Employee Services of America, Inc. ("ESA"), The TPI Group, Ltd. ("TPI"), Prostaff Human Resources, Inc. ("Prostaff") and NovaPro. Resource One, ESA, TPI and Prostaff were acquired prior to June 30, 1997 and are included in the historical results of operations from their respective dates of acquisition. The historical financial information is also adjusted to give effect to the full year impact of the contract between the Company and the Parent (the "NovaCare Contract") (further described in Note 2 of Notes to the Company's Consolidated Financial Statements contained elsewhere in this Prospectus). The Pro Forma Combined Statement of Operations has been prepared assuming the above acquisitions, the NovaCare Contract and the Offering occurred as of July 1, 1996. Adjustments related to the NovaPro acquisition and the Offering are described in the notes thereto. The financial information is based on certain assumptions and estimates that the Company believes are reasonable in the circumstances and does not purport to be indicative of the results which actually would have been attained had the above transactions occurred as of the dates indicated, or to project the Company's results of operations or financial position for any future period or date. This information should be read in conjunction with the Company's consolidated financial statements and related notes included elsewhere in this Prospectus. 20 21 PRO FORMA COMBINED STATEMENT OF OPERATIONS -- CONTINUED HISTORICAL RESULTS OF HISTORICAL ACQUIRED RESULTS OF PRO FORMA COMPANIES NOVAPRO FOR RESULTS FOR HISTORICAL RESULTS FROM THE PERIOD THE PERIOD FOR THE PERIOD JULY 1, 1996 FROM FROM OCTOBER 1, 1996 TO THE JULY 1, 1996 JULY 1, 1996 (INCEPTION) TO DATE OF TO JUNE 30, PRO FORMA TO JUNE 30, 1997 ACQUISITION(1) 1997(2) ADJUSTMENTS JUNE 30, 1997 ------------------ ------------- ------------- ----------- -------------- Revenues: Related party....................... $255,289 $ -- $ -- $ -- $255,289 Third parties....................... 138,904 149,885 7,624 -- 296,413 -------- --------- ------- ------- -------- Total revenues.................... 394,193 149,885 7,624 -- 551,702 Direct costs: Related Party: Salaries, wages and employment taxes of worksite employees..... 234,182 -- -- -- 234,182 Health care and workers' compensation, state unemployment taxes and other................. 15,368 -- -- -- 15,368 Third Parties: Salaries, wages and employment taxes of worksite employees..... 123,056 134,921 -- -- 257,977 Health care and workers' compensation, state unemployment taxes and other................. 9,349 8,888 6,886 -- 25,123 -------- --------- ------- ------- -------- Gross profit......................... 12,238 6,076 738 -- 19,052 Selling, general and administrative expenses............................ 8,247 7,827 827 1,212(4) 18,113 Provision for uncollectible accounts............................ 26 273 35 -- 334 Amortization of excess cost of net assets acquired..................... 1,034 -- -- 1,234(5) 2,268 -------- --------- ------- ------- -------- Income (loss) from operations........ 2,931 (2,024) (124) (2,446) (1,663) Investment income.................... 52 20 -- -- 72 Interest expense..................... (56) (774) -- 740(6) (90) Interest expense -- related party.... (693) -- -- (916)(7) (1,609) -------- --------- ------- ------- -------- Income (loss) before income taxes.... 2,234 (2,778) (124) (2,622) (3,290) Income taxes......................... 1,542 (376) -- (1,525)(9) (359) -------- --------- ------- ------- -------- Net income (loss)................... $ 692 $ (2,402) $ (124) $(1,097) $ (2,931) ======== ========= ======= ======= ======== Net (loss) attributable to common stock............................. $ (341) ======== Net (loss) per share................ $ (.02) ======== Unaudited pro forma net income (loss) per share(11).............. $ .03 $ (.14) ======== ======== Unaudited pro forma weighted average number of shares.................. 20,574 20,574 ======== ======== NOVACARE PRO FORMA CONTRACT COMBINED FROM JULY RESULTS 1, 1996 TO INCLUDING THE OFFERING PRO FORMA JANUARY 31, NOVACARE PRO FORMA AS 1997(3) CONTRACT ADJUSTMENTS ADJUSTED ----------- ------------- ----------- --------- <C Revenues: Related party....................... $ 326,395 $ 581,684 $ -- $581,684 Third parties....................... -- 296,413 -- 296,413 --------- --------- ------- -------- Total revenues.................... 326,395 878,097 -- 878,097 Direct costs: Related Party: Salaries, wages and employment taxes of worksite employees..... 298,610 532,792 532,792 Health care and workers' compensation, state unemployment taxes and other................. 22,334 37,702 -- 37,702 Third Parties: Salaries, wages and employment taxes of worksite employees..... -- 257,977 -- 257,977 Health care and workers' compensation, state unemployment taxes and other................. -- 25,123 -- 25,123 --------- --------- ------- -------- Gross profit......................... 5,451 24,503 -- 24,503 Selling, general and administrative expenses............................ 2,848 20,961 -- 20,961 Provision for uncollectible accounts............................ -- 334 -- 334 Amortization of excess cost of net assets acquired..................... -- 2,268 -- 2,268 --------- --------- ------- -------- Income (loss) from operations........ 2,603 940 -- 940 Investment income.................... -- 72 -- 72 Interest expense..................... -- (90) -- (90) Interest expense -- related party.... -- (1,609) 1,300(8) (309) --------- --------- ------- -------- Income (loss) before income taxes.... 2,603 (687) 1,300 613 Income taxes......................... 1,093 734 510(10) 1,244 --------- --------- ------- -------- Net income (loss)................... $ 1,510 $ (1,421) $ 790 $ (631) ========= ========= ======= ======== Net (loss) attributable to common stock............................. Net (loss) per share................ Unaudited pro forma net income (loss) per share(11).............. $ (.07) $ (.02) ========= ======== Unaudited pro forma weighted average number of shares.................. 20,574 25,574 (12) ========= ======== 21 22 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO THE PRO FORMA COMBINED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) (1) The Acquired Companies' adjustments represent the historical results of operations of Resource One, ESA, TPI, and Prostaff (collectively, the "Acquired Companies") from July 1, 1996 to their respective dates of acquisition, as noted below. Each of the acquisitions has been accounted for as a purchase. Accordingly, the results of operations of each of the Acquired Companies are included in the historical results of operations of the Company since the date of acquisition. FOR THE PERIOD FROM JULY 1, 1996 TO THE DATE OF ACQUISITION ------------------------------------------------------------------------ SELLING, GENERAL PROVISION FOR INCOME (LOSS) DIRECT AND ADMINISTRATIVE UNCOLLECTIBLE BEFORE COMPANY ACQUIRED AS OF REVENUES COSTS EXPENSES ACCOUNTS INCOME TAXES - ------------------- ---------------- -------- -------- ------------------ ------------- ------------- Resource One....... October 1, 1996 $ 9,068 $ 8,438 $ 587 $ -- $ 43 ESA................ February 1, 1997 87,046 83,131 3,816 -- 67 TPI................ February 1, 1997 51,206 49,772 3,278 273 (2,840) Prostaff........... February 1, 1997 2,565 2,468 146 -- (48) -------- ------- Total......... $149,885 $143,809 $7,827 $ 273 $(2,778) ======== ======= The income tax effect of the Acquired Companies' adjustment is considered in Note 9 below. (2) Effective July 1, 1997, the Company acquired the assets and liabilities of NovaPro in a purchase transaction, as described in Note 13 of Notes to the Company's Consolidated Financial Statements. The adjustments represent the historical results of operations of NovaPro from July 1, 1996 to June 30, 1997. (3) In February 1997, the Parent and the Company entered into the NovaCare Contract whereby the Parent's employees are co-employed by the Company for a five-year term with automatic annual renewals. Under the NovaCare Contract, the Company provides traditional PEO services such as payroll and benefits administration, worksite safety evaluation, employment-related risk management and benefits consultations. The Parent pays the Company a fee for its services currently equal to the salary and federal payroll tax costs plus 9.7% of gross earnings of covered employees, or approximately 117% of the gross earnings of the employees covered by the NovaCare Contract. The Parent may not terminate the NovaCare Contract except in the event of: (i) the breach of any of the Company's agreements, duties or performance standards under the NovaCare Contract; (ii) the making of false or misleading representations, warranties, or statements of material fact in documents submitted by or on behalf of the Company to the Parent; or (iii) the insolvency, bankruptcy or receivership of the Company. The NovaCare Contract adjustment for the year ended June 30, 1997 reflects the pro forma results of operations related to the NovaCare Contract from July 1, 1996 to January 31, 1997. Results of operations from the NovaCare Contract for the period from February 1, 1997 to June 30, 1997 are included in the historical results. (4) Includes adjustments representing net increases in selling, general and administrative expenses in support of the combined businesses. EXPENSE CATEGORY EXPENSE AMOUNT ----------------------------------------------------------- -------------- Salaries, wages and benefits............................... $ 736 Rental lease agreements.................................... 180 Other...................................................... 296 ------ Selling, general and administrative expenses adjustment.......................................... $1,212 ====== (5) Reflects additional amortization of the excess of the purchase price over the fair value of net assets acquired. The additional amortization consists of non-compete agreements, customer lists, assembled workforce and goodwill, amortized on a straight-line basis over the estimated useful lives of the assets which range from five to 40 years, as if the businesses were acquired as of July 1, 1996. 22 23 (6) Represents the reduction of expense assuming that late payment penalties and interest due to the Internal Revenue Service for late payment of federal withholding taxes incurred by a subsidiary would not have been incurred given the Company's availability of financing from the Parent, as described in Note 7 below. An additional $53 of interest expense has been recorded to reflect the borrowing from the Parent for the timely payment of the federal withholding taxes. (7) Represents interest due to the Parent (See Note 2 of Notes to the Company's Consolidated Financial Statements) for money borrowed by the Company to finance the acquisition of the Acquired Companies. The Company entered into a loan agreement where the Parent charges interest to the Company at the EuroDollar rate plus 0.5% to 1.125%. The weighted average interest rate was 6.6%. (8) Represents the reduction of interest expense resulting from the use of a portion of the net proceeds to pay certain indebtedness to the Parent (see Note 2 of Notes to the Company's Consolidated Financial Statements). (9) Represents an adjustment to income taxes to reflect the state and federal income tax liability which would have been provided on pro forma adjusted income before income taxes for the period from July 1, 1996 to June 30, 1997. State taxes were computed on a legal entity basis dependent upon the income subject to income tax for the same period at an effective rate of 6% to 8%. Federal income tax (34% rate) was computed on consolidated income before income taxes adjusting for the non-deductible portion of the amortization of excess cost of net assets acquired. (10) Represents an adjustment to state and federal income taxes which would have been provided on the reduction of interest expense discussed in Note 8 above. (11) As described in Note 1 of Notes to the Company's Consolidated Financial Statements -- "Historical, Unaudited Pro Forma and Unaudited Supplemental Pro Forma Net Income Per Share", unaudited pro forma net income per share has been computed by dividing net income (loss) by the number of shares of common stock and common stock equivalents outstanding as of September 5, 1997. (12) The Company intends to use a portion of the net proceeds from the Offering to retire certain indebtedness (see Note 13 of Notes to the Company's Consolidated Financial Statements). Unaudited pro forma net income per share as adjusted is computed by dividing net income, adjusted for the elimination of applicable interest expense, net of the related income tax effect, by total outstanding shares as of September 5, 1997 plus the shares to be issued in the Offering to retire outstanding debt. 23 24 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with, and is qualified in its entirety by, the Company's Consolidated Financial Statements and Notes thereto included elsewhere in this Prospectus. Historical results are not necessarily indicative of trends in operating results for any future period. OVERVIEW NovaCare Employee Services, Inc. (the "Company") is one of the largest (measured by revenues and number of worksite employees) professional employer organizations ("PEO"s) in the United States. The Company commenced operations on October 1, 1996, concurrent with the acquisition of Resource One, Inc. ("Resource One"), a PEO. Results for the quarter ended December 31, 1996 primarily represent the results of operations of Resource One. In February 1997, the Company acquired three additional PEOs -- Employee Services of America, Inc. ("ESA"); The TPI Group, Ltd. ("TPI"); and Prostaff Human Resources, Inc. ("Prostaff") and signed an agreement with NovaCare, Inc. (the "Parent") to provide traditional PEO services to principally all of the Parent's worksite employees (the "NovaCare Contract"). As of June 30, 1997, the Company served 1,742 client organizations with 35,028 employees at over 3,000 worksites in 45 states, principally in 10 different industries. On July 1, 1997, the Company acquired NovaPro, a rehabilitation temporary staffing business, from the Parent. The Company is an employee services company which provides small and medium-sized businesses with comprehensive, fully integrated outsourcing solutions to human resource issues, including payroll management, risk management, benefits administration, unemployment services and human resource consulting services. The Company was established by the Parent primarily to leverage the Parent's core competencies and investments in human resource management, information systems, outsourcing, relationship selling, workers' compensation, risk management and management of a dispersed workforce. The Company believes that these competencies are highly correlated with success in the PEO business. The Parent is a leading provider of medical rehabilitation services. Its services, delivered in over 2,000 facilities nationwide, include worksite evaluation, injury prevention and work injury rehabilitation. The Company believes that the abilities to deliver employment-related services to small, widely dispersed groups of employees and to manage effectively workers' compensation risk are central to a PEO. Revenues The Company enters into a PEO services agreement with its clients, establishing a three-party relationship among the Company, the client and the worksite employees. The agreement generally provides for an initial one-year term, subject to cancellation without cause on 30 days' notice by either the Company or the client. Although PEO services agreements have been canceled, no such cancellation singly, or in the aggregate, has had a material adverse effect on the Company's financial position or results of operations. The PEO services agreement also sets forth the service fee payable to the Company. Such service fee, which constitutes the Company's revenues, is based on the gross earnings of each employee plus the estimated costs of employment-related taxes, providing human resource services, performing administrative functions, providing insurance coverages and benefit plans and performing other services offered by the Company. This structure yields a comprehensive service fee percentage to be applied to each employee's gross pay. These fees are invoiced along with each periodic payroll. Pursuant to the PEO services agreement, the Company has the obligation to provide the benefits and services enumerated in that agreement as well as to pay the direct costs associated with such services, regardless of whether the client company makes timely payment to the Company of the associated service fee. The most significant direct costs associated with each PEO services agreement are the worksite employees' salaries and wages, which generally are disbursed promptly after the applicable client service fee is received. For a description of additional costs of services, see "Direct Costs" below. 24 25 The Company's revenues are dependent on the number of clients enrolled, the resulting number of employees paid each period, the gross earnings of such employees and the number of employees enrolled in benefit plans. Direct Costs The Company's primary direct costs are: (i) the salaries and wages of worksite employees (gross earnings), the employer's portion of Social Security, Medicare premiums and federal unemployment taxes; (ii) employee benefit plan costs; (iii) workers' compensation costs; and (iv) state unemployment taxes. Salaries and wages of worksite employees are affected by the inflationary effects on wage levels and by differences in the local economies of the Company's markets. Changes in gross earnings have a proportionate impact on the Company's revenues. The Company can significantly impact its gross profit margin by actively managing the direct costs described in clauses (ii), (iii) and (iv) (hereinafter referred to as "controllable direct costs"). Employment-related taxes consist of the employer's portion of payroll taxes required under FICA, which includes Social Security and Medicare, and federal and state unemployment taxes. The federal tax rates are defined by the appropriate federal regulations. State unemployment rates are subject to claims histories and vary from state to state. Employee benefit plan costs consist of medical insurance premiums, payments of and reserves for claims subject to deductibles and the costs of dental care, vision care, disability, employee assistance and other similar benefit plans. The Company's health care benefit plans consist of self-insured plans and guaranteed cost programs. Liabilities for health care self-insured claims are recorded based on the Company's evaluation of the nature and severity of individual claims and past claims experience. Workers' compensation costs include premiums, administrative costs and claims-related expenses under the Company's workers' compensation program. Currently, the coverage is provided under a workers' compensation deductible program with an aggregate stop loss that limits the liability to the Company at a capped percentage of the standard premium or a fixed aggregate deductible, whichever is higher. Through June 30, 1997, certain of the Company's worksite employees were covered by large deductible workers' compensation policies and certain other worksite employees were covered by guaranteed cost or low deductible workers' compensation insurance policies. Costs related to these prior plans include estimates of ultimate claims amounts that are recorded as accrued workers' compensation claims. Changes in these estimates are reflected as a component of direct costs in the period of the change. State unemployment taxes are based on rates which vary from state to state. Generally they are subject to certain minimum rates, but the aggregate rates payable by an employer are affected by the employer's claims history. The Company controls unemployment claims by aggressively contesting unfounded claims and, when possible, quickly returning employees to work by reassigning them to other worksites. Selling, General and Administrative Expenses The Company's principal selling, general and administrative expenses are salaries, wages, benefits and other personnel expenses of administrative employees and sales associates, general and administrative expenses and sales and marketing expenses. Income Taxes The Company's provision for income taxes typically differs from the U.S. statutory rate of 35% due primarily to state income taxes and non-deductible goodwill amortization. Operating Income The Company's operating income is determined in part by its ability to manage controllable direct costs and its ability to incorporate such costs into the service fees charged to clients. The Company attempts to reflect changes in the controllable direct costs through adjustments in service fees charged to clients, subject to contractual arrangements. 25 26 RESULTS OF OPERATIONS The following table sets forth certain income statement and statistical data for each of the quarters and in total for the period from the inception of the Company, October 1, 1996, to June 30, 1997, the Company's fiscal year end. FOR THE PERIOD FROM (UNAUDITED, IN THOUSANDS, EXCEPT FOR STATISTICAL DATA): ---------------------------------------------------------- OCTOBER 1, OCTOBER 1, JANUARY 1, APRIL 1, 1996 TO TO DECEMBER TO MARCH TO JUNE JUNE 30, 31, 1996 31, 1997 30, 1997 1997 ------------ ----------- -------- ---------- OPERATING RESULTS: Revenues................................................ $ 10,894 $ 151,076 $232,223 $394,193 Direct costs: Salaries, wages and employment taxes of worksite employees........................................... 9,082 136,731 211,425 357,238 Health care, workers' compensation, state unemployment taxes and other..................................... 970 9,617 14,130 24,717 ------- -------- -------- -------- Gross profit...................................... 842 4,728 6,668 12,238 Selling, general and administrative expenses............ 661 3,215 4,397 8,273 Amortization of excess cost of net assets acquired...... 27 440 567 1,034 ------- -------- -------- -------- Income from operations............................ 154 1,073 1,704 2,931 Interest expense, net................................... (30) (262) (405) (697) ------- -------- -------- -------- Income before income taxes........................ 124 811 1,299 2,234 Income taxes............................................ 63 591 888 1,542 ------- -------- -------- -------- Net income........................................ $ 61 $ 220 $ 411 $ 692 ======= ======== ======== ======== STATISTICAL DATA: EBITDA (in thousands)(1)................................ $ 202 $ 1,608 $ 2,407 $ 4,217 Number of clients at period end......................... 128 1,531 1,742 1,742 Worksite employees at period end: Third parties......................................... 1,958 16,917 18,634 18,634 Related party......................................... -- 15,728 16,394 16,394 ------- -------- -------- -------- Total............................................. 1,958 32,645 35,028 35,028 ======= ======== ======== ======== Weighted average worksite employees paid during the period: Third parties......................................... 1,757 11,860 16,656 11,764 Related party......................................... -- 15,546 16,061 15,879 Weighted average.................................. 1,757 22,285 32,717 18,582 Quarterly and year-to-date gross profit per weighted average worksite employee (in whole $'s): Third parties......................................... $ 479 $ 210 $ 190 $ 665 Related party......................................... -- 216 218 650 Weighted average.................................. $ 479 $ 212 $ 204 $ 659 - --------------- (1) EBITDA is defined as earnings before interest, income taxes, depreciation and amortization. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to incur and service debt. However, EBITDA should not be considered in isolation or as a substitute for net income or cash flow data prepared in accordance with generally accepted accounting principles or as a measure of a company's profitability or liquidity. Also, the EBITDA definition used herein may not be comparable to similarly titled measures reported by other companies. 26 27 The following table sets forth, as a percentage of revenues, certain statements of operations data for each of the quarters for the period from the inception of the Company, October 1, 1996, to June 30, 1997, the Company's fiscal year end. FOR THE PERIOD FROM: (UNAUDITED, % OF REVENUES) ------------------------------------------------- OCTOBER 1, JANUARY 1, APRIL 1, OCTOBER 1, TO TO TO 1996 TO DECEMBER 31, MARCH 31, JUNE 30, JUNE 30, 1996 1997 1997 1997 ------------ ---------- -------- ---------- OPERATING RESULTS: Revenues............................................................ 100.0% 100.0% 100.0% 100.0% Direct costs: Salaries, wages and employment taxes of worksite employees........ 83.4 90.5 91.0 90.6 Health care, workers' compensation, state unemployment taxes and other........................................................... 8.9 6.4 6.1 6.3 ----- ----- ----- ----- Gross profit.................................................. 7.7 3.1 2.9 3.1 Selling, general and administrative expenses........................ 6.1 2.1 1.9 2.1 Amortization of excess cost of net assets acquired.................. 0.2 0.3 0.2 0.3 ----- ----- ----- ----- Income from operations........................................ 1.4 0.7 0.8 0.7 Interest expense, net............................................... (0.3) (0.2) (0.2) (0.2) ----- ----- ----- ----- Income before income taxes.................................... 1.1 0.5 0.6 0.5 Income taxes........................................................ 0.6 0.4 0.4 0.4 ----- ----- ----- ----- Net income.................................................... 0.5% 0.1% 0.2% 0.1% ===== ===== ===== ===== HISTORICAL RESULTS OF OPERATIONS FOR THE PERIOD FROM OCTOBER 1, 1996 TO JUNE 30, 1997 Revenues increased from quarter to quarter, as reflected in the table above, primarily from an increase in the number of clients and worksite employees. The number of clients increased from 128 to 1,531 to 1,742 over the respective quarterly periods and the weighted average number of worksite employees increased from 1,757 to 22,285 to 32,717 over the same periods, respectively. These increases were due primarily to: (i) the NovaCare Contract, with approximately 14,400 employees at the contract date; (ii) the acquisition of ESA, with 8,037 worksite employees at the acquisition date; (iii) the acquisition of TPI, with 6,029 worksite employees at the acquisition date; (iv) the acquisition of Prostaff, with 346 worksite employees at the acquisition date; and (v) 11.3% internal growth in the number of worksite employees since the acquisition or contract dates (27% annualized growth rate). Salaries, wages and employment taxes of worksite employees increased from $9,082 for the quarter ended December 31, 1996 to $136,731 for the quarter ended March 31, 1997 to $211,425 for the quarter ended June 30, 1997 as a result of businesses acquired in February 1997 and the NovaCare Contract. As a percentage of revenues, salaries, wages and employment taxes of worksite employees increased from 83.4% to 90.5% to 91.0% for the same periods, respectively. The primary reason for the increase as a percentage of revenues from the quarter ended December 31, 1996 to the quarter ended March 31, 1997 is the impact of the acquired businesses and the NovaCare Contract, both of which have a higher cost to revenue ratio than that of the predecessor company. Health care, workers' compensation, state unemployment taxes and other were $24,717 for the period from inception to June 30, 1997, increasing from $970 for the quarter ended December 31, 1996 to $9,617 for the quarter ended March 31, 1997 to $14,130 for the quarter ended June 30, 1997 as a result of the acquired businesses and the NovaCare Contract. As a percentage of revenues, health care, workers' compensation, state unemployment taxes and other decreased from 8.9% to 6.4% to 6.1% over the respective quarterly periods. The primary reasons for the decrease as a percentage of revenues are the cost structure of the acquired companies in successive quarters and the NovaCare Contract. Gross profit as a percentage of revenues declined from 7.7% during the quarter ended December 31, 1996 to 3.1% for the quarter ended March 31, 1997 to 2.9% for the quarter ended June 30, 1997. The primary reasons for the decrease in the gross profit percentage are the increased salaries, wages and employment taxes 27 28 per worksite employee, which increased revenues but not gross profit dollars, and the relative impact of the NovaCare Contract, which has a lower gross profit percentage (2.2%) due to a more highly compensated employee population. In addition, state unemployment tax gross profit is typically higher in the first quarter of a calendar year than in other quarters. Selling, general and administrative expenses increased from $661 for the quarter ended December 31, 1996 to $4,397 for the quarter ended June 30, 1997 as a result of businesses acquired and the NovaCare Contract. As a percentage of revenues, selling, general and administrative expenses were 6.1%, 2.1% and 1.9% for the three quarters of fiscal 1997 since commencement of operations. The decrease from the quarter ended December 31, 1996 to the quarter ended March 31, 1997 is primarily a result of the acquisitions and the NovaCare Contract, all of which have lower selling, general and administrative cost structures. Amortization of excess cost of net assets acquired increased from $27 for the quarter ended December 31, 1996 to $440 for the quarter ended March 31, 1997 to $567 for the quarter ended June 30, 1997 as a result of the acquired businesses during the period. Interest expense, net was $697 for the period from October 1, 1996 to June 30, 1997 resulting primarily from interest due to the Parent for amounts loaned to the Company to finance the acquisition of the four businesses acquired during the same period. Interest is charged to the Company at the Parent's borrowing rate (EuroDollar rate plus a range of 0.5% to 1.125%). The weighted average rate for the period from October 1, 1996 to June 30, 1997 was 6.6%. Income taxes as a percentage of pretax income were 69.0% for the period from October 1, 1996 to June 30, 1997. The principal reasons for the effective rate being higher than the statutory federal rate were nondeductible amortization of excess cost of net assets acquired and state income taxes. PRO FORMA RESULTS OF OPERATIONS FOR THE YEAR ENDED JUNE 30, 1997 COMPARED WITH THE YEAR ENDED JUNE 30, 1996 The following pro forma consolidated results of operations give effect to each of the acquisitions as well as the NovaCare Contract as if they occurred on July 1, 1995 or the inception of the business acquired if the inception had been subsequent to July 1, 1995. In addition, it assumes that the sale of NovaPro (see Note 13 of Notes to the Company's Consolidated Financial Statements contained elsewhere in this Prospectus) from the Parent to the Company occurred as of the inception of NovaPro on July 1, 1996. The following discussion should be read in conjunction with, and is qualified in its entirety by, the Company's Combined Pro Forma Financial Statements and the Notes thereto appearing elsewhere herein. 28 29 FISCAL YEAR ENDED JUNE 30, (UNAUDITED) ----------------------------------------- DOLLARS (IN THOUSANDS, EXCEPT FOR STATISTICAL DATA) % OF REVENUES --------------------- --------------- 1996 1997 1996 1997 -------- -------- ----- ----- OPERATING RESULTS: Revenues...................................................... $753,311 $878,097 100.0% 100.0% Direct costs: Salaries, wages and employment taxes of worksite employees................................................. 683,772 790,769 90.8 90.0 Health care, workers' compensation, state unemployment taxes and other................................................. 54,446 62,825 7.2 7.2 -------- -------- ----- ----- Gross profit........................................... 15,093 24,503 2.0 2.8 Selling, general and administrative expenses.................. 16,727 21,295 2.2 2.4 Amortization of excess cost of net assets acquired............ 2,161 2,268 0.3 0.3 -------- -------- ----- ----- (Loss) income from operations.......................... (3,795) 940 (0.5) 0.1 Interest expense, net......................................... (3,304) (1,627) (0.5) (0.2) -------- -------- ----- ----- (Loss) before income taxes............................. (7,099) (687) (1.0) (0.1) Income taxes.................................................. 97 734 0.0 0.1 -------- -------- ----- ----- Net (loss)............................................. $ (7,196) $ (1,421) (1.0%) (0.2%) ======== ======== ===== ===== STATISTICAL DATA: EBITDA (in thousands)......................................... $ (1,087) $ 3,927 Number of clients at period end............................... 1,395 1,742 Worksite employees at period end: Third parties............................................... 15,589 19,956 Related party............................................... 13,322 15,072 -------- -------- Total.................................................. 28,911 35,028 ======== ======== Weighted average worksite employees paid during the period: Third parties............................................... 13,949 18,123 Related party............................................... 12,429 14,428 Weighted average....................................... 26,611 32,551 Gross profit per weighted average worksite employee (in whole $'s): Third parties............................................... $ 704 $ 731 Related party............................................... 424 780 Weighted average....................................... $ 567 $ 753 Revenues, on a pro forma basis, were $753,311 for the year ended June 30, 1996 compared with $878,097 for the year ended June 30, 1997, representing an increase of $124,786, or 16.6%. The increase was due primarily to an increased number of PEO clients and worksite employees. Between June 30, 1996 and June 30, 1997, the number of clients increased 24.9% from 1,395 to 1,742. The average number of worksite employees increased 22.3% over the same period from 26,611 to 32,551. Salaries, wages and employment taxes of worksite employees increased 15.6% from $683,772 for fiscal 1996 to $790,769 for fiscal 1997. As a percentage of revenues, salaries, wages and employment taxes of worksite employees decreased from 90.8% for the fiscal year ended June 30, 1996 to 90.0% for the fiscal year ended June 30, 1997. Health care, workers' compensation, state unemployment taxes and other increased from $54,446 for the fiscal year ended June 30, 1996 to $62,825 for the fiscal year ended June 30, 1997. As a percentage of revenues, health care, workers' compensation, state unemployment taxes and other remained constant at 7.2% for each of the fiscal years ended June 30, 1996 and 1997. Gross profit as a percentage of revenues increased from 2.0% to 2.8% for the fiscal years ended June 30, 1996 and 1997, respectively. Without the NovaCare Contract, gross profit as a percentage of revenues would have been 4.3% and 4.5% for the same periods, respectively. Selling, general and administrative expenses increased 27.3% from $16,727 for the year ended June 30, 1996 to $21,295 for the year ended June 30, 1997 due to increased administrative staff in support of the Company's growth in worksite employees and number of clients. Selling, general and administrative expenses as a percentage of revenues were 2.4% and 2.2% in fiscal 1997 and 1996, respectively. Amortization of excess cost of net assets acquired remained approximately the same for the fiscal years ended June 30, 1996 and June 30, 1997. 29 30 Interest expense, net decreased 50.8% from $3,304 for fiscal 1996 compared with $1,627 for fiscal 1997. This decrease was primarily a result of decreased outstanding indebtedness from fiscal 1996 compared with fiscal 1997 and a reduction in the weighted average interest rate for the same periods, respectively. Income taxes were computed on a legal entity basis using the income subject to income tax, adjusting for the non-deductible portion of the amortization of excess costs of net assets acquired for both state and federal income taxes. PRO FORMA QUARTERLY FINANCIAL RESULTS -- FISCAL 1997 The following table presents certain unaudited pro forma results of operations data for the interim quarterly periods of the Company since inception. The Company believes that all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the results of operations in accordance with generally accepted accounting principles, have been made. The results of operations for any interim period are not necessarily indicative of the operating results for a full year or any future period. FOR THE PERIOD FROM: (UNAUDITED, IN THOUSANDS, EXCEPT FOR STATISTICAL DATA) ------------------------------------------------------------- OCTOBER 1, JULY 1, TO TO SEPTEMBER 30, DECEMBER 31, JANUARY 1, TO APRIL 1, TO 1996 1996 MARCH 31, 1997 JUNE 30, 1997 ------------- ------------ -------------- ------------- OPERATING RESULTS: Revenues........................................... $ 202,285 $219,367 $223,333 $ 233,112 Direct costs: Salaries, wages and employment taxes of worksite employees...................................... 183,678 199,071 200,951 207,069 Health care, workers' compensation, state unemployment taxes and other................... 13,813 14,875 15,507 18,630 -------- -------- -------- -------- Gross profit................................ 4,794 5,421 6,875 7,413 Selling, general and administrative expenses....... 4,956 6,088 5,184 5,067 Amortization of excess cost of net assets acquired......................................... 529 556 616 567 -------- -------- -------- -------- (Loss) income from operations............... (691) (1,223) 1,075 1,779 Interest expense, net.............................. (410) (403) (395) (419) -------- -------- -------- -------- (Loss) income before income taxes........... (1,101) (1,626) 680 1,360 Income taxes....................................... 42 38 94 560 -------- -------- -------- -------- Net (loss) income........................... $ (1,143) $ (1,664) $ 586 $ 800 ======== ======== ======== ======== STATISTICAL DATA: EBITDA (in thousands).............................. $ 53 $ (418) $ 1,810 $ 2,482 Number of clients at period end.................... 1,437 1,499 1,531 1,742 Worksite employees at period end: Third parties.................................... 17,080 17,750 18,088 19,956 Related party.................................... 13,340 14,049 14,557 15,072 -------- -------- -------- -------- Total....................................... 30,420 31,799 32,645 35,028 ======== ======== ======== ======== Weighted average worksite employees paid during the period: Third parties.................................... 16,685 17,415 17,919 19,022 Related party.................................... 13,562 13,695 14,303 14,815 Weighted average............................ 30,247 31,110 32,222 33,837 Quarterly gross profit per weighted average worksite employee (in whole $'s): Third parties.................................... $ 159 $ 164 $ 212 $ 208 Related party.................................... 158 187 216 234 Weighted average............................ $ 159 $ 174 $ 213 $ 219 30 31 LIQUIDITY AND CAPITAL RESOURCES The Company periodically evaluates its liquidity requirements, capital needs and availability of capital resources in view of, among other things, expansion plans, accrued workers' compensation insurance claims liabilities, debt service requirements and other operating cash needs. As a result of this process, the Company has sought and may seek to raise additional capital or take other steps to increase or manage its liquidity and capital resources. Historically, these funds have been raised from the Parent. The Company believes that the proceeds from the Offering and cash flow from operations will be adequate to meet its liquidity requirements through at least fiscal 1998. As an additional liquidity source, the Company is presently negotiating a revolving credit facility with a syndicate of banks. The Company will rely on these sources, as well as other public and private debt and equity financing, to meet its long-term liquidity needs. The Company had $1.8 million in cash and cash equivalents as of June 30, 1997. As of the same date, the Company had negative working capital of $48.8 million, primarily as a result of $28.4 million due to the Parent for amounts borrowed under the line of credit due at the earlier of an initial public offering or November 1999 (See Note 2 of Notes to the Company's Consolidated Financial Statements) and $18.9 million deferred purchase price obligations incurred in connection with the Company's acquisitions, of which $17.5 million is due upon the earlier of an initial public offering or December 31, 1997. The Company's primary short-term liquidity requirements relate to the payment of accrued payroll and payroll taxes of its internal and worksite employees, accounts payable and the payment of accrued workers' compensation expense and health benefit plan premiums. The Company's cash flows used in operating activities for the period from October 1, 1996 (inception) to June 30, 1997 were $0.1 million resulting primarily from: (i) a $4.1 million increase in the accrual for workers' compensation and health claims; (ii) a $1.3 million depreciation and amortization non-cash charge; and (iii) a $1.7 million increase in accrued interest-related party and income taxes payable, offset by a $7.0 million net cash use for increases in accounts receivable and accrued salaries, wages and payroll taxes. Accounts receivable and accrued salaries, wages and payroll taxes are subject to fluctuations depending on the proximity of the financial reporting cycle to that of the payroll cycle. Cash expended for investing activities during the same period was $25.0 million, primarily resulting from payments for businesses acquired during the period. The Company also expended $1.1 million to repurchase shares of the Company's common stock. These investing activities were financed primarily through a loan from the Parent (see Note 2 of Notes to the Company's Consolidated Financial Statements). Although the Company currently has no significant capital commitments, the Company anticipates investing significant cash to acquire PEOs and other employee services businesses in strategic markets during fiscal 1998. Immediately subsequent to the consummation of the Offering, the Company intends to enter into a $25.0 million three-year revolving credit agreement with a group of financial institutions led by PNC Bank, National Association. The credit agreement, which has been fully negotiated, will provide for interest at a variable rate, depending on certain financial ratios, equal to (a) the EuroDollar rate plus a range of 1.375% to 2.50% or (b) the lead bank's prime rate plus a range of .125% to 1.25%. Loans made under the credit agreement will be secured by a pledge of all of (i) the Company's interest in the common stock of its subsidiaries, (ii) the assets of the Company and its subsidiaries and (iii) the Parent's interest in the Common Stock. The closing with respect to the credit agreement will be subject to certain conditions, including (i) the ownership by the Parent following the Offering of at least 65% of all of the issued and outstanding equity interests of the Company and (ii) the repayment by the Company of all amounts due to the Parent under the existing line of credit (which amount is $28.4 million as of the date of this Prospectus). In addition, (x) the closing by financial institutions which have committed to lend $15 million of the facility is contingent on the receipt by the Company of net proceeds of at least $40 million in the Offering and (y) the closing by financial institutions which have committed to lend the remaining $10 million of the facility is contingent on the receipt by the Company of net proceeds of at least $45 million in the Offering. There can be no assurance that the conditions precedent to the credit agreement will be satisfied. 31 32 INFLATION A significant portion of the Company's operating expenses and revenues is subject to inflationary increases, particularly worksite employees' salary increases. The Company believes the effects of inflation have not had a significant impact on its results of operations or its financial condition. RECENTLY ISSUED ACCOUNTING STANDARDS In June 1996, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125") as amended by the December 1996 issuance of Statement of Financial Accounting Standards No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125" ("SFAS 127"). SFAS 125, as amended, provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The Company does not believe the adoption of SFAS 125, as amended, will have a material effect on the Company's financial position or results of operations. In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128") which the Company is required to adopt no later than the second quarter of fiscal year 1998. SFAS 128 establishes accounting standards for computing and presenting earnings per share by replacing the presentations of weighted average shares outstanding, inclusive of common stock equivalents with a dual presentation of basic earnings per share which excludes dilution ("earnings per share") and diluted earnings per share ("earnings per share -- assuming dilution") which includes the dilutive effect of all potentially exercisable or convertible stock. SFAS 128 requires restatement once adopted of all prior period earnings per share data. RECENT DEVELOPMENTS Set forth below are summary operating data of the Company pertaining to the quarters ended June 30, 1997 and September 30, 1997. The data for the quarter ended September 30, 1997 are preliminary and are not necessarily indicative of what the financial results will be for the fiscal year ending June 30, 1998. QUARTER ENDED ------------------------------------ JUNE 30, 1997 SEPTEMBER 30, 1997 ------------- ------------------ (IN THOUSANDS) Revenues............................................... $ 232,223 $266,757 Gross profit........................................... 6,668 8,328 Income from operations................................. 1,704 2,126 Net income............................................. 411 937 Historical net income (loss) per share(1).............. $ (.01) $ -- Pro forma net income per share(1)...................... .02 .05 - --------------- (1) The computation is consistent with the computation described in Note 1 of Notes to the Company's Consolidated Financial Statements. Net revenues for the quarter ended September 30, 1997 of approximately $267 million represented a 15 percent increase from approximately $232 million for the previous three months ended June 30, 1997. The increase was primarily due to an increase in the number of worksite employees, an increase in revenue per worksite employee and the acquisition of NovaPro, a temporary staffing business, from the Parent, effective July 1, 1997 (see Note 13 of Notes to the Company's Consolidated Financial Statements). Gross profit for the first quarter of fiscal 1998 was approximately $8.3 million compared with approximately $6.7 million for the previous three months. The gross profit margin for the first quarter was approximately three percent of total net revenues, unchanged from the three months ended June 30, 1997. At September 30, 1997, the Company had 1,768 clients with approximately 38,000 worksite employees under contract located across 45 states. 32 33 BUSINESS GENERAL The Company is one of the largest (measured by revenues and number of worksite employees) PEOs in the United States. The Company is an employee services company which provides small to medium-sized businesses with comprehensive, fully integrated outsourcing solutions to human resource issues, including payroll management, workers' compensation risk management, benefits administration, unemployment services and human resource consulting services. The Company believes its services enable small and medium-sized businesses to cost-effectively manage and enhance the employment relationship by: (i) controlling the risks and costs associated with workers' compensation, workplace safety and employee-related litigation; (ii) providing employees with high quality health care coverage and related benefits; (iii) managing the increasingly complex legal and regulatory environment affecting employment; and (iv) achieving scale advantages typically available to larger organizations. As of June 30, 1997, the Company served 1,742 clients with 35,028 employees at over 3,000 worksites in 45 states, primarily in 10 different industries. The Company was established by its Parent in September 1996 and began operation in October 1996 with the acquisition of Resource One, a PEO. In February 1997, the Company acquired three additional PEOs -- ESA, TPI and Prostaff. On July 1, 1997, the Company acquired NovaPro, the rehabilitation temporary staffing business of its Parent. The Company is obligated to make certain additional contingent and/or non-contingent payments in connection with each PEO acquisition. Total non-contingent and contingent obligations in connection with acquired companies, if all contingent obligation targets are met but not exceeded, would amount to approximately $22.2 million in cash and 466,063 shares of Common Stock. See "Risk Factors -- Obligations in Connection with Acquisitions." The Company also entered into employment agreements with certain of the sellers of acquired businesses. See "Management -- Executive Compensation -- Employment and Other Arrangements." PROFESSIONAL EMPLOYER ORGANIZATION INDUSTRY According to NAPEO, the PEO industry has approximately $18 billion in annual revenues with an historical growth rate over the last five years of approximately 30% per year. The Company has had a relatively short operating history and has only managed the acquired companies for a short period of time. Accordingly, the Company does not have a meaningful historical growth rate and there can be no assurance that the Company's growth rate will equal or exceed that of the PEO industry. According to the U.S. Small Business Administration, there are nearly six million businesses in the United States with under 100 employees, employing over 52 million persons and with $1.1 trillion in aggregate annual payroll. NAPEO estimates that the PEO industry has less than three million worksite employees. The Company believes, therefore, approximately 49 million of these employees are currently unserved by the PEO industry. The PEO industry is highly fragmented. NAPEO data suggest that there are at least 2,400 PEOs currently in operation and that the ten largest PEOs account for less than 10% of existing revenues in the industry. The Company believes that significant consolidation opportunities exist within the PEO industry due to increasing industry regulatory complexity and capital requirements associated with developing larger service delivery infrastructures, more diversified services and more sophisticated management information systems. Demand for Services. The PEO industry evolved in the early 1980's in response to increasing employment and benefit costs, and the complexities of the legal and regulatory environment for the rapidly expanding small to medium-sized business sector. The Company believes demand for PEO services will continue to increase as (i) employment-related governmental regulation grows more complex, (ii) growth continues within the small to medium-sized business community, (iii) the need to provide health and retirement benefits in a cost-effective convenient manner increases and (iv) the business and regulatory communities accept and recognize the PEO industry. While various service providers, such as payroll processing firms, benefits and safety consultants and temporary services firms, are available to assist these 33 34 businesses with specific tasks, such organizations do not typically provide the more comprehensive range of services generally offered by PEOs. PEOs enter into agreements with numerous small to medium-sized employers, and can, therefore, achieve economies of scale as professional employers and offer benefits packages and human resource services at a level typically available only to larger corporations which have greater resources to devote to human resources management. The Company believes PEO services will continue to experience growing demand because of the growing trend among small to medium-sized employers to: (i) outsource non-core competencies; (ii) seek to reduce employee benefit costs; (iii) avoid employee-related risks and regulatory complexities; and (iv) attract better employees and retain them through improved benefit plans. Effectiveness of Services. According to estimates by the U.S. Small Business Administration, the management of an average small to medium-sized business devotes from 7% to 25% of its time to employee-related matters, leaving management with less time to focus on core competencies. A National Federation of Independent Business survey of small businesses in 1996 showed that six of the top 13 major problem areas for small business are issues that can be addressed by PEOs. These include (with their rank in importance according to the survey) cost of health insurance (1), workers' compensation costs (3), federal paperwork (7), frequent changes in federal tax laws (9), finding qualified employees (11) and state/local paperwork (13). Work-related injuries cost employers over $53 billion in medical expenses and employee productivity each year according to industry estimates. Employees are typically attracted to small and medium-sized businesses that provide employees with human resources services characteristic of large employers. An industry analyst's study indicated that 40% of the clients that outsourced services with a PEO were able to upgrade their employee benefits offerings and one-fourth of those clients were able to offer health care and other benefits for the first time. SERVICES The Company believes that other PEOs typically take a transaction processing approach to their services and do not emphasize other benefits such as the improved workforce performance that can be associated with satisfied employees. The Company believes that small to medium-sized businesses will increase their emphasis on cost-effectiveness, service excellence and the breadth of services provided in selecting PEO providers. The Company contractually assumes certain administrative and financial employer responsibilities with respect to worksite employees in a "co-employment" relationship. The Company believes its clients benefit from the Company's services by: (i) improving profitability through lowering or controlling costs associated with workers' compensation, health insurance, other benefit coverage and regulatory compliance; (ii) improving productivity through reducing the time and effort expended by business owners and executives to deal with the complexities of employment management, enabling them to focus on their business core competencies and growth; and (iii) improving employee satisfaction and performance. The Company helps employers improve job satisfaction and performance of their employees by: (i) providing improved health care and related benefits; (ii) delivering training programs; and (iii) delivering dependable payroll and benefits administration. As co-employer of worksite employees, the Company assumes responsibility for and manages the risks associated with: (i) worksite employee payroll; (ii) employee-related benefits, such as workers' compensation and health care insurance coverage; and (iii) compliance with certain employment-related governmental regulations that can be effectively managed away from the client's business. See "Risk Factors." The client retains responsibility for supervision and direction of the worksite employees' services in its business and generally remains responsible for compliance with other employment-related governmental regulations that are more closely related to worksite employee supervision. The service fee charged by the Company to its clients covers the cost of certain employment-related taxes, workers' compensation insurance coverage, administrative and field services, wages of worksite employees and the client's portion of health and retirement benefit plan costs. The Company also provides other value-added services such as rehabilitation temporary staffing, training and human resource consulting. 34 35 STRATEGY The Company's objective is to be the brand, service and performance leader in the PEO industry by creating a more profitable, more productive and more satisfying relationship between employers and employees and enabling its clients to focus on their business core competencies and growth. Supporting this purpose are the Company's beliefs, respect for the individual, service to the client, pursuit of excellence and commitment to personal integrity. For this reason, the Company seeks to create a values-based culture. Relying on these values, the Company will implement a strategy focusing on growth and operational excellence. It is the Company's belief that a strong commitment to these values and a philosophy oriented toward "caring for and about people," will enable the Company to provide a level of service that will build the businesses of its clients and itself and enhance the careers of its clients' employees. GROWTH STRATEGY The Company intends to grow through: (i) increasing investment in sales and marketing; (ii) focusing on geographic expansion; (iii) targeting high potential industries; (iv) acquiring PEOs and other employee service providers and entering into strategic alliances; and (v) leveraging the growth in the Parent's employee base. Of these five elements, the Company believes that leveraging the Parent's growth, increasing investment in sales and marketing and targeting high potential industries will be the most important in fiscal year 1998, with leveraging the Parent's growth expected to be the most important contributor to the Company's near-term growth. Beyond fiscal year 1998, expansion into new geographic markets and acquisitions are expected to become significant drivers of growth. Increasing Investment in Sales and Marketing. The Company's management is experienced in building businesses utilizing professional sales forces and focused marketing strategies. The Company believes that it has substantially improved the productivity of the Company's sales force from that existing at the time the Company acquired its constituent organizations by replacing 25% of the existing salespersons with strong professional sales people and sales management from both inside and outside the PEO industry. A significant part of the Company's marketing strategy is the development of a brand identity. A recognized brand name is a valuable marketing tool. By utilizing the nationally advertised brand name of the Parent, the Company believes it will achieve a strong brand identity at lower cost. The Company believes that its marketing efforts will benefit from its brand strategy. The Company's brand promise is to create a more satisfying and more productive relationship between its worksite employees and clients by "caring for and about people." By cost effectively and consistently delivering against this service commitment, the Company believes it will attain a brand name reputation for service excellence among existing and potential clients. In support of its brand strategy, the Company intends to spend approximately $2.0 million more in fiscal year 1998 on sales and marketing than it spent in fiscal 1997. Primary investment areas are expected to be additional sales management, telemarketing, direct mail, collateral material development and printing, computers and training. Most of this investment commenced early in fiscal year 1998 and the Company expects that it will continue throughout the year. In addition, as each new geographic market is entered, the Company intends to add a market-specific sales team. Focusing on Geographic Expansion. The Company has identified key attractive geographic target markets and has established a plan for entering those markets in a disciplined manner. The target markets are primarily those markets in which the relationship with the Parent provides existing employee and potential new client base density. The Company believes that the Parent's clients and other extensive business-to-business relationships represent significant opportunities to grow in these target markets. By concentrating on markets where the Parent has achieved density, the Company will seek to have scale immediately because it already co-employs the Parent's employees. The Company believes its market development model will enable it to penetrate new markets quickly. This market development model consists of a highly structured sales management control system and efficient selling process. The model includes market research to identify potential client businesses and a direct mail campaign staged over a 10-week period to reach those businesses. In the Company's first target market, approximately 12,000 candidates have been identified and the direct 35 36 mail program has been commenced. In certain cases, the Company may rely on platform acquisitions to achieve scale in a market. In either case, the Company's strategy is to leverage the Parent's customer referral sources and provider relationships. Entry priority for specific markets is determined by the level of PEO competition, the state regulatory environment and access to infrastructure to support operations. Once a market is selected, the Company's Director of Market Expansion will execute an entry plan which includes defining benefits plans and service offerings, recruiting a manager and sales team, site selection, training and orientation and launching a specific marketing plan to begin the selling process. The Company has implemented this process in Atlanta and will use that experience to refine the model before entering Philadelphia later this fiscal year. This market model is expected to provide the basis for future growth. Targeting High Potential Industries. Targeted industries will vary from market to market depending on economic characteristics and business demographics of each geographic location. The Company intends to focus on industries with high gross profit per worksite employee and significant workers' compensation profit opportunities. High potential industries are those, such as health care and construction, that the Company believes could benefit most from the Company's risk management expertise (e.g., traditional high workers' compensation classifications) and the Company's offering of an extensive benefits package (e.g., industries facing a shortage of workers). Other characteristics of high potential industries would include rapid growth or change. The sales force is expected to utilize the key industry strategy and become expert in one or more select industries in the markets in which they are operating. The relationship with the Parent brings a large potential client base of small to medium-sized long-term care providers and other health care customers who are currently obtaining outsourced contract rehabilitation from the Parent or who are referring patients to the Parent. Because of the compatibility of the Company's information systems related to payroll processing, the Company believes that the most attractive candidates in this group in the near term are assisted living facilities and continuing care retirement communities. After creating the appropriate systems interfaces, the Company will seek to expand its efforts to the skilled nursing facility market. The Company regards those businesses as likely candidates for the Company's sales efforts because of their existing relationships with the Parent. Acquiring PEOs and Other Employee Service Providers and Entering into Strategic Alliances. The Company believes that the opportunities for PEO consolidation are substantial with at least 2,400 PEOs (according to an estimate by NAPEO) operating in a highly fragmented industry. The Company believes that industry consolidation will be driven by increasing industry and regulatory complexity, increasing capital requirements and the significant economies of scale available to PEOs with a concentration of clients and employees in target markets. The Company intends to make opportunistic acquisitions where appropriate to achieve greater density in targeted geographic markets. The Parent is highly experienced in acquiring service businesses. It has created and integrated four different nationwide health care service businesses through acquisitions in the last 12 years. The Company believes it will be able to benefit from the Parent's experience as a consolidator and integrator in support of the Company's growth objective for acquisitions. Pursuant to the Company's management services agreement with the Parent, the Parent has agreed to make available to the Company financial, legal, business development and information technology resources. Under the agreement, these resources are provided at the Parent's cost when reasonably required, consistent with the Company's and the Parent's business objectives. The Company is creating strategic alliances with service providers to small and medium-sized businesses. For example, the Florida Home Builders Association, an organization that has 17,000 members with 450,000 employees, has endorsed the Company as the PEO of choice for its members. With the trend toward outsourcing non-core competencies, small and medium-sized businesses typically have service relationships with accountants, attorneys, banks, trade associations and other business advisors. Alliances with these service providers offer a cross-selling opportunity for the Company's employee services. The Company intends to develop such referral opportunities as an extension of its sales and marketing capability. 36 37 Leveraging the Parent's Growth. The Company believes that the Parent is the PEO industry's largest client. During fiscal year 1997, the Parent's worksite employee population grew by 23% (16% excluding NovaPro). Growth in the Parent's worksite employee base directly increases the Company's worksite employee population and revenue without the need for additional sales and marketing expenditures or client start-up costs. OPERATING STRATEGY The Company has developed an operating strategy designed to control costs while supporting growth. The operating strategy encompasses leveraging the Parent's existing infrastructure and implementing a sophisticated business model. Leveraging the Parent's Existing Infrastructure. As a national provider of medical rehabilitation services, the Parent has developed the core competencies for: (i) managing a dispersed workforce in third-party worksites; (ii) establishing and maintaining national information systems networks connecting clients, worksite employees and service providers; (iii) developing and implementing workplace safety and injury prevention programs; and (iv) managing regulatory change. This infrastructure is available to the Company pursuant to its management services agreement with the Parent. The agreement permits the Company to purchase access to the infrastructure at the Parent's out-of-pocket cost excluding depreciation and amortization. The relationship with the Parent also brings: (i) leverage to negotiate advantageous health care, workers' compensation and other benefit program costs given the Parent's status as a large employer in many geographic markets in which the Company operates; and (ii) the availability of health care services for Company employees from the Parent and other health care providers in the Parent's integrated delivery systems in the Company's target markets. See "Relationship with the Parent" below and "Risk Factors -- Dependence on the Parent; Potential Conflicts with the Parent." The Company intends to leverage the Parent's experience and business synergies to reduce costs by utilizing the Parent's integrated delivery system network of health care providers. Integrated delivery systems comprise health care providers that are networked as referral sources to facilitate integrated patient care and to ease administration for payors and providers. The Parent has established, and continues to develop, networks of rehabilitation providers, principally outpatient and occupational health providers, in targeted geographic markets. These networks can be used to provide rehabilitation to the Company's injured worksite employees, allowing the Company to benefit from the skill and expertise of the Parent in rehabilitating and returning to work injured employees. As a health care provider, the Parent has been an industry leader in responding to regulatory and legislative change in a highly regulated market. The Parent's experience in the regulatory environment will be a valuable resource to the Company as states and the federal government seek to implement new approaches to regulating the PEO industry. The Parent's regulatory compliance experience is available to the Company under the management services agreement between the Company and the Parent. Implementing a Sophisticated Business Model. The Company's business model includes a portfolio management system and an efficient operating model. Portfolio Management System. The Company has implemented a portfolio management system designed to control and improve its performance in the selection of new business, meeting its brand promise with respect to existing customers and analyzing lapsed business. The new business criteria orient marketing to potential clients in target industries with high gross profit per worksite employee and acceptable underwriting risk. The criteria include number of worksite employees, credit rating, three-year workers' compensation loss ratios, shock losses, workers' compensation insurance premium modification rate, state unemployment experience, expected administrative fee and predicted gross profit per employee. The current business portfolio component of the control system enables management to monitor new client start-ups, client specific financial and risk performance and employee and employer satisfaction. By focusing management attention on key business variables, the system permits day-to-day management to direct actions consistent with the Company's strategy and business plan. The business variables measured are 37 38 the same as those used to assess new business, and additionally include accounts receivable, health claims filed, at risk clients, employer and employee satisfaction. The Company believes that attention to these variables on a weekly basis increases gross profit per worksite employee. Lapsed business is analyzed by reason to facilitate identification of service delivery system issues and to improve future client retention. Operating Model. The Company has established an operating model that delivers services from two different locations. The Company's local service center places an emphasis on servicing the customer through local front-line activities. The local service center conducts enrollment and orientation of new employees and clients and worksite safety evaluation and monitoring. Sales activity and customer service will also be performed locally. Local activities relative to risk management promote safety, early intervention of workers' compensation reported claims and early return to work. Centralized activity includes nationally directed telemarketing, standard development of marketing materials, a national accounts sales force, and regional payroll processing, benefits administration and claims management. The major elements of finance, procurement and compliance will also be centralized. Staffing of the local centers and the centralized regional centers is based on a metric identifying the number of worksite employees or other applicable customers who can be adequately serviced by each kind of service representative, including customer care representatives, payroll technicians, benefits specialists, human resources consultants, workers' compensation specialists, safety engineers and underwriters. This staffing metric is designed to provide efficient service at carefully controlled cost. The Company believes it can achieve its strategic objectives by adopting the local services model in each of the strategic markets it enters. This model can be replicated in each key market. It also enables responsiveness to the client while maximizing administrative support productivity. The operating model provides the Company with transaction scale advantages while maintaining customer intimacy through localized service centers that are replicable. EMPLOYEE AND CLIENT SERVICES In order to implement its strategy to create a more satisfying and more productive relationship between employers and employees, the Company provides six primary categories of employee services: (i) workers' compensation cost containment and safety management; (ii) unemployment insurance cost containment; (iii) employee benefits administration; (iv) human resources and compliance management; (v) payroll management; and (vi) value-added services. By engaging the Company to provide these services, clients can focus on their core competencies. These services are provided under the Company's PEO services agreement which typically has an initial one year term; thereafter, the agreement is renewed periodically. The agreement is subject to termination by the Company or the client upon 30 days' prior written notice. Service revenues, billed to clients along with each periodic payroll, are based on a pricing model that takes into account the gross pay of each employee and a mark-up which includes the estimated costs of employment-related taxes, providing insurance coverage and benefit plans, performing human resources, payroll, benefits and compliance management and other services and an administration fee. The specific mark-up varies by client based principally on the workers' compensation classification of the worksite employees, their eligibility for health care benefits and the size of the client. Accordingly, the Company's average mark-up percentage will fluctuate based on client mix, which cannot be predicted with any degree of certainty. Clients are required to pay the Company its total fee concurrent with the applicable payroll date and receipt of funds is verified prior to the release of payroll. Although the Company is ultimately liable as employer to pay employees for work previously performed, it retains the right to terminate the PEO services agreement as well as the employees upon non-payment by a client. This right and the periodic nature of payroll, combined with client credit verifications and the Company's client selection process, are used to control this exposure. Bad debt expense was $26,000 for the period from October 1, 1996 to June 30, 1997. Workers' Compensation Cost Containment and Safety Management. Workers' compensation is a state-mandated, comprehensive insurance program that requires employers to fund medical expenses, lost wages 38 39 and other costs that result from work-related injuries and illnesses, regardless of fault and without any co-payment by the employees. See "Regulation" below. Pursuant to the Company's PEO services agreement, the Company assumes the obligations of its clients to pay workers' compensation claims. See "Risk Factors -- Adequacy of Reserves for Workers' Compensation Claims." The Company seeks to control its workers' compensation costs through comprehensive risk evaluation of prospective clients, the prevention of workplace injuries, timely intervention with employee injuries, aggressive management of the medical costs related to such injuries and the prompt return of employees to work. The Company seeks to prevent workplace injuries by implementing a wide variety of training and safety programs. The Company's efforts to return employees to work quickly involve both rehabilitation services and the placement of employees in transitional, light-duty positions until they are able to resume their former positions. Unemployment Insurance Cost Containment. Pursuant to the Company's PEO services agreement, the Company also assumes the obligation of its clients to pay unemployment insurance costs. The Company manages its unemployment insurance costs by establishing employee termination procedures, timely responding to unemployment claims, attending unemployment hearings and attempting to reassign employees to other worksites when a reduction in force occurs at any one worksite location. Employee Benefits Administration. Pursuant to the Company's PEO services agreement, the Company is required to offer employee benefits to the worksite employees. The Company offers worksite employees a benefits package which includes several health care options, such as point-of-service ("POS"), HMOs and indemnity plans. Supplemental benefit programs offer dental care, prescription drugs, and life and disability insurance options. The Company also offers 401(k) retirement savings and cafeteria style plans to its eligible employees. The Company delivers participant benefits to worksite employees and monitors and reviews claims for loss control purposes. The Company believes that its ability to provide and administer a wide variety of employee benefits on behalf of its clients tends to mitigate the competitive disadvantage small and medium-sized businesses normally face in the areas of employee benefit cost control and employee recruiting and retention. Human Resources and Compliance Management. Pursuant to the Company's PEO services agreement, the Company provides comprehensive human resources services to its clients. These services reduce the employment-related administrative burdens faced by its clients, and provide worksite employees with a wide array of benefits typically offered by large employers. The Company develops and administers personnel policies and procedures for each of its clients, relating to, among other things, recruiting, retention programs, performance management, discipline and terminations. The Company also provides orientation, training and development, counseling and substance abuse awareness for worksite employees. By contract, the Company generally assumes responsibility for complying with many employment-related regulatory requirements. In addition, the Company assists its clients in understanding and complying with other employment-related requirements for which the Company does not assume responsibility. Laws and regulations applicable to employers include state and federal tax laws, state workers' compensation laws, state unemployment laws, occupational safety laws, immigration laws, and discrimination, sexual harassment and other civil rights laws. Payroll Management and Reporting. Pursuant to the PEO services agreement, the Company is responsible for payroll processing, check preparation, distribution and recordkeeping, payroll tax deposits, payroll tax reporting, employee file maintenance, unemployment claims and monitoring and responding to changing regulatory requirements. The Company indemnifies the client against the Company's failure to comply with regulatory requirements. Payroll reports are prepared for clients for financial and other recordkeeping purposes. The providing of these services by the Company reduces the client's employment liabilities and allow clients to focus on their core business. Other Value-Added Services. Since the acquisition of NovaPro on July 1, 1997, the Company has offered rehabilitation temporary staffing in the long-term care industry. The rehabilitation temporary staffing service currently can draw on a pool of over 6,000 rehabilitation clinicians to provide staff to skilled nursing facility clients, at which over 1,300 worksite employees were performing services as of July 1, 1997. This business is supported by technology which provides detailed recruitment and sales productivity information for management purposes. It also generates billing and utilization reports for clients. 39 40 The Company also plans to offer additional value-added services to clients and worksite employees. Such services may include such things as employee recognition programs, travel discount arrangements, vision care, credit union membership, smart cards, warehouse club memberships and various financial services. Some of these services may generate fee income or commissions for the Company. The Company's standard PEO services agreement also establishes the division of responsibilities between the Company and the client as co-employers. The division of responsibilities is generally as follows: THE COMPANY CLIENT JOINT - -------------------------------------------- ------------------------------ ------------------------------ - - Payment of payroll - Supervision of job-specific - Implementation of policies activities of worksite and practices relating to the - - Tax reporting and payment (state and employees, including employer-employee federal withholding, Federal Insurance designation of job relationship Contributions Act ("FICA"), Federal descriptions and duties and Unemployment Tax Act ("FUTA"), and state responsibilities - Selection of fringe unemployment) benefits, including employee - Assignment to, and ownership leave policies (other than - - Workers' compensation compliance, of, all intellectual as controlled by the Family procurement, management, payment and property rights and Medical Leave Act of reporting 1993 or other laws) - Product liability - - Employee benefit procurement, - Compliance with Code administration and payment - Professional liability or provisions regarding malpractice benefits discrimination - - Compliance with Immigration Reform and Control Act and Consumer Credit Protection - Compliance with OSHA - Hiring, terminating and Act, as well as monitoring changes in regulations, state and local disciplining worksite other government regulations governing the government contracting employees employer-employee relationship and provisions, professional updating the client when necessary licensing requirements and - Compliance with Title VII of fidelity bonding the Civil Rights Act of requirements 1964, the Age Discrimination in Employment Act, the - Negligent or tortious Americans with Disabilities conduct of worksite employees Act, the Fair Labor acting under the direction Standards Act and similar and control of the client state or local legislation - Determination of compensation of worksite employees RELATIONSHIP WITH THE PARENT The Parent is the founder of the Company and will beneficially own approximately 75.7% of the Common Stock after the Offering. The Parent established the Company and entered into the NovaCare Contract primarily for four reasons. The Company is intended to enable the Parent to leverage its core competencies and investments in human resource management, information systems, relationship selling, workers' compensation risk management, outsourcing and management of a dispersed workforce. By leveraging the investments already made in its core competencies, the Parent expects to increase the return to its shareholders from those investments. The Parent believes its shareholders will benefit from its relationship with the Company through appreciation in the value of the Parent's investment in the Company. For that reason, the Parent has issued a line of credit to the Company and provided services to the Company at the Parent's cost. See "Certain Related Party Transactions." The Parent's business, other than that of the Company, is medical rehabilitation services. The Parent provides (i) rehabilitation therapy and rehabilitation program consulting and management services on a contract basis to health care institutions, primarily long-term care facilities, and (ii) outpatient, orthotic and prosthetic and occupational health rehabilitation services through a national network of patient care centers. In its purchase of health care and workers' compensation insurance coverage for its worksite employees, the Company represents a substantial customer of health care payors who, in turn, are major customers for the Parent's rehabilitation services. Accordingly, the Parent believes that its relationship with the Company will make it more likely for these health care payors to utilize the Parent's rehabilitation services. 40 41 In addition, the Company allows the Parent to offer a broader array of services to its existing customers. Through the Company, the Parent can address all of its customers' human resource needs, rather than limiting its services to rehabilitation staffing only. Providing a broader array of services can strengthen the Parent's relationship with its customers. Finally, the Company is a customer for the Parent's rehabilitation services. As the Company grows, it will add non-Parent clients and employees who may become new customers for the Parent's workers' compensation risk management and rehabilitation services. As part of its strategy to leverage its employee services expertise, in February 1997, the Parent transferred to the Company 60 of its employees who were performing most of the Parent's employee services functions, including payroll, benefits administration and information systems, as well as the Parent's employee services center. In addition, in February 1997, the Parent entered into the NovaCare Contract, a five-year evergreen contract to provide the Parent with the services previously carried out for the Parent by the transferred staff. As part of the NovaCare Contract, as of June 30, 1997, 15,072 of the Parent's employees became co-employees of the Company. For those employees, the Company provides typical PEO services, including payroll and benefits administration, worksite safety evaluation, employment-related risk management and compensation and benefits consultation. The Parent pays the Company a fee for its services currently equal to approximately 117% of the gross earnings of the employees covered by the NovaCare Contract. The Parent may not terminate the NovaCare Contract except in the event of: (i) the breach of any of the Company's agreements, duties, or performance standards under the NovaCare Contract; (ii) the making of false or misleading representations, warranties, or statements of material fact in documents submitted by or on behalf of the Company to the Parent; or (iii) the insolvency, bankruptcy, or receivership of the Company. On a pro forma basis, the Company would have recorded approximately $582 million of aggregate fee revenue for the 12 months ended June 30, 1997 under the NovaCare Contract. By benefiting from the scale at which the Company is now operating, the Company seeks to improve the efficiency of delivery of employee services to the Parent and reduce the cost of those services. In recognition of these cost-saving opportunities, the Company has agreed to reduce its fee under the NovaCare Contract by 0.1% each year during the first five years of the term of the contract. See "Certain Related Party Transactions." INFORMATION TECHNOLOGY The Company intends to leverage the Parent's nationwide information systems network to connect its local customer service centers, regional processing centers, worksite employees, clients and service providers. Through this relationship with the Parent, the Company believes it will benefit from the technological advances the Parent deploys in its business to provide value, help reduce costs and provide operating efficiencies. These technologies include, but are not limited to, a combined Internet/Intranet electronic mail system, client server based expertise which provides distributed processing and rapid implementation of business changes, Internet/Intranet access, telecopier to data technology (which eliminates the need for manual data entry), and a state-of-the-art nursing home management system. The Company intends to establish regional processing centers which will utilize the Parent's network to meet the processing requirements of the Company's clients. The Company has completed the centralization of its information systems operations into its first regional processing center in Bradenton, Florida. By utilizing the Parent's network, the regional processing centers can serve as disaster recovery backup sites, having the capability to handle the Company's operations for a short period of time. The Company currently uses commercially available software to manage information related to payroll processing, benefits administration, human resource management and employee enrollment. The Company has also developed the requirements and key vendor relationships to create a proprietary information management system to handle the expected growth in worksite employees. The Company intends to follow the Parent's information technology strategy of creating relational databases on state-of-the-art client server development systems. 41 42 SALES AND MARKETING The Company's client base as of June 30, 1997 consisted of 1,742 client companies, representing 35,028 worksite employees. The Parent represented 65% of the Company's fiscal 1997 revenues, on a pro forma basis. See "Relationship with the Parent" above, "Certain Related Party Transactions" and "Risk Factors." The Company's clients, excluding the Parent, have an average of 11 employees. As of June 30, 1997, the Company's approximate distribution of worksite employees by major Standard Industrial Classification ("SIC") code industry grouping was: WITHOUT WITH THE PARENT THE PARENT ---------- ---------- Wholesale/Retail Trade....................................... 31% 18% Construction................................................. 15% 8% Hospitality.................................................. 15% 8% Restaurants.................................................. 10% 6% Transportation............................................... 8% 4% Manufacturing................................................ 6% 3% Automotive................................................... 6% 3% Finance, Insurance and Real Estate........................... 4% 2% Agriculture.................................................. 4% 2% Health Care.................................................. 1% 46% The Company is focused on serving clients in targeted industries that generate high gross profit per worksite employee. See "Strategy -- Growth Strategy" above. All prospective clients are evaluated individually on the basis of workers' compensation risk, group medical history, unemployment history and operating stability. The Company's sales and marketing efforts are focused on the Company's target markets and industries. The Company markets its services through 40 sales professionals who specialize in one or more of the Company's target industries. Thirty-three of these sales representatives are direct employees and seven are dedicated independent contractors who work exclusively for the Company. Employed sales representatives are paid a combination of salary and incentive compensation. The incentive is based on the gross profit projected to be earned with respect to a customer contract and is paid after the contract has been in effect for one full calendar month. The incentive is required to be repaid by the sales representative if the applicable contract is terminated within 120 days after inception. Independent contract sales representatives are paid monthly on an incentive basis after customer contracts are executed as revenue is received. The Company's sales materials are client specific and communicate its broad range of high quality services and the potential benefits to employers and employees. The Company will seek to utilize professional marketing tools and strategies to communicate its brand promise and performance to target audiences. First, the Company will seek to identify target audiences through market research. The Company has commissioned an opinion survey to assist in designing the messages to be delivered to the target audiences. The Company intends to utilize public relations and advertising to communicate its brand promise and its performance to the target audiences. Direct mail, referrals from the Parent and other clients and telemarketing will be used to generate qualified customer leads. The sales force will then deliver targeted presentations to qualified prospects using industry- and customer-specific marketing materials. The Company expects to benefit from joint public relations and advertising with the Parent. These media are intended to supplement and enhance the effectiveness of the Company's marketing efforts and reinforce brand loyalty on the part of employees and clients. Brand loyalty is expected to generate referrals, improve client retention and thereby improve profitability. The Company plans to survey the marketplace, its worksite employees and potential clients on a continuous basis to measure satisfaction and the effectiveness of its marketing efforts. For its worksite employees, the Company believes its brand promise is fulfilled by: (i) establishing a respectful and trusting relationship between the Company and its worksite employees through clearly defined 42 43 policies and procedures, and competitive health care and related benefits; (ii) providing a positive work environment by way of risk prevention and safety programs and recognition programs; (iii) consistently rendering dependable and responsive employee services, most notably payroll and benefits administration; and (iv) providing training and placement during cyclical changes in its client businesses. For its clients, the Company seeks to: (i) improve employee satisfaction and thereby improve workforce performance and productivity; (ii) reduce the time and effort required by business owners and executives to deal with the complexities of employment and payroll management; (iii) improve client business performance by enabling management to focus on core competencies, increasing workforce productivity through training, recognition, risk prevention and safety programs, and lowering costs associated with workers' compensation, health insurance, other benefit coverage and regulatory compliance; and (iv) establish a respectful and trusting relationship between the Company and its clients through expert, responsive and dependable service and accountability for performance. The Company has benefited from a high level of client retention, resulting in a significant recurring revenue stream. The Company believes its client attrition is attributable to a variety of factors, including: (i) client business failure or downsizing; (ii) sale or acquisition of the client company; (iii) termination by the Company resulting from the client's inability to make timely payments; and (iv) client nonrenewal due to price or dissatisfaction with service. The Company believes that only a small percentage of nonrenewing clients withdrew due to dissatisfaction with service or to retain the services of a competitor. The Company's portfolio management approach, utilizing a management control system focused on key operating variables, is designed to reduce further the incidence of non-renewal. The Company plans to enter new geographic markets on a regular basis. The Company believes its market development model, which consists of a structured sales management control system and selling process, will enable it to penetrate new markets quickly. The Company provides at least two weeks of training for each new sales person to familiarize them with the Company's services, policies and procedures. The training focuses on the Company's values, business model and target market approach. The sales force is expected to utilize the key industry strategy and become expert in one or more select industries in the markets in which they are operating. The composition of the sales force to be assigned to each target market will be determined by business objectives related to worksite employees, profit, client growth and individual sales productivity. The Company's sales management control system, which monitors activity both on an individual and a consolidated basis, is designed to ensure an efficient sales process in support of the Company's objectives. The measurement criteria used in the sales management process include the tracking of qualified sales lead generation, proposal presentation, close ratio, profit per worksite employee and retention trends. Referrals from existing clients and professionals (such as accountants, bankers and lawyers) are a primary source of sales leads. Each sales person is required to visit his or her clients periodically in order to maintain an ongoing relationship and to benefit from referrals. Referrals are also expected to result from the Company's brand recognition and the Company's strategic alliances with other outsourcing service providers to small and medium-sized businesses, including the Company's relationship with the Parent. The sales leads result in initial presentations to prospective clients. The Company's sales executives then gather information about the prospective client, employees, workers' compensation job classifications and claims history, health insurance claims history, compatibility with the Company's workplace safety program philosophy, salary and the desired level of employee benefits and credit history. These various factors are reviewed in the context of the Company's pricing model and client selection profile. A client proposal is prepared for potential clients. This prospective client screening process plays a vital role in controlling the Company's cost and limiting exposure to liability. Once a prospective client accepts the Company's proposal, the new client is incorporated into the Company's system by a new account start-up team. A Company customer service manager then assumes responsibility for ensuring service performance for the client and its employees. 43 44 WORKERS' COMPENSATION AND HEALTH CARE PROGRAM Historically, the majority of the Company's controllable direct costs relate to workers' compensation benefits and health care. Consequently, the Company's ability to manage the workers' compensation and health care costs of its worksite employees is critical to its success and profitability. To manage effectively its workers' compensation and health care costs, the Company intends to utilize: (i) careful underwriting and selection of new clients; (ii) the Parent's experience in implementing effective workers' compensation injury prevention, medical management, rehabilitation and return to work techniques; (iii) the health care services of the Parent and other health care providers in the Parent's health care networks in key markets; and (iv) effective July 1, 1997, a fixed cost workers' compensation program. If an injury occurs, the Company's goal is to take control of the claim within 24 hours after receipt of the injury report, aggressively medically manage the injury by coordinating with the employer, employee and provider, and return the employee to work as early as is safe and feasible. This approach substantially lowers injury-related costs, particularly the most expensive cost component, lost workdays. Temporarily placing injured employees in light duty positions until they are able to return to their previous duties is an opportunity afforded the Company in its dense markets. The Company's workers' compensation insurance coverage is currently provided by Liberty Mutual, the largest workers' compensation insurance carrier in the United States. The coverage is provided under a workers' compensation deductible program with an aggregate stop loss that limits the liability to the Company to a capped percentage of the standard premium or a fixed aggregate deductible, whichever is greater. Under this program, the Company receives the benefit of reducing actual claims experience below the cap. The Company accrues workers' compensation expense based on management's evaluation of the nature and severity of individual claims and past claims experience. Actual claims experience is then recognized against the amount accrued. The Liberty Mutual arrangement will extend through June 30, 2000 and provides for: (i) a dedicated claims processing unit; (ii) intensive training of the Company's safety consultants and risk assessors; and (iii) favorable rates and payment terms. The Parent has reduced its workers' compensation costs by 38% as a percentage of employee earnings over the prior three calendar years. The Parent's program has proven to be cost-effective in the health care industry. The Parent's worksite employees will be self-insured by the Company. When buying health care coverage for its employees, the Company believes it is in a strong position with insurers, as a result of the participation of the Parent in local market integrated health care delivery systems as well as the leverage that the Company's scale provides. Accordingly, the Company believes that it will be able to achieve favorable health care rates by forming strategic partnerships with national and regional providers. COMPETITION The PEO industry consists of at least 2,400 companies (according to an estimate by NAPEO), most of which serve a single market or region. The Company is one of the largest (measured by revenues and number of worksite employees) PEOs in the United States. The Company considers its primary competition to include: (i) traditional in-house human resources departments; (ii) other PEOs; and (iii) providers of unbundled employment related services such as payroll processing firms, temporary employment firms, commercial insurance brokers, human resources consultants, workers' compensation insurers, HMOs and other specialty managed care providers. Competition in the highly fragmented PEO industry is generally on a local or regional basis. Management believes that the primary elements of competition are quality of service, choice and quality of benefits, reputation and price. The Company believes that brand recognition, regulatory expertise, financial resources, risk management, information technology capability and economies of scale can distinguish a large-scale PEO from the rest of the industry. The Company believes that it competes favorably in these areas. The Company believes that barriers to entry into the PEO industry are increasing due to, among others, the following factors: (i) the complexity of the PEO business and the need for expertise in multiple disciplines; (ii) the three to five years of experience required to establish experience ratings in key cost areas of 44 45 workers' compensation, health insurance and unemployment; and (iii) the need for sophisticated management information systems to track all aspects of business in a high growth environment. REGULATION The Company is subject to local, state and federal regulations which include operating, fiscal and licensing requirements. Adding complexity to the Company's regulatory environment are (i) uncertainties resulting from the non-traditional employment relationships created by PEOs, (ii) variations in state regulatory schemes and (iii) the ongoing evolution of regulations regarding health care and workers' compensation. The Parent is a leader in regulatory change management. The Company expects to benefit from the Parent's expertise in this area. Many of the federal and state laws and regulations relating to tax, benefit and employment matters applicable to employers were enacted prior to the development of non-traditional employment relationships and, accordingly, do not specifically address the obligations and responsibilities of PEOs or the co-employment relationship. Moreover, the Company's PEO services are regulated primarily at the state level. Regulatory requirements regarding the Company's business therefore vary from state to state, and as the Company enters new states it will be faced with new regulatory and licensing environments. There can be no assurance that the Company will be able to satisfy the licensing requirements or other applicable regulations of any particular state, that it will be able to provide the full range of services currently offered, or that it will be able to operate profitably within the regulatory environment of any state in which it does not obtain regulatory approval. The absence of required licenses would require the Company to restrict the services it offers. New legislation or new interpretations of current licensing and regulatory requirements could impose operating or licensing requirements on the Company which it may not be able to satisfy or which could have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. Additionally, interpretation of such legislation or regulation by regulatory agencies with broad discretionary powers could require the Company to modify its existing operations materially in order to comply with applicable regulations. The application of many laws to the Company's PEO services will depend on whether the Company is considered an employer under the relevant statutes and regulations. The IRS is currently examining this issue. See "Employee Benefit Plans" below. In addition, from time to time there have been proposals to enact a statutory definition of employer for certain purposes of the Code. Regulation in the health care and workers' compensation fields continues to evolve. Numerous reform proposals have been the subject of debate at both the federal and state government levels. The Company cannot predict what effect any such proposed reform will have on its business. If new legislation results in increased health care costs, which comprise a significant portion of the Company's direct costs, and if the Company is not able to reflect promptly such increased costs in its service fees, such legislation could have a material adverse impact on the Company's business, financial condition, results of operations and liquidity. PEO Licensing Requirements. A critical aspect of the growth of the PEO industry has been increasing recognition and acceptance of PEOs by state authorities. As the concept of PEO services has become more understood by regulatory authorities, the regulatory environment has begun to shift from one of hostility and skepticism to one of regulatory recognition of the industry. During the mid to late 1980s, legitimate industry participants were challenged to overcome well publicized failures of financially unsound and, in some cases, unscrupulous operators. While many states do not explicitly regulate PEOs, approximately one-third of the states, including Florida, have passed laws that have licensing or registration requirements for PEOs and several additional states, including Pennsylvania, are considering such regulation. Such laws vary from state to state but generally provide for monitoring the fiscal responsibility of PEOs. The Company is licensed in seven states and has begun the licensing program in eight states. State regulation assists in screening insufficiently capitalized PEO operations and resolves issues concerning an employee's status for specific purposes under applicable state law. Because existing regulations are relatively new, there is limited interpretive or enforcement guidance 45 46 available. The development of additional regulations and interpretation of existing regulations can be expected to evolve over time. In Florida, the Company's PEO operations are licensed under the Florida Employee Leasing Licensing Act of 1991 (the "Florida Licensing Act"). The Florida Licensing Act requires PEOs and their controlling persons to be licensed, mandates reporting requirements and allocates several employer responsibilities. The Florida Licensing Act also requires licensed PEOs to submit annual financial statements and maintain a tangible accounting net worth and positive working capital. The Florida Licensing Act also requires PEOs to, among other things: (i) reserve the right of direction and control over the leased employees; (ii) enter into a written agreement with the client company; (iii) pay wages to the leased employees; (iv) pay and collect payroll taxes; (v) maintain authority to hire, terminate, discipline and reassign employees; (vi) reserve a right to direct and control the management of safety, risk and hazard control at the worksite; (vii) promulgate and administer employment and safety policies; and (viii) manage workers' compensation claims. Federal and State Employment Taxes. The Company assumes the responsibility and liability for the payment of federal and state employment taxes with respect to wages and salaries paid to its employees, including worksite employees. There are essentially three types of federal employment tax obligations: (i) income tax withholding requirements; (ii) social security obligations under FICA; and (iii) unemployment obligations under FUTA. Under the applicable Code sections, the employer has the obligation to withhold and remit the employer portion and, where applicable, the employee portion of these taxes. To date, the IRS has relied extensively on the common law test of employment in determining employer status and the resulting liability for failure to withhold. However, the IRS has formed a Market Segment Study Group for the stated purpose of examining whether PEOs, such as the Company, are the employers of the worksite employees under the Code provisions applicable to federal employment taxes and, consequently, whether they are exclusively responsible for payment of employment taxes on wages and salaries paid to such employees. Another stated purpose of the Market Segment Study Group is to determine whether owners of client companies can be employees of PEOs under the federal employment tax laws. See "Risk Factors -- Risk of Loss of Qualified Status for Certain Tax Purposes." The interpretive uncertainties raised by the Market Segment Study Group may affect the Company's ability to report employment taxes on its own account rather than for the accounts of its clients and would increase administrative burdens on the Company's payroll service function. In addition, while the Company believes that it can contractually assume the client company's withholding obligations, in the event the Company fails to meet these obligations, the client company may be held jointly and severally liable therefor. Employee Benefit Plans. The Company offers various employee benefit plans to its worksite employees, including 401(k) plans (a profit-sharing plan with an employer contribution feature), cafeteria plans, group health plans, group life insurance plans, group disability insurance plans and employee assistance programs. Generally, employee benefit plans are subject to provisions of both the Code and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). In order to qualify for favorable tax treatment under the Code, the plans must be established and maintained by an employer for the exclusive benefit of its employees. Most of these benefit plans are also offered to the Company's corporate employees. The Market Segment Study Group established by the IRS is examining whether PEOs, such as the Company, are the employers of worksite employees under Code provisions applicable to employee benefit plans and consequently able to offer to worksite employees benefit plans that qualify for favorable tax treatment. The Market Segment Study Group is also examining whether client company owners are employees of PEOs under Code provisions applicable to employee benefit plans. Although the IRS has indicated that the Market Segment Study is expected to be completed in January 1998, the Company is unable to predict the actual timing or nature of the findings of the Market Segment Study Group or the ultimate outcome of such conclusions or findings. If the IRS study were to conclude that a PEO is not an employer of its worksite employees for plan purposes, worksite employees might not be able to continue to make contributions to the Company's 401(k) plans or cafeteria plans. The Company believes that although unfavorable to the Company, a prospective application by the IRS of an adverse conclusion would not have a 46 47 material adverse effect on its financial position and results of operations. If such conclusion were applied retroactively, employees' vested account balances would become taxable immediately, the Company would lose its tax deduction to the extent the contributions were not vested, the plans' trusts would become taxable trusts and penalties could be assessed. In such a case, the Company would face the risk of client dissatisfaction as well as potential litigation. A retroactive application by the IRS of an adverse conclusion could have a material adverse effect on the Company's business, financial position, results of operations and liquidity. While the Company believes that a retroactive disqualification is unlikely, there can be no assurance as to the ultimate resolution of these issues. See "Risk Factors -- Risk of Loss of Qualified Status for Certain Tax Purposes." In addition to the employer/employee relationship requirement described above, pension and profit-sharing plans, including the Company's 401(k) plans, must satisfy certain other requirements under the Code. These other requirements are generally designed to prevent discrimination in favor of highly compensated employees to the detriment of non-highly compensated employees with respect to both the availability of, and the benefits, rights and features offered in, qualified employee benefit plans. The Company applies the nondiscrimination requirements of the Code at both a consolidated and client company level to ensure that its 401(k) plans are in compliance with the requirements of the Code. Employee pension and welfare benefit plans are also governed by ERISA. ERISA defines the term employer as "any person acting directly as an employer, or indirectly in the interest of an employer, in relation to an employee benefit plan." ERISA defines the term employee as "any individual employed by an employer." The United States Supreme Court has held that the common law test of employment must be applied to determine whether an individual is an employee or an independent contractor under ERISA. A definitive judicial interpretation of employer in the context of a PEO or employee leasing arrangement has not been established. If the Company were found not to be an employer for ERISA purposes, its plans might not comply with ERISA , the level of services the Company could offer may be materially adversely affected, and the Company and its plans might not enjoy the preemption of state laws provided by ERISA and could be subject to varying state laws and regulations, as well as to claims based upon state common laws. Workers' Compensation. Workers' compensation is a state-mandated, comprehensive insurance program that requires employers to fund medical expenses, lost wages and other costs resulting from work-related injuries and illnesses. In exchange for providing workers' compensation coverage for employees, employers are not subject to litigation by employees for benefits in excess of those provided by the relevant state statute. In most states, the extensive benefits coverage (for both medical costs and lost wages) is provided through the purchase of commercial insurance from private insurance companies, participation in state-run insurance funds or employer self-insurance. Workers' compensation benefits and arrangements vary on a state-by-state basis and are often highly complex. These laws establish the rights of workers to receive benefits and to appeal benefit denials. Workers' compensation laws also regulate the methods and procedures which the Company may employ in its workers' compensation managed care programs. For example, workers' compensation laws prohibit medical co-payment and deductible payment by employees. In addition, certain states restrict employers' rights to select health care providers and establish maximum fee levels for treatment of injured workers. As a creation of state law, workers' compensation is subject to change by each state's legislature and is influenced by the political processes in each state. Several states have mandated that employers receive coverage only from state-operated funds. Florida and other states have adopted legislation requiring that all workers' compensation injuries be treated through a managed care program. While such legislation may increase the market for the Company's workers' compensation managed care services, it may also intensify the competition faced by the Company for such services. In addition, federal health care reform proposals include a proposal that may require 24-hour health coverage, in which the coverage of traditional employer-sponsored health plans is combined with workers' compensation coverage to provide a single insurance plan for health problems, whether or not related to work. Incorporating workers' compensation coverage into conventional health plans may adversely affect the market for the Company's services and may intensify the competition faced by the Company from HMOs and other health care providers. Moreover, because workers' compensa- 47 48 tion benefits are mandated by law and are subject to extensive regulation, payors and employers do not have the same flexibility to alter benefits as they have with other health benefit programs. Finally, because workers' compensation programs vary from state to state, it is difficult for payors and multi-state employers to adopt uniform policies to administer, manage and control the costs of benefits. Other Employer-Related Requirements. As an employer, the Company is subject to a wide variety of federal, state and local laws and regulations governing employer-employee relationships, including the Immigration Reform and Control Act, the Americans with Disabilities Act, the Family and Medical Leave Act, the Occupational Safety and Health Act, wage and hour regulations, and comprehensive local, state and federal civil rights laws and regulations, including those prohibiting discrimination and sexual harassment. The definition of employer may be broadly interpreted under these laws. Responsibility for complying with various state and federal laws and regulations is allocated by agreement between the Company and its clients, or in some cases is the joint responsibility of both. See "Employee and Client Services" above. Because the Company acts as a co-employer with the client company, it is possible that the Company could incur liability for violations of laws even though the Company is not contractually or otherwise responsible for the conduct giving rise to such liability. The Company's standard client agreement generally provides that the client will indemnify the Company for liability incurred as a result of an act of negligence of a worksite employee under the direction and control of the client or to the extent the liability is attributable to the client's failure to comply with any law or regulation for which it has specified contractual responsibility. However, there can be no assurance that the Company will be able to enforce such indemnification and the Company may therefore be ultimately responsible for satisfying the liability in question. EMPLOYEES At June 30, 1997, the Company had 260 non-worksite employees. Of these, 37 are corporate management and 223 are administrative and clerical. None of the Company's non-worksite employees is represented by a labor union and the Company is not aware of any current activity to organize any of its non-worksite employees. The Company considers relations with its non-worksite employees to be good. For information with respect to the Company's worksite employees, see "Employee and Client Services" above. PROPERTIES The Company's principal executive offices are located at 2621 Van Buren Avenue, Norristown, Pennsylvania 19403. In addition, the Company leases other office space in various cities in the United States. See Notes 4 and 8 of Notes to the Company's Consolidated Financial Statements for information concerning the Company's leases for its facilities. The Company does not anticipate that it will experience any difficulty in renewing any such leases upon their expiration or obtaining different space on comparable terms if such leases are not renewed. The Company believes that these facilities are well maintained and are of adequate size for present needs and planned expansion in the near future. INSURANCE The Company believes that it maintains the types and amounts of insurance customary in the industry, including coverage for general liability and workers' compensation. The Company considers its insurance coverage to be adequate both as to risks and amounts. LEGAL PROCEEDINGS From time to time, the Company is party to certain claims, suits and complaints which arise in the ordinary course of business. Currently, there are no such claims, suits or complaints which, in the opinion of the Company, would have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. 48 49 MANAGEMENT DIRECTORS AND EXECUTIVE OFFICERS The following sets forth certain information with respect to directors and executive officers of the Company: NAME AGE POSITION - ------------------------------------------- ---- ------------------------------------------------ E. Martin Gibson(1)(2)..................... 59 Chairman of the Board, Director Loren J. Hulber............................ 54 President, Chief Executive Officer and Director Bernard C. Byrd, Jr........................ 35 Senior Vice President of Operations Thomas D. Schubert......................... 36 Senior Vice President and Chief Financial and Accounting Officer Andrew W. Stith............................ 29 Senior Vice President of Sales and Marketing Lynn A. Cannon............................. 39 Senior Vice President of Temporary Services Arthur T. Locilento, Jr.................... 53 Senior Vice President of Human Resources Christina D. Harris, Esquire............... 35 Senior Vice President of Regulatory Affairs and Compliance Marie L. Martino, Esquire.................. 37 General Counsel and Secretary John H. Foster............................. 55 Director Timothy E. Foster.......................... 45 Director Harvey V. Fineberg, M.D., Ph.D.(1)(2)...... 51 Director Stephen E. O'Neil, Esquire(1)(2)........... 63 Director - --------------- (1) Member of Compensation Committee (2) Member of Audit Committee The following is a brief summary of the business experience of each of the directors and executive officers of the Company: E. Martin Gibson. Mr. Gibson has been the Chairman of the Board of Directors of the Company since March 3, 1997. He has served as a director of the Parent since March 1992. Mr. Gibson, who is retired, served as Chairman and Chief Executive Officer of Corning Lab Services, Inc., a subsidiary of Corning Incorporated, from 1990 until December 1994. He currently serves as a director of International Technology Corp., an environmental management company, of Hardinge Brothers, Inc., a manufacturer of machine tools, and of Sensus Corp., a private biotechnology company. Loren J. Hulber. Mr. Hulber has been the President, Chief Executive Officer and a director of the Company since March 3, 1997. For the previous ten years, he served in various capacities for American Brands, Inc., most recently as President and Chief Executive Officer of Day-Timers, Inc., a subsidiary specializing in time management and personal organization. From 1973 until 1981, Mr. Hulber was President and Chief Executive Officer of Durand Corporation, an office products company. Upon Durand Corporation's acquisition by Jostens, Inc. in 1981 and until 1987, Mr. Hulber was President of that company's Business Products Group, a provider of business products and services. Mr. Hulber currently serves as Vice Chairman of the Board of Trustees of Lehigh Valley Hospital and Health Network. Bernard C. Byrd, Jr. Mr. Byrd became Senior Vice President of Operations of the Company on March 3, 1997. In 1992, he founded the Company's initial acquisition, Resource One, and served as its President and Chief Executive Officer. Prior to founding Resource One, Mr. Byrd was Vice President of Finance for Your Staff, Inc., a PEO that was acquired by Kelly Services, Inc., a provider of temporary employee services. Before joining Your Staff, Inc., he was the Chief Financial Officer for Staffing Services, Inc., which was a founding member of NAPEO. Since 1994, Mr. Byrd has been a member of the Florida Board of Employee Leasing Companies and serves as its immediate past chairman. 49 50 Thomas D. Schubert. Mr. Schubert has been the Senior Vice President and Chief Financial and Accounting Officer of the Company since June 4, 1997. Prior to joining the Company, he served in various capacities with Chemical Leaman Tank Lines, Inc., a transportation and logistics company, since 1991, most recently as Vice President of Finance. From 1984 to 1990, he worked in the accounting/auditing practice with the Philadelphia office of Ernst & Young where he managed a variety of client engagements in the manufacturing and service sectors. Andrew W. Stith. Mr. Stith became Senior Vice President of Sales and Marketing of the Company on March 3, 1997. In 1994, he joined the Parent as Assistant to the Chairman of the Parent. In 1995, Mr. Stith assumed the position of Vice President of Sales for the Contract Rehabilitation Division of the Parent. Prior to joining the Parent, from 1992 to 1994, Mr. Stith obtained his M.B.A. from the Amos Tuck School of Management of Dartmouth College. From 1989 to 1992, he was associated with River Capital, Inc. as a venture capital associate. Lynn A. Cannon. Mr. Cannon became Senior Vice President of Temporary Services of the Company on July 1, 1997. Mr. Cannon founded Cannon & Associates, Inc., a consulting firm which specializes in advising clients in the long-term care industry on reimbursement, regulatory and service offering opportunities, in 1988. Mr. Cannon served as President of Cannon & Associates until 1994, when it was acquired by the Parent. In May 1994, he became Executive Vice President of Product Development of the Polaris Group, an operating unit of Cannon & Associates. In May 1996, Mr. Cannon was appointed President and General Manager of NovaPro, the Temporary Services division of Cannon & Associates. Arthur T. Locilento, Jr. Mr. Locilento became Senior Vice President of Human Resources of the Company on March 3, 1997. From September 1996 to March 1997, Mr. Locilento was a director and Vice President of the Company. From 1988 to 1996, he served as Senior Vice President of Human Resources of the Parent. From 1982 to 1988, Mr. Locilento served as Senior Vice President of Human Resources at Shearson Lehman Brothers Inc., a financial services company. Christina D. Harris, Esq. Ms. Harris became Senior Vice President of Regulatory Affairs and Compliance of the Company on July 18, 1997. Prior to joining the Company, she was National Vice President of Marketing (Alternative Staffing) for AIG Risk Management, Inc. ("AIG") from April 1996 to July 1997. Before joining AIG, she was Vice President for Legal Affairs and General Counsel for The Vincam Group, Inc., a PEO, from December 1991 to April 1996. Ms. Harris has served as NAPEO's chief delegate on employment law to its government affairs committees and as Chairperson of its Legal Advisory Council. She is also the immediate past president of the Florida Association of Professional Employer Organizations ("FAPEO"). Marie L. Martino, Esq. Ms. Martino became General Counsel and Secretary of the Company on March 3, 1997. She also serves as Assistant General Counsel responsible for litigation and employment law at the Parent, where she has been employed since 1994. From 1993 to 1994, Ms. Martino was an associate in the Labor and Employment Law Group at Dechert Price & Rhoads, a Philadelphia law firm. For the four years prior to that, she practiced in the employment law group at Bell Atlantic Corp. John H. Foster. Mr. Foster became a director of the Company on March 3, 1997. He has been Chairman of the Board of the Parent since December 1984. From December 1984 until May 1997, he was also Chief Executive Officer of the Parent. Mr. Foster is a director of Corning Incorporated, an international corporation with business interests in specialty materials, communications, laboratory services and consumer products. Since March 1991, Mr. Foster also has been Chairman of the Board and Chief Executive Officer of Apogee, Inc., a national provider of mental health services. Mr. Foster is founder and Chairman of Foster Management Company, an investment advisor, and general partner of various venture capital investment funds. Timothy E. Foster. Mr. Foster became a director of the Company on March 3, 1997. He has been Chief Executive Officer of the Parent since May 1997. Between October 1994 and May 1997, he was President and Chief Operating Officer of the Parent. He has been a director of the Parent since December 1984. Prior to 50 51 becoming President, he served in a variety of finance and administrative roles at the Parent, beginning in 1984. Since February 1993, he has also been a director of Apogee, Inc. Harvey V. Fineberg, M.D., Ph.D. Dr. Fineberg became a director of the Company on March 3, 1997. He was named Provost of Harvard University in July of 1997. Until then, he had been Dean of the Harvard School of Public Health since 1984 and a Professor of Health Policy and Management there since 1982. From 1995 to 1996, he served as President of the Association of Schools of Public Health. He is also a member of the Institute of Medicine. Dr. Fineberg is a director of Principal Care, Inc., a women's health care company, and Apogee, Inc. Stephen E. O'Neil, Esq. Mr. O'Neil became a director of the Company on March 3, 1997. He has been a director of the Parent since December 1984. Mr. O'Neil has been a principal of The O'Neil Group, a private investment firm, since 1981. He is a director of Brown Forman Corporation; Castle Convertible Fund, Inc.; Spectra Fund, Inc.; Alger Fund, Inc.; and Alger American Funds. BOARD OF DIRECTORS All directors hold office until the next annual meeting of stockholders and until their successors have been elected and qualified, or until their death, resignation or removal. Committees. The Company's Board of Directors has established a Compensation Committee and an Audit Committee. The membership of each committee is indicated by footnotes to the table above. The Compensation Committee administers the Company's compensation programs, including the Stock Option Plan (including determining the persons who are to receive options and the number of shares subject to each option), and performs such other duties as may from time to time be determined by the Board of Directors. The Audit Committee reviews the scope and results of the annual audit of the Company's consolidated financial statements conducted by the Company's independent accountants, the scope of other services provided by the Company's independent accountants, proposed changes in the Company's financial and accounting standards and principles, and the Company's policies and procedures with respect to its internal accounting, auditing, financial and legal and regulatory compliance controls. The Audit Committee also makes recommendations to the Board of Directors on the engagement of the independent accountants, as well as other matters which may come before it or as directed by the Board of Directors. Compensation. Non-employee directors of the Company receive reimbursement of reasonable expenses incurred in serving as a director. In addition, pursuant to the Company's Stock Option Plan, each director of the Company who is not an employee of the Company automatically receives on the date such person first becomes a director a grant of nonqualified options to purchase 20,000 shares of Common Stock, which will vest one-third on each anniversary of the date of grant. In addition, following each annual meeting of the Company's stockholders, each such outside director will receive an annual grant of options to purchase an additional 10,000 shares of Common Stock, all of which vest one-third on each anniversary of the date of grant. The exercise price of all such options is the fair market value at the time the options are granted. Options to purchase a total of 20,000 shares of Common Stock have been granted under such arrangement to each of Messrs. Gibson, O'Neil, John H. Foster, Timothy E. Foster and Dr. Fineberg at an exercise price of $2.80 per share. Mr. Gibson has received an additional grant of options to purchase 20,000 shares of Common Stock in consideration of his service as Chairman of the Company at an exercise price of $2.80 per share. Directors who are employees of the Company or of the Parent receive no compensation for their services as directors, except the initial option grants described in this paragraph. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS Prior to the appointment of the current members of the Compensation Committee, executive compensation decisions for the Company were made by the Parent. The Company expects to receive in excess of 5% of its gross revenues for the next fiscal year from the Parent. 51 52 EXECUTIVE COMPENSATION The following table sets forth information for the fiscal year ended June 30, 1997 concerning the compensation paid or awarded to the Chief Executive Officer and the other most highly compensated executive officer whose salary and bonus exceeded $100,000. SUMMARY COMPENSATION TABLE ANNUAL LONG-TERM COMPENSATION COMPENSATION ------------------ ------------- ALL OTHER NAME AND PRINCIPAL POSITION SALARY BONUS OTHER AWARDS COMPENSATION(1) - ------------------------------------------------ -------- ------- ---- ------ ------------ Loren J. Hulber................................. $ 69,231 $31,500 0 0 $1,105 President and Chief Executive Officer Arthur T. Locilento, Jr......................... $131,117 $73,355 0 25,000 $1,795 Senior Vice President of Human Resources - --------------- (1) Consists of contributions made by the Company to the Company's 401(k) Plan and the Company's Supplemental Deferred Compensation Plan. The following table sets forth the grants of stock options to the executive officers named in the Summary Compensation Table that have occurred during the current fiscal year ended June 30, 1997: OPTION GRANTS IN FISCAL YEAR 1997 POTENTIAL REALIZABLE VALUE AT ASSUMED ANNUAL RATES OF STOCK % OF OPTIONS PRICE APPRECIATION GRANTED TO EXERCISE FOR OPTION TERM(2) OPTIONS EMPLOYEES IN PRICE EXPIRATION --------------------- NAME GRANTED FISCAL YEAR ($/SHARE)(1) DATE 5% 10% - --------------------------- ------ ---------------- ------------ ---------- --------- --------- Arthur T. Locilento, Jr. ..................... 25,000 7% $ 2.80 2/28/07 $114,020 $181,556 - --------------- (1) The per share exercise price equals the fair market value of Common Stock on the date of grant. There was no trading market for the Common Stock during the fiscal year ended June 30, 1997. Accordingly, fair market value was determined by the Board of Directors based on an independent appraisal as of the grant date. (2) Amounts represent hypothetical gains that could be achieved for the respective options if exercised at the end of the option term. These gains are based on assumed rates of stock price appreciation of 5% and 10% compounded annually from the date the respective options were granted to their expiration date. This table does not take into account any appreciation in the price of the Common Stock to date. No options were exercised by the executive officers named in the Summary Compensation Table during the fiscal year ended June 30, 1997. The following table sets forth for the executive officers named in the Summary Compensation Table certain information concerning the value of unexercised options at the end of the fiscal year ended June 30, 1997: FISCAL YEAR-END OPTION VALUES NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT FISCAL YEAR-END IN-THE-MONEY OPTIONS ----------------------------- ----------------------------- NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - --------------------------------------------- ----------- ------------- ----------- ------------- Arthur T. Locilento, Jr. .................... 0 25,000 $ 0 $ 155,000 - --------------- (1) Amounts are shown as the positive spread between the exercise price and fair market value (based on the public offering price of $9.00 per share). 52 53 Employment and Other Arrangements Mr. Loren J. Hulber entered into a three-year employment agreement with the Company on January 10, 1997. Under the agreement, Mr. Hulber receives a base salary of $200,000 per year. Mr. Hulber is eligible to receive an annual bonus of up to 50% of his base salary, based on achievement of agreed-to objectives and attainment of financial targets. He is also entitled to receive a separate one-time payment of $100,000 if the Offering closes on or before December 31, 1997. Pursuant to his employment agreement, Mr. Hulber purchased 375,000 shares of the Company's Common Stock on January 10, 1997 at a cost of $1.92 per share, the fair market value of the Common Stock as of that date. There was no trading market for the Common Stock on the date of sale. Accordingly, fair market value was determined by the Board of Directors based on an independent appraisal as of the sale date. Mr. Hulber's rights to the stock vest in equal parts over three years. Vesting may be accelerated in the event of a change of control of the Company or upon termination of Mr. Hulber's employment by the Company. Mr. Hulber will receive severance of up to one year's salary and bonus upon termination by the Company without cause. Mr. Bernard C. Byrd, Jr. entered into a five-year employment agreement with the Company in October 1996, which agreement was amended in April 1997. Under the agreement, Mr. Byrd receives a base salary of $75,000 per year, subject to annual merit reviews. Mr. Byrd is also eligible to receive an annual bonus of up to $25,000, based on achievement of agreed-to productivity and performance criteria. Mr. Byrd was a stockholder of Resource One, which the Company acquired in October 1996. In consideration for his capital stock in Resource One, the Company paid Mr. Byrd $1,000,000 in cash, issued Mr. Byrd a five-year 6% subordinated promissory note in the amount of $393,500 and issued Mr. Byrd 93,750 shares of the Company's Common Stock at the closing of the acquisition and agreed to pay Mr. Byrd (i) $1,000,000 upon the consummation of the Offering and (ii) certain other additional cash payments and shares of the Company's Common Stock if Resource One achieves certain operating objectives. Subsequent to the closing of the transaction, the Company removed the contingency from certain of Mr. Byrd's additional payments and lent Mr. Byrd $83,700, collateralized by those payments. Mr. Byrd is currently entitled to receive future non-contingent payments totaling $440,000 and 61,250 shares of the Company's Common Stock. Mr. Byrd utilized the loan to purchase 30,000 shares of the Company's Common Stock. Those shares vest over five years and unvested shares may be repurchased by the Company if Mr. Byrd should leave the Company prior to the shares becoming vested. Mr. Byrd also received $360,000 and 22,500 shares of the Company's Common Stock subsequent to the closing in satisfaction of the Company's obligation with respect to the first contingent payment due under the acquisition agreement. The Company also repurchased from Mr. Byrd 281,250 shares of the Company's Common Stock at a price of $1.92 per share on January 10, 1997. Stock Option Plan On February 28, 1997, the Company's Board of Directors adopted and its stockholders approved the Company's 1997 Stock Option Plan (the "Stock Option Plan") under which 625,000 shares of Common Stock are currently reserved for issuance upon exercise of stock options. The Stock Option Plan provides for the grant of both incentive stock options intended to qualify as such under Section 422 of the Code ("incentive stock options") and non-qualified options to directors, officers, key employees, consultants and other individual contributors of or to the Company, its parent and its subsidiaries, as determined at the discretion of the Board. Effective March 3, 1997, the Board delegated authority to make decisions respecting the grant of options under the Stock Option Plan to the Compensation Committee of the Board. Pursuant to the terms of the Stock Option Plan, options may not be granted with an exercise price that is less than 100% of fair market value of the Company's Common Stock on the date of grant, as reasonably determined by the Compensation Committee. The Stock Option Plan will terminate on February 28, 2007, unless sooner terminated by the Board of Directors. As of November 6, 1997, there were outstanding under the Stock Option Plan options to purchase an aggregate of 424,000 shares of Common Stock. Options to purchase 380,000 shares are at an exercise price of $2.80 per share. The remaining options to purchase 44,000 shares are at an exercise price of $4.50 per share. None of the options is currently exercisable. The Company intends to file a registration statement under the Securities Act to register shares of Common Stock reserved for issuance under the Plan. See "Shares Eligible for Future Sale." 53 54 On August 8, and September 5, 1997, the Company granted options to purchase 14,000 and 30,000 shares, respectively, of Common Stock at an exercise price of $4.50 per share. There was no trading market for the Common Stock as of each respective date. For financial statement purposes, a fair market value for the Common Stock of $7.12 on August 8, 1997 and $9.00 on September 5, 1997 has been determined by the Board of Directors based on a straight line increase from $4.50 at July 1, 1997 to the public offering price of $9.00. Accordingly, the Company will record deferred compensation expense, based on the difference between the exercise price and the fair market value of the Common Stock on the date of grant, in the aggregate amount of $171,680. This amount, which was recorded as a reduction to shareholders' equity during the quarter ended September 30, 1997, will be recognized as compensation expense, on a straight line basis, over the vesting period of five years. 54 55 PRINCIPAL SHAREHOLDERS The following table sets forth certain information regarding the beneficial ownership of the Company's Common Stock (i) as of November 6, 1997 and (ii) as adjusted to reflect the sale of 5,000,000 shares of Common Stock offered by the Company in the Offering by (a) each person known by the Company to own beneficially more than 5% of the Company's Common Stock, (b) each director of the Company who beneficially owns Common Stock, (c) each of the persons named in the Summary Compensation Table who beneficially owns Common Stock and (d) all officers and directors of the Company as a group. Each named beneficial owner has sole voting and investment power with respect to the shares owned. PERCENT OF COMMON STOCK --------------------- COMMON STOCK BEFORE AFTER NAME AND ADDRESS BENEFICIALLY OWNED OFFERING OFFERING - ---------------------------------------------------------- ------------------ -------- -------- NovaCare, Inc............................................. 19,400,000 94.0% 75.7% 1016 West Ninth Avenue King of Prussia, PA 19406 Loren J. Hulber........................................... 375,000 1.8% 1.5% All Directors and Officers as a group (13 persons)........ 536,675 2.6% 2.1% 55 56 CERTAIN RELATED PARTY TRANSACTIONS The Company was founded as a subsidiary of the Parent. After the Offering, the Parent will own approximately 75.7% of the Common Stock of the Company. The Parent has loaned the Company approximately $28.4 million, of which $23.7 million will be repaid from a portion of the proceeds of the Offering. See "Use of Proceeds." In return for its efforts as the founder and its initial investment of $40,000, the Company issued 16,000,000 shares of the Company's Common Stock to a subsidiary of the Parent. In consideration of a license to use certain intellectual property, it subsequently received 2,200,000 shares of the Company's Common Stock. In consideration for the transfer of the assets of the Parent's temporary staffing business on July 1, 1997, the Parent received 1,200,000 shares of the Company's Common Stock. John H. Foster and Timothy E. Foster are each an officer and director, and E. Martin Gibson and Stephen E. O'Neil are directors, of the Parent. In February 1997, the Company entered into the NovaCare Contract under which the Parent's employees are co-employed by the Company for a five-year term, ending on January 31, 2002. Under the NovaCare Contract, the Company provides traditional PEO services such as payroll administration, worksite safety evaluation, employment-related risk management and compensation and benefits consultation required by the Parent for its employees, with the exception of 275 employees in the States of Washington and New Mexico. The annual revenue derived from the NovaCare Contract will vary based on the number of the Parent's employees covered by the agreement and the nature of the services provided. As of June 30, 1997, 15,072 of the Parent's employees were co-employed under the NovaCare Contract. The Company expects that revenue from the NovaCare Contract during the 12 months ending December 31, 1997 will be approximately $600 million. Under the NovaCare Contract, the Company currently receives a fee that equals the salary and federal payroll tax costs plus 9.7% of gross earnings of covered employees (a formula which generally results in the payment of approximately 117% of the gross earnings of such employees). See "Business -- Employee and Client Service," "Business -- Relationship with the Parent." See the Company's Consolidated Statement of Operations and Note 2 of Notes to the Company's Consolidated Statement for information regarding the contribution of the NovaCare Contract to the Company's revenue. The Parent has subleased office space to the Company on a pass-through basis in the Parent's offices in Norristown, Pennsylvania pursuant to a seven-year sublease under which the Company currently pays approximately $9,000 per month, subject to certain escalations. In addition, the Parent and the Company have entered into a management services agreement pursuant to which the Company is permitted to purchase access to the Parent's infrastructure at the Parent's out-of-pocket cost excluding depreciation and amortization. See "Business -- Operating Strategy -- Leveraging the Parent's Existing Infrastructure." The Company believes that the terms of the transactions with affiliated persons described above are no less favorable to the Company than the Company could have obtained from non-affiliated parties. DESCRIPTION OF CAPITAL STOCK The Company's authorized capital stock consists of 60,000,000 shares of Common Stock, par value $.01 per share (the "Common Stock"), and 1,000,000 shares of Preferred Stock, par value $.01 per share (the "Preferred Stock"). At November 6, 1997, there were 20,643,187 shares of Common Stock outstanding. The Company has not authorized the issuance of any shares of Preferred Stock. The following description of certain matters relating to the capital stock of the Company is a summary and is qualified in its entirety by the provisions of the Company's Certificate of Incorporation and By-Laws, copies of which have been filed as exhibits to the Registration Statement of which this Prospectus forms a part. COMMON STOCK At November 6, 1997, approximately 26 persons were holders of record of the 20,643,187 shares of Common Stock outstanding. Each holder of record of Common Stock is entitled to one vote for each outstanding share of Common Stock owned by such holder, and is not entitled to cumulative voting for the 56 57 election of directors and does not have preemptive rights. The issued and outstanding shares of Common Stock are, and all shares of Common Stock to be issued and to be sold in the Offering will be, validly issued, fully paid and nonassessable. All shares of Common Stock have equal rights and are entitled to receive ratably such dividends, if any, as the Board of Directors may declare from time to time out of funds legally available therefor. Upon liquidation of the Company, after payment or provision for payment of all of the Company's debts and obligations and payment in full of all amounts, if any, due to holders of Preferred Stock, the holders of the Common Stock will share ratably in the net assets, if any, available for distribution to holders of Common Stock upon liquidation. PREFERRED STOCK The Company is authorized to issue Preferred Stock with such designations, rights and preferences as may be determined from time to time by the Board of Directors. Accordingly, the Board of Directors is empowered, without stockholder approval, to issue Preferred Stock with dividend, liquidation, conversion, voting or other rights which could adversely affect the voting power or other rights of the holders of the Company's Common Stock. In the event of issuance, the Preferred Stock could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change in control of the Company. The Company has no present intention to issue any shares of its Preferred Stock. LIMITATIONS ON DIRECTOR AND OFFICER LIABILITY Article Sixth of the Certificate of Incorporation of the Company provides that the Company shall indemnify and hold harmless any director, officer, employee or agent of the Company from and against any and all expenses and liabilities that may be imposed upon or incurred by him in connection with, or as a result of, any proceeding in which he may become involved, as a party or otherwise, by reason of the fact that he is or was such a director, officer, employee or agent of the Company, whether or not he continues to be such at the time such expenses and liabilities shall have been imposed or incurred, to the extent permitted by the laws of the State of Delaware, as they may be amended from time to time. Article Eleventh of the Certificate of Incorporation of the Company contains a provision which eliminates the personal liability of a director of the Company to the Company or to any of its stockholders for monetary damages for a breach of his fiduciary duty as director, except in the case in which the director breaches his duty of loyalty, failed to act in good faith, engaged in intentional misconduct or knowingly violated a law, authorized a payment of a dividend or approved a stock repurchase in violation of the Delaware General Corporation Law, or obtained an improper personal benefit. The Company is subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law. In general, the statute prohibits a public Delaware corporation from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. A "business combination" includes a merger, asset sale and other transaction resulting in a financial benefit to the interested stockholder. An "interested stockholder" is a person who, together with affiliates and associates, owns (or within three years, did own) 15% or more of the corporation's voting stock. TRANSFER AGENT The transfer agent for the Common Stock will be The Bank of New York, New York, New York. 57 58 SHARES ELIGIBLE FOR FUTURE SALE Upon completion of the Offering, the Company will have 25,643,187 shares of Common Stock outstanding, of which 20,643,187 shares (approximately 81% of the shares to be outstanding) will be held by persons who acquired such shares in transactions in which such shares were not registered under the Securities Act. These shares may not be sold unless registered under the Securities Act or sold pursuant to an applicable exemption from registration, such as Rule 144 under the Securities Act ("Rule 144"). Rule 144, as currently in effect and subject to its provisions and other applicable federal and state securities laws, permits a person (or persons whose shares are aggregated) who has beneficially owned his or her shares for at least one year to sell within any three month period a number of shares that does not exceed the greater of 1% of the total number of outstanding shares of Common Stock or the average weekly trading volume during the four calendar weeks preceding the sale. Sales under Rule 144 are also subject to certain manner of sale provisions, notice requirements and the availability of current public information concerning the Company. Rule 144 also permits, under certain circumstances, such sales of shares without any quantity limitations or current public information requirements described above by a person who is not an affiliate of the Company and who has satisfied a two-year holding period. At any time after the consummation of the Offering, holders of an aggregate of 543,750 shares of the Common Stock may require the Company to register the shares of the Common Stock held by them with the Commission; provided, however, that no such registration is required if any firm or counsel representing the Company in connection with such registration shall advise the Company and such stockholders that in its opinion registration under the Securities Act is not necessary to permit the sale of such shares in the intended method of disposition. The Company, its officers and directors and substantially all other holders of Common Stock and securities convertible into or exercisable or exchangeable for Common Stock have agreed that during the Lockup Period, they will not, without the prior written consent of BancAmerica Robertson Stephens, offer, sell, contract to sell or otherwise dispose of Common Stock or any securities convertible into or exercisable or exchangeable for Common Stock except in certain limited circumstances. Upon the expiration of the Lockup Period, at least 19,380,937 of the shares to be outstanding (approximately 75.6% of such shares) will be eligible for sale under Rule 144, subject to compliance with Rule 144 volume limitations. Of the shares which will be eligible for sale under Rule 144 at such date, 287,008 shares are held by officers, directors and affiliates of the Company. See "Underwriting." The Company cannot predict the number of shares of Common Stock which may be sold in the future pursuant to Rule 144 since such sales will depend upon the market price of the Common Stock, the individual circumstances of holders thereof and other factors. Any sales of a substantial number of shares of Common Stock in the public market could have a significant adverse effect on the market price of the Common Stock. The Company intends to file a registration statement on Form S-8 under the Securities Act to register the 625,000 shares of Common Stock authorized and reserved for issuance pursuant to the Stock Option Plan. Upon the filing of such Form S-8, outstanding shares of Common Stock so registered may be freely sold without restriction, except for shares held by officers, directors and other affiliates of the Company. See "Management -- Executive Compensation -- Stock Option Plan." 58 59 UNDERWRITING The underwriters named below (the "Underwriters"), acting through their representatives, BancAmerica Robertson Stephens and Smith Barney Inc. (collectively, the "Representatives"), have severally agreed, subject to the terms and conditions of an underwriting agreement among the Company and the Underwriters (the "Underwriting Agreement"), to purchase the number of shares of Common Stock set forth opposite their respective names below. The Underwriters are committed to purchase and pay for all of such shares if any are purchased. NUMBER UNDERWRITER OF SHARES - ---------------------------------------------------------------------------------- ---------- BancAmerica Robertson Stephens.................................................... 1,950,000 Smith Barney Inc. ................................................................ 1,950,000 Hambrecht & Quist LLC............................................................. 225,000 Advest, Inc. ..................................................................... 175,000 Robert W. Baird & Co. Incorporated................................................ 175,000 Janney Montgomery Scott Inc. ..................................................... 175,000 Raymond James & Associates, Inc. ................................................. 175,000 The Robinson-Humphrey Company, LLC................................................ 175,000 --------- Total................................................................... 5,000,000 ========= The Representatives have advised the Company that they propose to offer the shares of Common Stock to the public at the offering price set forth on the cover page of this Prospectus and to certain dealers at such price less a concession of not in excess of $0.36 per share, of which $0.10 may be reallowed to other dealers. After the initial public offering, the public offering price, concession and reallowance to dealers may be reduced by the Representatives. No such reduction shall affect the amount of proceeds to be received by the Company as set forth on the cover page of this Prospectus. The Company has granted to the Underwriters an option, exercisable during the 30-day period after the date of this Prospectus, to purchase up to 750,000 additional shares of Common Stock at the same price per share as the Company will receive for the 5,000,000 shares that the Underwriters have agreed to purchase from the Company. To the extent that the Underwriters exercise such option, each of the Underwriters will have a firm commitment to purchase approximately the same percentage of such additional shares that the number of shares of Common Stock to be purchased by it shown in the above table represents as a percentage of the 5,000,000 shares offered hereby. If purchased, such additional shares will be sold by the Underwriters on the same terms as those on which the 5,000,000 shares are being sold. The Underwriting Agreement contains covenants of indemnity between the Underwriters and the Company against certain civil liabilities, including liabilities under the Securities Act. Pursuant to the terms of lock-up agreements, the holders of approximately 20,888,187 shares of the Common Stock have agreed with the Representatives that during the Lockup Period, subject to certain limited exceptions, they will not sell or otherwise dispose of shares of Common Stock, including shares issuable under options or warrants exercisable during the Lockup Period, any options or warrants to purchase shares of Common Stock or any securities convertible into or exchangeable for shares of Common Stock owned directly by such holders or with respect to which they have the power of disposition without the prior written consent of BancAmerica Robertson Stephens. The Underwriters do not intend to confirm sales of the Common Stock offered hereby to any accounts over which they exercise discretionary authority. Certain persons participating in this Offering may overallot or effect transactions which stabilize, maintain or otherwise affect the market price of the Common Stock at levels above those which might otherwise prevail in the open market, including by entering stabilizing bids or effecting syndicate covering 59 60 transactions. A stabilizing bid means the placing of any bid or effecting of any purchase, for the purpose of pegging, fixing or maintaining the price of the Common Stock. A syndicate covering transaction means the placing of any bid on behalf of the underwriting syndicate or the effecting of any purchase to reduce a short position created in connection with the Offering. Such transactions may be effected on The Nasdaq Stock Market, in the over-the-counter market, or otherwise. Such stabilizing, if commenced, may be discontinued at any time. Prior to the Offering, there has been no public market for the Common Stock. Consequently, the initial public offering price for the Common Stock was determined by negotiations between the Company and the Representatives. Among the factors considered in determining the initial public offering price were the history of, and the prospects for, the Company's business and the industry in which it competes, an assessment of the Company's management, its past and present operations, its past and present earnings and the trend of such earnings, the prospects for earnings of the Company, the present state of the Company's development, the general condition of the securities market at the time of the Offering and the market prices and earnings of similar securities of comparable companies at the time of the Offering. VALIDITY OF COMMON STOCK The validity of the Common Stock offered hereby will be passed upon for the Company by Haythe & Curley, 237 Park Avenue, New York, New York 10017, and for the Underwriters by Dewey Ballantine LLP, 1301 Avenue of the Americas, New York, New York 10019. EXPERTS The consolidated financial statements of the Company as of June 30, 1997 and for the period from October 1, 1996 (date of inception) to June 30, 1997 included in this Prospectus have been so included in reliance on the report of Price Waterhouse LLP, independent accountants, given on the authority of said firm as experts in auditing and accounting. The financial statements of Resource One as of December 31, 1994 and 1995 and September 30, 1996 and for the years ended December 31, 1994 and 1995 and the nine-month period ended September 30, 1996 included in this Prospectus have been so included in reliance on the report of Brewer, Beemer, Kuehnhackl & Koon, P.A., independent accountants, given on the authority of said firm as experts in auditing and accounting. The financial statements of ESA as of December 31, 1994, 1995 and 1996 and January 31, 1997, and for the years ended December 31, 1994, 1995 and 1996 and the one-month period ended January 31, 1997 included in this Prospectus have been so included in reliance on the report of Varnadore, Tyler, Hoffner, King, Hawthorne, Hammer & Stathis, P.A., independent accountants, given on the authority of said firm as experts in auditing and accounting. The financial statements of TPI and subsidiaries as of December 31, 1994, 1995 and 1996 and January 31, 1997 and for the years ended December 31, 1994, 1995 and 1996 and the one-month period ended January 31, 1997 included in this Prospectus have been so included in reliance on the report of Lazar, Levine & Company LLP, independent accountants, given on the authority of said firm as experts in auditing and accounting. 60 61 ADDITIONAL INFORMATION The Company has filed with the Securities and Exchange Commission, Washington, D.C. (the "Commission"), a Registration Statement on Form S-1 under the Securities Act with respect to the shares of Common Stock offered hereby (the "Registration Statement"). This Prospectus does not contain all of the information set forth in the Registration Statement and the exhibits and schedules thereto, certain items of which are omitted as permitted by the rules and regulations of the Commission. Statements contained in this Prospectus concerning the provisions of any documents filed with the Registration Statement as exhibits are necessarily summaries of such documents, and each such statement is qualified in its entirety by reference to the copy of the applicable document filed as an exhibit to the Registration Statement, although this Prospectus contains all information material to investors regarding the provisions of such document. For further information about the Company and the Common Stock offered hereby, reference is made to the Registration Statement and to the financial statements, schedules and exhibits filed as a part thereof. Upon completion of the Offering, the Company will be subject to the information requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith, will file reports and other information with the Commission. The Registration Statement, the exhibits and schedules forming a part thereof and the reports and other information filed by the Company with the Commission in accordance with the Exchange Act may be inspected without charge at the public reference facilities maintained by the Commission at Judiciary Plaza, 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549 and at its New York Regional Office located at Seven World Trade Center, New York, New York 10048 and its Chicago Regional Office located at 500 West Madison Street, Suite 1400, Chicago, Illinois 60661, copies of such documents can be obtained from the public reference section of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of the prescribed rates. In addition, the Commission maintains a Web site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission through the Electronic Data Gathering, Analysis and Retrieval System ("EDGAR"). The Registration Statement has been filed electronically through EDGAR and may be retrieved through the Commission's Web site on the Internet. The statements contained in this Prospectus concerning any contract or document are not necessarily complete; where such contract or other document is an exhibit to the Registration Statement, each such statement is qualified in all respects by the provisions of such exhibit. 61 62 INDEX TO FINANCIAL STATEMENTS PAGE ---- NovaCare Employee Services, Inc. and Subsidiaries Report of Independent Accountants................................................... F-3 Consolidated Balance Sheet and Pro Forma Unaudited Balance Sheet as of June 30, 1997............................................................................. F-4 Consolidated Statement of Operations for the period October 1, 1996 (inception) to June 30, 1997.................................................................... F-5 Consolidated Statement of Shareholders' Equity for the period October 1, 1996 (inception) to June 30, 1997..................................................... F-6 Consolidated Statement of Cash Flows for the period October 1, 1996 (inception) to June 30, 1997.................................................................... F-7 Notes to Consolidated Financial Statements.......................................... F-8 Unaudited Pro Forma Combined Financial Information Pro Forma Combined Financial Information............................................ F-19 Pro Forma Unaudited Combined Statement of Operations for the year ended June 30, 1997............................................................................. F-20 Notes to the Unaudited Pro Forma Combined Statement of Operations................... F-21 Unaudited Pro Forma Consolidated Balance Sheet as of June 30, 1997.................. F-23 Notes to the Unaudited Pro Forma Consolidated Balance Sheet......................... F-24 Resource One, Inc. Independent Auditors Report......................................................... F-25 Combined Balance Sheets as of December 31, 1994 and 1995 and September 30, 1996..... F-26 Combined Statements of Income for the two years in the period ended December 31, 1995 and the nine months ended September 30, 1996................................ F-27 Combined Statements of Changes in Stockholders' Equity for the two years in the period ended December 31, 1995 and the nine months ended September 30, 1996...... F-28 Combined Statements of Cash Flows for the two years in the period ended December 31, 1995 and the nine months ended September 30, 1996................................ F-29 Notes to Combined Financial Statements.............................................. F-30 Employee Services of America, Inc. and Subsidiaries Report of Independent Certified Public Accountants.................................. F-35 Combined Balance Sheet as of January 31, 1997....................................... F-36 Combined Statement of Income for the one month ended January 31, 1997............... F-37 Combined Statement of Shareholders' Equity for the one month ended January 31, 1997............................................................................. F-38 Combined Statement of Cash Flows for the one month ended January 31, 1997........... F-39 Notes to Combined Financial Statements.............................................. F-40 Report of Independent Certified Public Accountants.................................. F-45 Combined Balance Sheets as of December 31, 1994, 1995 and 1996...................... F-46 Combined Statements of Income for the three years in the period ended December 31, 1996............................................................................. F-47 Combined Statements of Shareholders' Equity for the three years in the period ended December 31, 1996................................................................ F-48 Combined Statements of Cash Flows for the three years in the period ended December 31, 1996......................................................................... F-49 Notes to Combined Financial Statements.............................................. F-50 F-1 63 PAGE ---- The TPI Group, Ltd. and Subsidiaries Independent Auditors' Report........................................................ F-56 Consolidated Balance Sheet as of January 31, 1997................................... F-57 Consolidated Statement of Operations for the one month period ended January 31, 1997............................................................................. F-58 Consolidated Statement of Stockholders' Equity for the one month period ended January 31, 1997................................................................. F-59 Consolidated Statement of Cash Flows for the one month period ended January 31, 1997............................................................................. F-60 Notes to Consolidated Financial Statements.......................................... F-61 Independent Auditors' Report........................................................ F-68 Consolidated Balance Sheets as of December 31, 1994, 1995 and 1996.................. F-69 Consolidated Statements of Operations for the three years in the period ended December 31, 1996................................................................ F-70 Consolidated Statements of Stockholders' Equity for the three years in the period ended December 31, 1996.......................................................... F-71 Consolidated Statements of Cash Flows for the three years in the period ended December 31, 1996................................................................ F-72 Notes to Consolidated Financial Statements.......................................... F-73 F-2 64 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of NovaCare Employee Services, Inc. In our opinion, the accompanying Consolidated Balance Sheet and the related Consolidated Statements of Operations, of Cash Flows and of Changes in Shareholders' Equity present fairly, in all material respects, the financial position of NovaCare Employee Services, Inc. and its subsidiaries (the "Company") at June 30, 1997, and the results of their operations and their cash flows for the period from October 1, 1996 (inception) to June 30, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. PRICE WATERHOUSE LLP Philadelphia, Pennsylvania July 31, 1997, except for Notes 1 and 13 as to which the date is November 10, 1997 F-3 65 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA) PRO FORMA JUNE 30, JUNE 30, 1997 1997 -------- ----------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents.......................................... $ 1,782 $ 1,782 Accounts receivable: Related party (Note 2).......................................... 27,607 27,607 Unbilled........................................................ 7,215 7,215 Third parties, net of allowance for doubtful accounts of $26.... 1,910 1,910 Deferred income taxes.............................................. 296 296 Other current assets............................................... 1,069 1,069 ------- ------- Total current assets....................................... 39,879 39,879 Property and equipment, net.......................................... 1,326 1,326 Excess cost of net assets acquired, net.............................. 53,691 53,691 Other assets, net.................................................... 1,102 1,102 ------- ------- $ 95,998 $95,998 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of financing arrangements.......................... $ 298 $ 298 Accounts payable and accrued expenses.............................. 6,172 6,172 Accrued salaries, wages and payroll taxes.......................... 28,159 28,159 Current portion of accrued workers' compensation and health claims.......................................................... 5,423 5,423 Note payable to related party (Note 2)............................. 28,382 28,382 Current portion of deferred purchase price obligations............. 18,905 18,905 Income taxes payable............................................... 1,382 1,382 ------- ------- Total current liabilities.................................. 88,721 88,721 Financing arrangements, net of current portion....................... 1,068 1,068 Accrued workers' compensation and health claims, net of current portion............................................................ 1,910 1,910 Deferred purchase price obligations, net of current portion.......... 856 856 Other................................................................ 411 411 ------- ------- Total liabilities.......................................... 92,966 92,966 ------- ------- Commitments and contingencies (Note 12).............................. -- -- Mandatorily redeemable common stock.................................. 2,731 -- Shareholders' equity: Preferred stock, $.01 par value; authorized 1,000 shares; no shares issued or outstanding........................................... -- -- Common stock, $.01 par value; authorized 60,000 shares, issued 19,193 shares (20,006 shares pro forma)......................... 192 200 Additional paid-in capital......................................... 1,189 3,912 Retained earnings.................................................. -- -- ------- ------- 1,381 4,112 Less: Common stock in treasury (at cost), 563 shares............... (1,080) (1,080) ------- ------- Total shareholders' equity................................. 301 3,032 ------- ------- $ 95,998 $95,998 ======= ======= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-4 66 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- Revenues: Related party (Note 2)..................................................... $ 255,289 Third parties.............................................................. 138,904 --------- Total revenues..................................................... 394,193 Direct costs: Related party (Note 2): Salaries, wages and employment taxes of worksite employees.............. 234,182 Health care and workers' compensation................................... 14,362 State unemployment taxes and other...................................... 1,006 Third parties: Salaries, wages and employment taxes of worksite employees.............. 123,056 Health care and workers' compensation................................... 8,199 State unemployment taxes and other...................................... 1,150 --------- Gross profit....................................................... 12,238 Selling, general and administrative expenses................................. 8,247 Provision for uncollectible accounts......................................... 26 Amortization of excess cost of net assets acquired........................... 1,034 --------- Income from operations............................................. 2,931 Investment income............................................................ 52 Interest expense............................................................. (56) Interest expense -- related party (Note 2)................................... (693) --------- Income before income taxes......................................... 2,234 Income taxes................................................................. 1,542 --------- Net income......................................................... $ 692 ========= Historical information: Net (loss) applicable to common stock...................................... $ (341) ========= Net (loss) per share....................................................... $ (.02) ========= Weighted average shares outstanding........................................ 20,574 ========= Unaudited pro forma information: Unaudited pro forma net income............................................. $ 692 ========= Unaudited pro forma net income per share................................... $ .03 ========= Unaudited pro forma weighted average shares outstanding.................... 20,574 ========= Unaudited supplemental pro forma information: Unaudited supplemental pro forma net income................................ $ 1,025 ========= Unaudited supplemental pro forma net income per share...................... $ .04 ========= Unaudited supplemental weighted average shares outstanding................. 25,574 ========= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-5 67 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (IN THOUSANDS) SHARES ISSUED COMMON ADDITIONAL ----------------- STOCK TREASURY PAID-IN RETAINED COMMON TREASURY ($.01 PAR VALUE) STOCK CAPITAL EARNINGS ------ -------- ---------------- -------- ---------- -------- Balance at October 1, 1996 (inception)................... -- -- $ -- $ -- $ -- $ -- Common stock issued to related party (Note 2)................ 6,200 -- 62 -- -- Common stock issued to employees..................... 430 -- 4 -- 870 -- Common stock split.............. 12,000 -- 120 -- (120) -- Repurchase of common stock...... 563 (563) 6 (1,080) 780 -- Accretion of mandatorily redeemable common stock....... -- -- -- -- (341) (692) Net income...................... -- -- -- -- -- 692 ------ ---- ---- ------- ------ ----- Balance at June 30, 1997........ 19,193 (563) $192 $(1,080) $1,189 $ -- ====== ==== ==== ======= ====== ===== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-6 68 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN THOUSANDS) OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income................................................................... $ 692 Adjustments to reconcile net income to net cash flows from operating activities: Depreciation and amortization.............................................. 1,285 Provision for uncollectible accounts....................................... 26 Deferred income taxes...................................................... 116 Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable -- third parties.................................... (2,293) Accounts receivable -- related party (Note 2)........................... (27,607) Other current assets.................................................... 114 Accounts payable and accrued expenses................................... (1,309) Accrued salaries, wages and payroll taxes............................... 22,865 Accrued interest -- related party (Note 2).............................. 693 Accrued workers' compensation and health claims......................... 4,113 Income taxes payable.................................................... 1,037 Other, net.............................................................. 164 ------- Net cash flows used in operating activities........................ (104) ------- CASH FLOWS FROM INVESTING ACTIVITIES: Payments for businesses acquired, net of cash acquired....................... (24,250) Additions to property and equipment.......................................... (329) Other, net................................................................... (387) ------- Net cash flows used in investing activities........................ (24,966) ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from financing arrangements with related party (Note 2)............. 27,689 Payment of long-term debt and credit arrangements............................ (94) Proceeds from common stock issued............................................ 914 Purchase of treasury stock................................................... (1,080) Other, net................................................................... (577) ------- Net cash flows provided by financing activities.................... 26,852 ------- Net increase in cash and cash equivalents.................................... 1,782 Cash and cash equivalents, beginning of year................................. -- ------- Cash and cash equivalents, end of year....................................... $ 1,782 ======= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-7 69 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1997 (DOLLARS IN THOUSANDS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations: NovaCare Employee Services, Inc. (the "Company") is a national professional employer organization ("PEO") that provides businesses with comprehensive, fully integrated outsourcing solutions to human resource issues, including payroll management, risk management, benefits administration, unemployment services, rehabilitation temporary staffing and human resource consulting services. The Company provides such services to small and medium-sized companies in a variety of industries. The Company operates primarily in Florida, Pennsylvania, New York and California with such states accounting for approximately 29%, 10%, 9%, and 6%, respectively, of the Company's 1997 revenues. Employee services are typically provided under a standard PEO services agreement which provides for an initial one year term; thereafter, the agreement is renewable periodically. The agreement is subject to termination without cause by the Company or the client at any time upon 30 days' prior written notice. The Company was established by NovaCare, Inc. (the "Parent") in September 1996 as a subsidiary and began operation in October 1996 with the acquisition of Resource One, Inc. ("Resource One"), a PEO based in Florida. In February 1997, the Company acquired three additional PEOs -- Employee Services of America, Inc. ("ESA") and Prostaff Human Resources, Inc. ("Prostaff") in Florida and The TPI Group, Ltd. ("TPI") in New York, and entered into a contract with the Parent to co-employ substantially all of the Parent's workforce (the "NovaCare Contract") (See Note 2). The Parent established the Company and entered into the NovaCare Contract primarily because (i) the Company provides a vehicle for the Parent to leverage its core competencies and investments in human resource management, information systems, relationship selling, workers' compensation risk management, outsourcing and management of a dispersed workforce, and (ii) by leveraging the investments already made in its core competencies, the Parent can increase the return to its shareholders from those investments. Principles of Consolidation: The Consolidated Financial Statements include the accounts of NovaCare Employee Services, Inc. and all wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Revenue Recognition: Revenues and the related costs of wages, salaries, and employment taxes pertaining to worksite employees are recognized in the period in which the employee performs the service. Because the Company is at risk for all of its direct costs, independently of whether payment is received from its clients, and consistent with industry practice, all amounts billed to clients for gross salaries and wages, related employment taxes, and health care and workers' compensation coverage are recognized as revenue by the Company. The Company establishes an allowance for doubtful accounts for both related and third party accounts receivable based on prior experience. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles 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. Cash and Cash Equivalents: The Company considers its holdings of highly liquid debt and money-market instruments to be cash equivalents if the securities mature within 90 days from the date of acquisition. These investments are carried at cost, which approximates fair value. Property and Equipment: Property and equipment are stated at cost. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which principally range from three to ten years. F-8 70 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Assets under capital leases and leasehold improvements are amortized over the lesser of the lease term or the asset's estimated useful life. Excess Cost of Net Assets Acquired: Assets and liabilities acquired in connection with business combinations accounted for under the purchase method are recorded at their respective fair values. Deferred taxes have been recorded to the extent of the difference between the fair value and the tax basis of the assets acquired and liabilities assumed. The excess of the purchase price over the fair value of net assets acquired, including the recognition of applicable deferred taxes, consists of non-compete agreements, customer lists, assembled workforce, and goodwill and is amortized on a straight-line basis over the estimated useful lives of the assets which range from five to 40 years. The Company will perform a periodic assessment of the recoverability of goodwill based on estimated future cash flows. Workers' Compensation: The Company is contractually obligated to provide workers' compensation coverage for its employees and co-employees. The Company accomplishes this through a combination of various commercial insurance policies and self insurance programs. The Company records estimated accruals for workers' compensation and health care claims, including estimates for incurred but not reported claims, based upon review of the claims activity and past experience. Management believes any differences which may arise between actual settlement of claims and reserves at June 30, 1997 would not have a material effect on the Company's financial position. On July 1, 1997, the Company entered into a three-year contract with a commercial insurance company for workers' compensation coverage. Under this program, the Parent's worksite employees will continue to be covered under a self insurance program. Other worksite employees will be covered under a fixed cost insurance program, which is subject to certain per incident and aggregate deductibles. Income Taxes: The Company records deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Historical, Unaudited Pro Forma and Unaudited Supplemental Pro Forma Net Income Per Share: Net income per share has been computed in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 83 ("SAB 83"). SAB 83 requires that common shares issued by the Company in the twelve months immediately preceding a proposed public offering plus the number of common equivalent shares which became issuable during the same period pursuant to the grant of stock options at prices substantially less than the initial public offering price be included in the calculation of common stock and common stock equivalent shares, using the treasury stock method, as if they were outstanding for all periods presented. Historical net income per share is computed by dividing net income, net of the accretion of mandatorily redeemable common stock (see Note 10), by the number of shares of common stock and common stock equivalents outstanding at September 5, 1997, the last date on which any common stock or common stock equivalent was issued. Unaudited pro forma net income per share is computed by dividing net income, without consideration to the accretion of mandatorily redeemable common stock, by the number of shares of common stock and common stock equivalents outstanding as of September 5, 1997. The Company intends to use a portion of the net proceeds from offering 5,000,000 shares of its common stock to retire certain indebtedness (see Note 13), and therefore has presented unaudited supplemental pro forma net income per common share in the accompanying financial statements. Unaudited supplemental net income per share is computed by dividing net income, adjusted for the elimination of applicable interest expense, net of related income tax effect, by total outstanding shares as of September 5, 1997 plus estimated additional shares required to be sold, at the public offering price on November 10, 1997, to retire outstanding debt. F-9 71 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The calculation of historical net income per share applicable to common stock, pro forma net income per share and supplemental pro forma net income per share is as follows: FOR THE PERIOD ENDED JUNE 30, 1997 ----------------------------------------- UNAUDITED UNAUDITED PRO SUPPLEMENTAL HISTORICAL FORMA PRO FORMA ---------- --------- ------------ Net income........................................ $ 692 $ 692 $ 692 ADJUSTMENT TO NET INCOME: Deduct -- Accretion of mandatorily redeemable common stock................................. (1,033) -- -- Add -- Elimination of interest, net of tax, upon assumed payment of debt...................... -- -- 333 ------ ------ ------ Net (loss) income attributable to common stock.... $ (341) $ 692 $1,025 ====== ====== ====== WEIGHTED AVERAGE SHARES OUTSTANDING(1): Shares issued during the period................. 18,576 18,576 18,576 Mandatorily redeemable common stock (Note 10)... 662 662 662 Issue of 1,200,000 shares for purchase of NovaPro (Note 13)............................ 750 750 750 Common equivalent -- guaranteed stock payments to be issued (Note 3)........................ 301 301 301 Common equivalent -- stock options (Note 11).... 285 285 285 Common equivalent -- debt retired............... -- -- 5,000 ------ ------ ------ Weighted average shares outstanding............. 20,574 20,574 25,574 ====== ====== ====== Net (loss) income per share..................... $ (.02) $ .03 $ .04 ====== ====== ====== - --------------- (1) Calculated using the treasury stock method, in accordance with SAB 83. Recently Issued Accounting Standards: In June 1996, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125") as amended by the December 1996 issuance of Statement of Financial Accounting Standards No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125" ("SFAS 127"). SFAS 125, as amended, provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The Company does not believe the adoption of SFAS 125, as amended, will have a material effect on the Company's financial position or results of operations. In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128") which the Company is required to adopt no later than the second quarter of fiscal year 1998. SFAS 128 establishes accounting standards for computing and presenting earnings per share by replacing the presentations of weighted shares outstanding, inclusive of common stock equivalents, with a dual presentation of basic earnings per share which excludes dilution ("earnings per share") and diluted earnings per share ("earnings per share-assuming dilution") which includes the dilutive effect of all potentially exercisable or convertible stock. Once adopted, SFAS 128 requires restatement of all prior period earnings per share data. 2. RELATED PARTY TRANSACTIONS In return for its efforts as the founder, its initial investment of $40 and the use of the Parent's trademark, the Company issued 18,200,000 shares (as adjusted for the common stock split -- see Note 9) of the common F-10 72 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) stock to the Parent. Given that the transactions were between companies under common control, the issuance of shares was recorded at the cost basis of the Parent. The excess of the consideration given to the Parent over the Parent's cost basis in the assets transferred was recorded as a reduction of additional paid-in capital, the same account credited upon issuance of the shares. Therefore, the transaction had no net effect on shareholders' equity. Effective October 1996, the Company entered into a line of credit agreement with the Parent which provides for an unspecified availability. Amounts borrowed are due upon the earlier of the initial public offering of the common stock of the Company or the termination date of the Parent's revolving credit agreement, which is currently November 1999. Interest is charged to the Company at the Parent's borrowing rate which is the EuroDollar rate plus a range of 0.5% to 1.125%. The weighted average borrowing rate over the period from October 1, 1996 to June 30, 1997 was 6.6%. The Parent has established an irrevocable letter of credit on behalf of the Company in the amount of $1,141 which expires on December 31, 1997. The letter has been established to meet the security requirements of the Company's workers' compensation policy held with a commercial insurance carrier at June 30, 1997. No amount is outstanding at June 30, 1997. In February 1997, the Parent and the Company entered into the NovaCare Contract, whereby the Parent's employees are co-employed by the Company in a five-year term with automatic annual renewals. Under the NovaCare Contract, the Company provides traditional PEO services such as payroll and benefits administration, worksite safety evaluation, employment-related risk management and benefits consultation. The Parent pays the Company a fee for its services currently equal to the salary and Federal payroll costs plus 9.7% of gross earnings of employees, or approximately 117% of the gross earnings of the employees covered by the NovaCare Contract. The Parent may not terminate the NovaCare Contract except in the event of: (i) the breach of any of the Company's agreements, duties, or performance standards under the NovaCare Contract; (ii) the making of false or misleading representations, warranties, or statements of material fact in documents submitted by or on behalf of the Company to the Parent; or (iii) the insolvency, bankruptcy, or receivership of the Company. The Parent has subleased office space to the Company. The sublease is a month-to-month arrangement, terminable on 30 days' notice by either party, under which the Company pays the Parent approximately $9 per month which equals the Parent's cost. The Parent also provides information systems consulting services and general administrative and financial services to the Company on an as-needed basis at the Parent's cost. During fiscal 1997 the Company reimbursed the Parent for certain expenses, in the amount of $160, based upon estimates of time incurred by the Parent's personnel on behalf of the Company. As described in Note 13 -- Subsequent Events, effective July 1, 1997 the Company acquired the assets and liabilities of NovaPro, a rehabilitation temporary staffing business of the Parent. The terms of the aforementioned related party transactions are equivalent to those that would result from transactions among unrelated parties. 3. ACQUISITIONS During the period from October 1, 1996 through June 30, 1997, the Company acquired four professional employer organizations located in the northeastern and southeastern portions of the United States. The following unaudited pro forma consolidated results of operations of the Company give effect to each of the acquisitions as if they occurred on October 1, 1996. F-11 73 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE PERIOD FROM OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 ------------------- Revenues.................................................. $ 476,929 Net loss.................................................. (2,346) Pro forma net loss per share.............................. $ (.11) The above pro forma information is not necessarily indicative of the results of operations that would have occurred had the acquisitions been made as of October 1, 1996, or the results that may occur in the future. Information with respect to businesses acquired in purchase transactions was as follows: AS OF JUNE 30, 1997 ------------- Goodwill....................................................... $46,440 Customer lists................................................. 5,488 Other.......................................................... 2,797 ------- Excess cost of net assets acquired........................... 54,725 Less: accumulated amortization............................... 1,034 ------- $53,691 ======= FOR THE PERIOD ENDED JUNE 30, 1997 ------------- Cash paid (net of cash acquired)............................. $24,250 Deferred purchase price obligations.......................... 19,948 Mandatorily redeemable common stock (Note 10)................ 2,452 Notes issued................................................. 1,328 Other consideration.......................................... 1,178 ------- 49,156 Liabilities assumed.......................................... 15,199 ------- 64,355 Fair value of assets acquired................................ 9,630 ------- Cost in excess of fair value of net assets acquired..... $54,725 ======= The acquisitions were accounted for using the purchase method of accounting. Accordingly, a portion of the purchase price was allocated to net assets acquired based on their estimated fair values. Net assets acquired consisted primarily of accounts receivable and property and equipment. The acquired accounts receivable were recorded at their estimated fair value on the date of acquisition with a discount from face value of $773 after consideration of the collectibility of outstanding receivables. Certain purchase agreements require additional payments if specific financial targets and non-financial conditions are met. Of the aggregate contingent amounts of $2,500 cash and 125,000 shares of common stock payable under these agreements, $400 cash and 25,000 shares of mandatorily redeemable common stock, valued at $70, have been accrued at June 30, 1997. The remaining contingent payments have not been included in the cost of businesses acquired because the amount of such contingent consideration, if any, is not presently determinable. During the period from October 1, 1996 (inception) through June 30, 1997, the Company paid $1,428 in cash and issued 85,000 shares of mandatorily redeemable common stock in connection with these agreements, valued at $238. F-12 74 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Deferred purchase obligations at June 30, 1997 of $19,761 represent $19,291 of guaranteed purchase price payments due to former owners and the $470 accrued for additional contingent payments. Of the $19,291 guaranteed purchase price payments, $17,500 is due upon the earlier of an initial public offering of the Company's common stock or December 31, 1997, and $900 in cash and 341,063 shares, valued at $891, is payable within two years of the date of acquisition. The $470 accrued for additional contingent payments, consisting of $400 in cash and 25,000 shares, valued at $70, has been accrued based on the expectation that the acquired company will meet its financial targets. These payments, if earned, will be due on March 31, 1998. The shares have been included in the computation of weighted average shares outstanding. 4. PROPERTY AND EQUIPMENT The components of property and equipment were as follows: AS OF JUNE 30, 1997 ------------- Land and buildings............................................. $ 70 Property, equipment and furniture.............................. 1,019 Leasehold improvements......................................... 162 Capitalized software........................................... 240 ------ 1,491 Less: accumulated depreciation and amortization................ 165 ------ $ 1,326 ====== Depreciation expense for the period from October 1, 1996 (inception) to June 30, 1997 was $165. 5. FINANCING ARRANGEMENTS Financing arrangements consisted of the following: AS OF JUNE 30, 1997 ------------- Subordinated promissory notes (6% to 10%), payable through 2002......................................................... $ 1,322 Capitalized lease obligations, payable through 2000............ 44 ------ 1,366 Less: current portion.......................................... 298 ------ $ 1,068 ====== At June 30, 1997, aggregate annual maturities of financing arrangements were as follows for the next five fiscal years and thereafter: FISCAL YEAR ------------------------------------------------------------ 1998........................................................ $ 298 1999........................................................ 306 2000........................................................ 311 2001........................................................ 290 2002........................................................ 136 Thereafter.................................................. 25 ------ $1,366 ====== F-13 75 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Interest paid on debt during the period October 1, 1996 through June 30, 1997 amounted to $49. 6. ACCRUED WORKERS' COMPENSATION AND HEALTH CLAIMS The Company's accruals for claims are summarized as follows: AS OF JUNE 30, 1997 ------------- Accrued health benefit premiums payable and claims reserves.... $ 3,756 Accrued workers' compensation premiums payable and claims reserves..................................................... 3,577 ------- 7,333 Less: workers' compensation claims expected to be settled in more than one year........................................... 1,910 ------- $ 5,423 ======= Under the NovaCare Contract as described in Note 2, the Company is self-insured for certain health benefits up to $150 per individual per year. The Company expensed amounts for estimated losses occurring from both asserted and unasserted claims. The estimate of the liability for unasserted claims arising from unreported incidents is based on an analysis of historical claims rates. The Parent has a defined contribution 401(k) plan in which certain of the Company's employees participate. Company contributions for the period from October 1, 1996 to June 30, 1997 related to those employees were $19. The Company established a non-qualified supplemental benefit plan covering certain key employees. The Company's matching contribution was $25 for the same period. 7. INCOME TAXES The components of income tax expense were as follows: PERIOD FROM OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- Current: Federal.................................................... $ 937 State...................................................... 470 ------ 1,407 ------ Deferred: Federal.................................................... 122 State...................................................... 13 ------ 135 ------ $ 1,542 ====== F-14 76 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The components of net deferred tax assets as of June 30, 1997 were as follows: AS OF JUNE 30, 1997 ------------- Net operating loss carryforward................................ $ 2,454 Accruals and reserves not currently deductible for tax purposes..................................................... 363 ---- Gross deferred tax assets...................................... 2,817 Valuation reserve.............................................. (2,454) ---- Total deferred tax assets...................................... 363 Expenses capitalized for financial statement purposes.......... (67) ---- Net deferred tax asset.................................... $ 296 ==== In fiscal 1997, the Company acquired net operating loss carryforwards of approximately $6,000 expiring through 2010. The Internal Revenue Code of 1986, as amended (the "Code"), places certain restrictions on the use of net operating loss carryforwards acquired through purchase transactions. Accordingly, the Company has placed a full valuation allowance against these amounts. The reconciliation of the expected tax expense (computed by applying the federal statutory tax rate to income before income taxes) to actual tax expense was as follows: PERIOD FROM OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- Expected Federal income tax expense.......................... $ 782 State income taxes, less Federal benefit..................... 470 Non-deductible amortization of excess cost of net assets acquired................................................... 349 Tax credits.................................................. (10) Other, net................................................... (49) ------ $ 1,542 ====== Income taxes paid during the period October 1, 1996 through June 30, 1997 amounted to $178. 8. OPERATING LEASES The Company rents office space and equipment under non-cancelable operating leases. Total rent expense charged to operations was $394 for the period from October 1, 1996 to June 30, 1997. Future minimum lease commitments for all non-cancelable leases as of June 30, 1997 are as follows: OPERATING FISCAL YEAR LEASES ---------------------------------------------------------- --------- 1998...................................................... $ 832 1999...................................................... 711 2000...................................................... 555 2001...................................................... 531 2002...................................................... 464 Thereafter................................................ 986 ------ Total minimum lease payments.............................. $ 4,079 ====== F-15 77 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. SHAREHOLDERS' EQUITY On September 16, 1996, the Board of Directors authorized 1,000,000 shares of preferred stock with a par value of $.01 per share. No shares are issued and outstanding as of June 30, 1997, nor were there shares issued and outstanding at any time during the period from inception to June 30, 1997. During the period from October 1, 1996 through June 30, 1997, five employees purchased 430,000 shares of the Company's common stock. The Chief Executive Officer of the Company purchased 375,000 shares of the Company's common stock on January 10, 1997 at the fair market value of $1.92 per share. The other shares were purchased on various dates from February 28, 1997 through June 10, 1997 at the fair market value of $2.80 per share. On January 2, 1997, the Board of Directors declared a four-for-one stock split of the Company's common stock to shareholders of record on January 2, 1997. Accordingly, $126 was transferred from additional paid-in capital to common stock, representing the par value of additional shares issued. On January 2, 1997, the Company repurchased 562,500 shares of mandatorily redeemable common stock from a former owner of an acquired business. Upon repurchase, the mandatorily redeemable common stock becomes a component of permanent equity. Accordingly, the 562,500 shares and the related par value and additional paid-in capital associated with these shares have been reflected in the accompanying consolidated statement of shareholders' equity. 10. MANDATORILY REDEEMABLE COMMON STOCK In connection with the acquisitions described in Note 3, 1,375,687 shares (as adjusted for the stock split -- see Note 9) of common stock were issued subject to an agreement which provides certain registration rights with respect to the common stock, as well as the right, two years from the date of acquisition, to put the shares to the Company at a price of $16.00 per share. The put option is rendered inoperative if the Company files an initial public offering of the Company's common stock prior to two years from the date of acquisition and, in one case, the Company is publicly trading on December 31, 1998. Of the 1,375,687 shares, 750,000 (as adjusted for the stock split), 375,000 and 154,687 were issued, as of the date of acquisition, to the selling shareholders of Resource One, ESA and TPI, respectively, at the fair market value per share of $1.20 (as adjusted for the stock split) for Resource One and $2.48 for ESA and TPI. Subsequent to the date of acquisition, contingent and non-contingent payments of 41,250, 43,750, and 11,000 shares were issued with respect to the Resource One, ESA and Prostaff acquisitions, respectively, at the fair market value of $2.80 per share. The mandatorily redeemable common stock was recorded at the fair value at the date of issuance. The excess of the put price over the carrying value is being accreted by periodic charges to retained earnings or additional paid-in capital, as applicable, over a two year period. As of June 30, 1997, 813,187 shares of mandatorily redeemable common stock are outstanding. During the period from October 1, 1996 to June 30, 1997, the Company recorded $1,033 of accretion to retained earnings and additional paid-in capital. 11. BENEFIT PLANS Stock Option Plan: On February 28, 1997, the Company's Board of Directors adopted and its shareholders approved the Company's 1997 Stock Option Plan (the "Plan") under which 625,000 shares of common stock are currently reserved for issuance upon the exercise of stock options. Under the Plan, substantially all options are granted for a term of up to 10 years at prices equal to the fair value at the date of grant. Options granted generally are exerciseable at the rate of 20% per year, on a cumulative basis, commencing one year after the date of grant. At June 30, 1997, the weighted average remaining contractual life of the outstanding options was 9.67 years. F-16 78 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following summarizes the activity of this stock option plan: PERIOD FROM OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- Options: Granted.................................................... 375,000 Canceled................................................... (4,000) -------- Outstanding at end of year................................. 371,000 ======== Option price per share ranges: Granted.................................................... $2.80 Outstanding at end of year................................. $2.80 Options exercisable at end of year........................... -- Options available for grant at end of year under the 1997 Stock Option Plan.......................................... 254,000 The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), and applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for the plan. The table below sets forth the pro forma information as if the Company had adopted the compensation recognition provisions of SFAS 123: OCTOBER 1, 1996 (INCEPTION) TO JUNE 30, 1997 --------------- Increase to: Net income................................................. $13 Net income per share....................................... -- Assumptions: Expected life (years)...................................... 4.6 - 6.6 Risk-free interest rate.................................... 6.1% - 6.5% Volatility................................................. 0% Dividend yield............................................. N/A The compensation recognition was calculated assuming a fair market value for the Company's common stock equal to the assumed share value as of the date of the initial public offering. Certain options were grouped together for purposes of valuation based upon vesting periods and the date of grant. The weighted average fair value of the stock options, calculated using the Black-Scholes option pricing model, granted during the period ended June 30, 1997 was $0.82. 12. COMMITMENTS AND CONTINGENCIES The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on the financial position or results of operations of the Company. The Company's employer and health care operations are subject to numerous Federal, state and local laws related to employment, taxes and benefit plan matters. Generally, these regulations affect all companies in the United States. However, the regulatory environment for professional employer organizations is an evolving area due to uncertainties resulting from the non-traditional employment relationships. Many Federal F-17 79 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and state laws relating to tax and employment matters were enacted prior to the development of PEO companies and do not specifically address the obligations and responsibilities of these co-employer relationships. If the IRS concludes that PEOs are not "employers" of certain worksite employees for purposes of the Code, the Company's cafeteria plan may lose its favorable tax status, and the Company may no longer be able to assume its clients' Federal employment tax withholding obligations. 13. SUBSEQUENT EVENTS Effective July 1, 1997, the Company issued 1,200,000 shares of its common stock, valued at $5,400, to acquire the assets and liabilities of NovaPro, formerly a business of the Parent (see Note 2), in a transaction accounted for as a purchase. Given that the transaction is between companies under common control, the transfer of assets and liabilities will be recorded at the historical cost basis of the Parent. The excess paid over the historical cost will be treated as a reduction of additional paid-in capital. The following unaudited pro forma consolidated results of operations of the Company give effect to the purchase of NovaPro as if it had occurred as of the inception of the Company: FOR THE PERIOD FROM: ------------------------------------------------------ OCTOBER 1, JANUARY 1, APRIL 1, TO TO TO DECEMBER 31, 1996 MARCH 31, 1997 JUNE 30, 1997 ----------------- -------------- ------------- Revenue..................... $11,347 $151,727 $ 233,112 Gross profit................ 671 4,979 7,413 Operating (loss) income..... (137) 1,148 2,063 Net (loss) income........... $ (128) $ 263 $ 619 The Company has filed a registration statement with the Securities and Exchange Commission to register the sale of up to 5,000,000 shares of its common stock. The Company intends to use the net proceeds of the offering to retire certain outstanding indebtedness as follows: (i) to satisfy $17,500 of deferred purchase price obligations incurred in connection with the Company's acquisitions (see Note 3) and (ii) to repay $23,707 borrowed under the Company's line of credit from the Parent (see Note 2). 14. PRO FORMA BALANCE SHEET (UNAUDITED) The pro forma balance sheet as of June 30, 1997 represents the pro forma effect of the conversion of the Company's mandatorily redeemable common stock into 813,187 shares of common stock as of that date. As disclosed in Note 10, the mandatorily redeemable common stock is automatically convertible in the event of an initial public offering of the Company's common stock. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) For the period from October 1, 1996 (inception) to June 30, 1997: OCTOBER 1, 1996 JANUARY 1, 1997 APRIL 1, 1997 TO TO TO DECEMBER 31, 1996 MARCH 31, 1997 JUNE 30, 1997 ----------------- --------------- ------------- Revenues.................... $10,894 $ 151,076 $ 232,223 Gross profit................ 842 4,728 6,668 Income from operations...... 154 1,073 1,704 Net income.................. $ 61 $ 220 $ 411 F-18 80 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES PRO FORMA COMBINED FINANCIAL INFORMATION (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) The following unaudited pro forma Combined Statement of Operations for the year ended June 30, 1997 and unaudited pro forma Consolidated Balance Sheet as of June 30, 1997 are based on the historical consolidated financial statements of NovaCare Employee Services, Inc. (the "Company") for the period from October 1, 1996 (commencement of operations) to June 30, 1997, adjusted to give effect to the acquisition of Resource One, Inc. ("Resource One") (the predecessor company), Employee Services of America, Inc., ("ESA"), The TPI Group, Ltd. ("TPI"), Prostaff Human Resources, Inc. ("Prostaff ") and NovaPro. Resource One, ESA, TPI and Prostaff were acquired prior to June 30, 1997 and are included in the historical results of operations from their respective dates of acquisition. Effective July 1, 1997, the Company issued 1,200 shares of its common stock to acquire the assets and liabilities of NovaPro, a NovaCare, Inc. (the "Parent") business (see Note 13 of Notes to the Company's Consolidated Financial Statements contained elsewhere in this Prospectus). The historical financial information is also adjusted to give effect to the full year impact of the contract between the Company and the Parent (the "NovaCare Contract") (further described in Note 2 of Notes to the Company's Consolidated Financial Statements contained elsewhere in this Prospectus). The application of a portion of the proceeds of this Offering is assumed to pay certain debt which reduced pro forma as adjusted interest expense. The Pro Forma Combined Statement of Operations has been prepared assuming the above acquisitions, the NovaCare Contract and the Offering occurred as of July 1, 1996. The Pro Forma Combined Balance Sheet has been prepared assuming that the NovaPro acquisition and the Offering had occurred as of June 30, 1997. Adjustments related to the NovaPro acquisition and the Offering are described in the notes thereto. The financial information is based on certain assumptions and estimates that management believes are reasonable in the circumstances and does not purport to be indicative of the results which actually would have been attained had the above transactions occurred as of the dates indicated, or to project the Company's results of operations or financial position for any future period or date. This information should be read in conjunction with the Company's consolidated financial statements and related notes included elsewhere in this Prospectus. F-19 81 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES PRO FORMA COMBINED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) HISTORICAL PRO FORMA RESULTS HISTORICAL HISTORICAL COMBINED FOR THE RESULTS OF RESULTS OF RESULTS PERIOD ACQUIRED NOVAPRO FOR FOR THE OCTOBER 1, COMPANIES THE PERIOD PERIOD 1996 FROM FROM FROM (INCEPTION) JULY 1, 1996 JULY 1, 1996 JULY 1, TO TO TO 1996 TO JUNE 30, THE DATE OF JUNE 30, PRO FORMA JUNE 30, 1997 ACQUISITION(1) 1997(2) ADJUSTMENTS 1997 ----------- -------------- ------------- ----------- --------- Revenues: Related party....................... $ 255,289 $ -- $ -- $ -- $255,289 Third parties....................... 138,904 149,885 7,624 -- 296,413 --------- -------- ------- ------- -------- Total revenues.................... 394,193 149,885 7,624 -- 551,702 Direct costs: Related Party: Salaries, wages and employment taxes of worksite employees..... 234,182 -- -- -- 234,182 Health care and workers' compensation, state unemployment taxes and other................. 15,368 -- -- -- 15,368 Third Parties: Salaries, wages and employment taxes of worksite employees..... 123,056 134,921 -- -- 257,977 Health care and workers' compensation, state unemployment taxes and other................. 9,349 8,888 6,886 -- 25,123 --------- -------- ------- ------- -------- Gross profit...................... 12,238 6,076 738 -- 19,052 Selling, general and administrative expenses............................ 8,247 7,827 827 1,212(4) 18,113 Provision for uncollectible accounts............................ 26 273 35 -- 334 Amortization of excess cost of net assets acquired..................... 1,034 -- -- 1,234(5) 2,268 --------- -------- ------- ------- -------- Income (loss) from operations..... 2,931 (2,024) (124) (2,446) (1,663) Investment income.................... 52 20 -- -- 72 Interest expense..................... (56) (774) -- 740(6) (90) Interest expense-related party....... (693) -- -- (916)(7) (1,609) --------- -------- ------- ------- -------- Income (loss) before income taxes........................... 2,234 (2,778) (124) (2,622) (3,290) Income taxes......................... 1,542 (376) -- (1,525)(9) (359) --------- -------- ------- ------- -------- Net income (loss)................. $ 692 $ (2,402) $ (124) $(1,097) $ (2,931) ========= ======== ======= ======= ======== Net (loss) attributable to common stock........................... $ (341) ========= Net (loss) per share.............. $ (.02) ========= Unaudited pro forma net income (loss) per share(11)............ $ .03 $ (.14) ========= ======== Unaudited pro forma weighted average number of shares........ 20,574 20,574 ========= ======== NOVACARE PRO FORMA CONTRACT COMBINED PRO FORMA PRO FORMA FROM RESULTS ADJUSTMENTS COMBINED JULY 1, 1996 TO INCLUDING THE RELATING TO RESULTS JANUARY 31, NOVACARE THE INCLUDING THE 1997(3) CONTRACT OFFERING OFFERING ---------------- -------------- ----------- ------------- < Revenues: Related party....................... $326,395 $581,684 $ -- $ 581,684 Third parties....................... -- 296,413 -- 296,413 -------- -------- ------- --------- Total revenues.................... 326,395 878,097 -- 878,097 Direct costs: Related Party: Salaries, wages and employment taxes of worksite employees..... 298,610 532,792 -- 532,792 Health care and workers' compensation, state unemployment taxes and other................. 22,334 37,702 -- 37,702 Third Parties: Salaries, wages and employment taxes of worksite employees..... -- 257,977 -- 257,977 Health care and workers' compensation, state unemployment taxes and other................. -- 25,123 -- 25,123 -------- -------- ------- --------- Gross profit...................... 5,451 24,503 -- 24,503 Selling, general and administrative expenses............................ 2,848 20,961 -- 20,961 Provision for uncollectible accounts............................ -- 334 -- 334 Amortization of excess cost of net assets acquired..................... -- 2,268 -- 2,268 -------- -------- ------- --------- Income (loss) from operations..... 2,603 940 -- 940 Investment income.................... -- 72 -- 72 Interest expense..................... -- (90) -- (90) Interest expense-related party....... -- (1,609) 1,300(8) (309) -------- -------- ------- --------- Income (loss) before income taxes........................... 2,603 (687) 1,300 613 Income taxes......................... 1,093 734 510(10) 1,244 -------- -------- ------- --------- Net income (loss)................. $ 1,510 $ (1,421) $ 790 $ (631) ======== ======== ======= ========= Net (loss) attributable to common stock........................... Net (loss) per share.............. Unaudited pro forma net income (loss) per share(11)............ $ (.07) $ (.02) ======== ========= Unaudited pro forma weighted average number of shares........ 25,574 25,574(12) ======== ========= F-20 82 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO THE PRO FORMA COMBINED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) (1) The Acquired Companies adjustments represent the historical results of operations of Resource One, ESA, TPI and Prostaff (collectively, the "Acquired Companies") from July 1, 1996 to their respective dates of acquisition, as noted below. Each of the acquisitions has been accounted for as a purchase. Accordingly, the results of operations of each of the Acquired Companies are included in the historical results of operations of the Company since the date of acquisition. FOR THE PERIOD FROM JULY 1, 1996 TO THE DATE OF ACQUISITION ------------------------------------------------------------------------ SELLING, GENERAL PROVISION FOR INCOME (LOSS) DIRECT AND ADMINISTRATIVE UNCOLLECTIBLE BEFORE INCOME COMPANY ACQUIRED AS OF REVENUE COSTS EXPENSES ACCOUNTS TAXES ------------------- ----------------- -------- -------- ------------------ ------------- ------------- Resource One....... October 1, 1996 $ 9,068 $ 8,438 $ 587 $ -- $ 43 ESA................ February 1, 1997 87,046 83,131 3,816 -- 67 TPI................ February 1, 1997 51,206 49,772 3,278 273 (2,840) Prostaff........... February 1, 1997 2,565 2,468 146 -- (48) -------- -------- ------ ---- ------- Total..... $149,885 $143,809 $7,827 $ 273 $(2,778) ======== ======== ====== ==== ======= The income tax effect of the Acquired Companies adjustments is considered in Note 9 below. (2) Effective July 1, 1997, the Company acquired the assets and liabilities of NovaPro in a purchase transaction, as described in Note 13 of Notes to the Company's Consolidated Financial Statements. The adjustments represent the historical results of operations of NovaPro from July 1, 1996 to June 30, 1997. (3) In February 1997, the Parent and the Company entered into the NovaCare Contract whereby the Parent's employees are co-employed by the Company for a five-year term with automatic annual renewals. Under the NovaCare Contract, the Company provides traditional PEO services such as payroll and benefits administration, worksite safety evaluation, employment-related risk management and benefits consultation. The Parent pays the Company a fee for its services currently equal to the salary and federal payroll tax costs plus 9.7% of gross earnings of employees, or approximately 117% of the gross earnings of the employees covered by the NovaCare Contract. The Parent may not terminate the NovaCare Contract except in the event of: (i) the breach of any of the Company's agreements, duties or performance standards under the NovaCare Contract; (ii) the making of false or misleading representations, warranties, or statements of material fact in documents submitted by or on behalf of the Company to the Parent; or (iii) the insolvency, bankruptcy, or receivership of the Company. The NovaCare Contract adjustment for the year ended June 30, 1997 reflects the pro forma results of operations related to the NovaCare Contract from July 1, 1996 to January 31, 1997. Results of operations from the NovaCare Contract for the period from February 1, 1997 to June 30, 1997 are included in the historical results. (4) Includes adjustments representing net increases in selling, general, and administrative expenses in support of the combined businesses. EXPENSE EXPENSE CATEGORY AMOUNT ------------------------------------------------------------------------------ ------ Salaries, wages and benefits.................................................. $ 736 Rental lease agreements....................................................... 180 Other......................................................................... 296 ------ Selling, general and administrative expenses adjustment............. $1,212 ====== F-21 83 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO THE PRO FORMA COMBINED STATEMENT OF OPERATIONS -- (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) (5) Reflects additional amortization of the excess of the purchase price over the fair value of net assets acquired. The additional amortization consists of non-compete agreements, customer lists, assembled workforce, and goodwill, amortized on a straight-line basis over the estimated useful lives of the assets which range from five to 40 years, as if the businesses were acquired as of July 1, 1996. (6) Represents the reduction of expense assuming that late payment penalties and interest due to the Internal Revenue Service for late payment of federal withholding taxes incurred by a subsidiary would not have been incurred given the Company's availability of financing from the Parent, as described in Note 7 below. An additional $53 of interest expense has been recorded to reflect the borrowing from the Parent for the timely payment of the federal withholding taxes. (7) Represents interest due to the Parent (See Note 2 of Notes to the Company's Consolidated Financial Statements) for money borrowed by the Company to finance the acquisition of the Acquired Companies. The Company entered into a loan agreement where the Parent charges interest to the Company at the EuroDollar rate plus 0.5% to 1.125%. The weighted average interest rate was 6.6%. (8) Represents the reduction of interest expense resulting from the use of a portion of the net proceeds to pay certain indebtedness to the Parent (see Note 2 of Notes to the Company's Consolidated Financial Statements). (9) Represents an adjustment to income taxes to reflect the state and federal income tax liability which would have been provided on pro forma adjusted income before income taxes for the period from July 1, 1996 to June 30, 1997. State taxes were computed on a legal entity basis dependent upon the income subject to income tax for the same period at an effective rate of 6% to 8%. Federal income tax (34% rate) was computed on consolidated income before income taxes adjusting for the non-deductible portion of the amortization of excess cost of net assets acquired. (10) Represents an adjustment to state and federal income taxes which would have been provided on the reduction of interest expense discussed in Note 8 above. (11) As described in Note 1 of Notes to the Company's Consolidated Financial Statements -- "Historical Unaudited Pro Forma and Unaudited Supplemental Pro Forma Net Income Per Common Share", unaudited pro forma net income per share has been computed by dividing net income (loss) by the number of shares of common stock and common stock equivalents outstanding as of September 5, 1997. (12) The Company intends to use a portion of the net proceeds from the Offering to retire certain indebtedness (see Note 13 of Notes to the Company's Consolidated Financial Statements). Unaudited pro forma net income per share as adjusted is computed by dividing net income, adjusted for the elimination of applicable interest expense, net of the related income tax effect, by total outstanding shares as of September 5, 1997 plus the shares to be issued in the Offering to retire outstanding debt. F-22 84 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES PRO FORMA COMBINED BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) HISTORICAL ------------- THE PRO FORMA COMPANY THE COMPANY OFFERING AS OF PRO FORMA AS OF PRO FORMA PRO FORMA JUNE 30, 1997 NOVAPRO(1) ADJUSTMENTS(2) JUNE 30, 1997 ADJUSTMENTS AS ADJUSTED ------------- ---------- -------------- --------------- -------------- ----------- ASSETS Current assets: Cash and cash equivalents.... $ 1,782 $ 20 $ -- $ 1,802 $ -- $ 1,802 Accounts receivable: Related party.............. 27,607 -- -- 27,607 -- 27,607 Unbilled................... 7,215 -- -- 7,215 -- 7,215 Third parties, net of allowance for doubtful accounts of $26.......... 1,910 1,626 -- 3,536 -- 3,536 Deferred income taxes........ 296 -- -- 296 -- 296 Other current assets......... 1,069 144 -- 1,213 -- 1,213 ------- ------ ------ ------- -------- --------- Total current assets....... 39,879 1,790 -- 41,669 -- 41,669 Property and equipment, net.... 1,326 449 -- 1,775 -- 1,775 Excess cost of net assets acquired, net................ 53,691 -- -- 53,691 -- 53,691 Other assets, net.............. 1,102 93 -- 1,195 (577)(3) 618 ------- ------ ------ ------- -------- --------- $95,998 $ 2,332 $ -- $98,330 $ (577) $ 97,753 ======= ====== ====== ======= ======== ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of financing arrangements............... $ 298 $ -- $ -- $ 298 $ -- $ 298 Accounts payable and accrued expenses................... 6,172 2,457 -- 8,629 -- 8,629 Accrued salaries, wages and payroll taxes.............. 28,159 -- -- 28,159 -- 28,159 Current portion of accrued workers' compensation and health claims.............. 5,423 -- -- 5,423 -- 5,423 Note payable to related party...................... 28,382 -- -- 28,382 (23,707)(4) 4,675 Current portion of deferred purchase price obligations................ 18,905 -- -- 18,905 (17,500)(4) 1,405 Income taxes payable......... 1,382 -- -- 1,382 -- 1,382 ------- ------ ------ ------- -------- --------- Total current liabilities.............. 88,721 2,457 -- 91,178 (41,207) 49,971 Financing arrangements, net of current portion.............. 1,068 -- -- 1,068 -- 1,068 Accrued workers' compensation and health claims, net of current portion.............. 1,910 -- -- 1,910 -- 1,910 Deferred purchase price obligations, net of current portion...................... 856 -- -- 856 -- 856 Other.......................... 411 -- -- 411 -- 411 ------- ------ ------ ------- -------- --------- Total liabilities.......... 92,966 2,457 -- 95,423 (41,207) 54,216 ------- ------ ------ ------- -------- --------- Commitments and contingencies................ -- -- -- -- -- -- Mandatorily redeemable common stock........................ 2,731 -- -- 2,731 (2,731)(5) -- Shareholders' equity: Preferred Stock, $.01 par value; authorized 1,000 shares; no shares issued or outstanding................ -- -- -- -- -- -- Common stock, $.01 par value; authorized 60,000 shares, issued 19,193 shares as of June 30, 1997 (issued 20,393 shares after effect of acquisition of NovaPro and 26,206 shares after effect of the Offering).... 192 -- 12 204 58(6) 262 Additional paid-in capital... 1,189 -- (137) 1,052 43,303(6) 44,355 Retained earnings............ -- (125) 125 -- -- -- ------- ------ ------ ------- -------- --------- 1,381 (125) -- 1,256 43,361 44,617 Less: common stock in treasury (at cost), 563 shares................... (1,080) -- -- (1,080) -- (1,080) ------- ------ ------ ------- -------- --------- Total shareholders' equity................... 301 (125) -- 176 43,361 43,537 ------- ------ ------ ------- -------- --------- $95,998 $ 2,332 $ -- $98,330 $ (577) $ 97,753 ======= ====== ====== ======= ======== ========= F-23 85 NOVACARE EMPLOYEE SERVICES, INC. AND SUBSIDIARIES NOTES TO THE PRO FORMA COMBINED BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) (1) Represents the historical balance sheet of NovaPro as of June 30, 1997. See Note 2 for further information. (2) As described in Note 13 of Notes to the Company's Consolidated Financial Statements, the Company issued 1,200 shares of its common stock to acquire the assets and liabilities of NovaPro, in a transaction accounted for as a purchase effective July 1, 1997. Given that the transaction is between companies under common control, the transfer of net assets has been recorded at the historical cost basis of the Parent. The excess paid over the historical cost has been treated as a reduction of additional paid-in capital. (3) The adjustment to other assets, net represents the reclassification of certain costs, previously incurred related to the Offering of the Company's common stock, to additional paid-in capital. (4) The adjustment to deferred purchase price obligations and the note payable to shareholder reflects the retirement of certain liabilities by applying the estimated net proceeds of the Offering in the order described under "Use of Proceeds," as if the Offering had occurred at June 30, 1997. The remaining deferred purchase price obligations relate to guaranteed payments due at specified dates subsequent to the Offering. Shares offered in the Offering (5,000,000 shares at $9.00 public offering price)................ $45,000 Less: Offering costs incurred to date.................................. (577) Additional costs estimated....................................... (3,793) ------- Net proceeds............................................. 40,630 Payment of deferred purchase price obligations................... (17,500) Plus: Offering costs incurred to date............................ 577 ------- Cash used to reduce note payable to shareholder.......... $23,707 ======= (5) The adjustment to mandatorily redeemable common stock (i.e. temporary equity) reflects the conversion of the 813 shares of mandatorily redeemable common stock to permanent equity. (6) The adjustment to common stock and additional paid-in capital is as follows: ADDITIONAL COMMON STOCK PAID-IN CAPITAL ------------ --------------- Estimated shares issued in the Offering (as described in Note 4)................ $ 50 $40,580 Conversion of mandatorily redeemable common stock (as described in Note 5)... 8 2,723 ---- ------- Adjustment ............................. $ 58 $43,303 ==== ======= F-24 86 INDEPENDENT AUDITOR'S REPORT To the Stockholders of Resource One, Inc. We have audited the accompanying combined balance sheets of Resource One, Inc. as of September 30, 1996 and December 31, 1995 and 1994 and the related combined statements of income, changes in stockholders' equity and cash flows for the nine months and years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of Resource One, Inc. as of September 30, 1996 and December 31, 1995 and 1994, and the results of its operations and its cash flows for the nine months and years then ended in conformity with generally accepted accounting principles. Brewer, Beemer, Kuehnhackl & Koon, P.A. Orlando, FL April 4, 1997 F-25 87 RESOURCE ONE, INC. COMBINED BALANCE SHEETS (SEE NOTE 1) DECEMBER 31, SEPTEMBER 30, ------------------------- ------------- 1994 1995 1996 ---------- ---------- ------------- ASSETS Current assets: Cash and cash equivalents.......................... $ 281,585 $ 362,106 $ 194,489 Receivables, net: Trade, net of allowance for doubtful accounts of $2,586 in 1994................................ 54,375 46,624 86,721 Accrued leased employee revenue receivable...... 353,074 447,552 817,356 Claims administration fees receivable........... 123,725 121,671 147,406 Administration fees receivable.................. -- -- 32,999 Insurance commissions receivable................ 8,320 7,995 15,673 Deferred income taxes.............................. -- -- 2,347 Other current assets............................... -- -- 23,350 ---------- ---------- ---------- Total current assets....................... 821,079 985,948 1,320,341 Property and equipment, net.......................... 166,009 148,423 149,469 Other assets......................................... 18,432 107,090 73,956 ---------- ---------- ---------- Total assets......................................... $1,005,520 $1,241,461 $ 1,543,766 ========== ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of notes payable................... $ 94,529 $ 70,233 $ -- Accounts payable and accrued expenses.............. 53,287 13,524 99,607 Accrued leased employee costs and expenses payable......................................... 404,962 593,570 946,424 Amounts owed to customer........................... -- 47,534 36,410 Income taxes payable............................... 38,525 23,023 4,273 ---------- ---------- ---------- Total current liabilities.................. 591,303 747,884 1,086,714 Notes payable, net of current portion.............. 68,848 30,765 7,577 Other liabilities.................................. -- 69,685 -- ---------- ---------- ---------- Total liabilities.......................... 660,151 848,334 1,094,291 ---------- ---------- ---------- Stockholders' equity: Common stock, $.01 par value, 1,000,000 shares authorized, 100,000 shares issued and outstanding..................................... 1,000 1,000 1,000 Additional paid-in capital......................... 204,280 144,280 144,280 Retained earnings.................................. 140,089 247,847 304,195 ---------- ---------- ---------- Total stockholders' equity................. 345,369 393,127 449,475 ---------- ---------- ---------- Total liabilities and stockholders' equity........... $1,005,520 $1,241,461 $ 1,543,766 ========== ========== ========== See accompanying notes to combined financial statements. F-26 88 RESOURCE ONE, INC. COMBINED STATEMENTS OF INCOME (SEE NOTE 1) NINE MONTHS YEAR ENDED ENDED DECEMBER 31, SEPTEMBER 30, --------------------------- ------------- 1994 1995 1996 ----------- ----------- ------------- Revenues: Leased employee revenues......................... $ 9,975,120 $16,897,280 $22,101,897 Claims administration fees....................... 1,694,251 1,479,232 1,089,355 Insurance commissions............................ 201,335 190,189 168,195 Other administration fees........................ 58,484 127,394 60,019 Other revenues................................... 57,550 55,119 45,254 ----------- ----------- ----------- 11,986,740 18,749,214 23,464,720 ----------- ----------- ----------- Costs and expenses: Leased employee payroll and benefits............. 9,426,636 16,117,676 21,224,300 Selling, general and administrative expenses..... 2,237,827 2,298,799 2,169,671 ----------- ----------- ----------- 11,664,463 18,416,475 23,393,971 ----------- ----------- ----------- Income from operations............................. 322,277 332,739 70,749 ----------- ----------- ----------- Other income (expense): Interest income.................................. 3,478 7,470 5,535 Interest expense................................. (6,152) (13,132) (3,219) Miscellaneous income............................. 3,992 400 4,357 ----------- ----------- ----------- 1,318 (5,262) 6,673 ----------- ----------- ----------- Income before income taxes......................... 323,595 327,477 77,422 Income tax expense................................. 94,193 63,534 21,074 ----------- ----------- ----------- Net income......................................... $ 229,402 $ 263,943 $ 56,348 =========== =========== =========== See accompanying notes to combined financial statements. F-27 89 RESOURCE ONE, INC. COMBINED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1994 AND 1995 AND THE NINE MONTHS ENDED SEPTEMBER 30, 1996 (SEE NOTE 1) ADDITIONAL TOTAL COMMON PAID-IN RETAINED STOCKHOLDERS' STOCK CAPITAL EARNINGS EQUITY ------ ---------- --------- ------------- Balance, December 31, 1993................. $1,000 $206,885 $ 322,168 $ 530,053 Purchase and retirement of treasury stock.................................... -- (2,605) -- (2,605) Distributions to shareholders.............. -- -- (411,481) (411,481) Net income................................. -- -- 229,402 229,402 ------ -------- --------- --------- Balance, December 31, 1994................. 1,000 204,280 140,089 345,369 Purchase and retirement of treasury stock.................................... (60,000) -- (60,000) Distributions to shareholders.............. -- -- (156,185) (156,185) Net income................................. -- -- 263,943 263,943 ------ -------- --------- --------- Balance, December 31, 1995................. 1,000 144,280 247,847 393,127 Net income................................. -- -- 56,348 56,348 ------ -------- --------- --------- Balance, September 30, 1996................ $1,000 $144,280 $ 304,195 $ 449,475 ====== ======== ========= ========= See accompanying notes to combined financial statements. F-28 90 RESOURCE ONE, INC. COMBINED STATEMENTS OF CASH FLOWS (SEE NOTE 1) NINE MONTHS YEAR ENDED DECEMBER ENDED 31, SEPTEMBER 30, --------------------- ------------- 1994 1995 1996 -------- -------- ------------- Cash flows from operating activities Net income............................................ $229,402 $263,943 $ 56,348 Adjustments to reconcile net income to net cash (used for) provided by operating activities: Depreciation....................................... 108,182 90,228 52,262 Provision for uncollectible accounts............... 2,586 -- -- Deferred income taxes.............................. -- -- (2,347) Changes in assets and liabilities: Increase in accounts receivable.................. (115,258) (84,348) (476,313) Increase in prepaid expenses..................... -- -- (23,350) Increase (decrease) in other assets.............. (10,030) (88,658) 33,134 Increase in accounts payable and other liabilities................................... 34,424 29,922 16,398 Increase in accrued leased employee costs and expenses payable.............................. 144,348 188,608 352,854 (Increase) decrease in amounts owed to customer...................................... -- 47,534 (11,124) (Increase) decrease in income taxes payable...... 38,525 (15,502) (18,750) --------- --------- --------- Net cash provided by (used for) operating activities....................................... 432,179 431,727 (20,888) --------- --------- --------- Cash flows from investing activities Purchases of property and equipment, net of minor retirements........................................ (28,024) (72,642) (53,308) --------- --------- --------- Net cash used for investing activities............. (28,024) (72,642) (53,308) --------- --------- --------- Cash flows from financing activities Distributions to shareholders......................... (411,481) (156,185) -- Purchase of treasury stock............................ (2,605) (60,000) -- Principal borrowings on notes payable................. 178,681 60,000 -- Principal repayments on notes payable................. (33,379) (122,379) (93,421) --------- --------- --------- Net cash used for financing activities............. (268,784) (278,564) (93,421) --------- --------- --------- Net (increase) decrease in cash....................... 135,371 80,521 (167,617) Cash and cash equivalents at beginning of period...... 146,214 281,585 362,106 --------- --------- --------- Cash and cash equivalents at end of period............ $281,585 $362,106 $ 194,489 ========= ========= ========= See accompanying notes to combined financial statements. F-29 91 RESOURCE ONE, INC. NOTES TO COMBINED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1994 AND 1995 AND THE NINE MONTHS ENDED SEPTEMBER 30, 1996 NOTE 1 -- NATURE OF BUSINESS, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: BUSINESS ACTIVITY AND BASIS OF PRESENTATION Resource One, Inc. (the "Company") is a Florida corporation with two wholly-owned subsidiaries -- Human Resource One, Inc. ("HR One"), a Florida corporation engaged in the business of employee leasing, and Professional Insurance Planners of Florida, Inc. ("PIP"), a Florida corporation which serves as a third party administrator for an insurance trust and other commercial clients which self-insure. Effective January 1, 1996, the Company, which had no operations prior to that date, issued 100% of its common shares outstanding in exchange for all of the outstanding common shares of HR One and PIP. Because the companies are controlled by a common group of shareholders, the transaction was accounted for as a combination of interests at historical cost, which is similar to a pooling of interests. RX One, Inc. ("RX One") is a Florida corporation engaged in the business of providing prescription drug cards for the employees of clients of HR One and PIP. RX One commenced operations during the first quarter of 1996 and has been included in the combined financial statements because it is affiliated with the Company through common ownership. Consequently, the accompanying financial statements reflect the combined financial position and results of operations for HR One, PIP and RX One for all periods presented. Any reference made to the Company in the combined financial statements includes RX One, as well as the Company's wholly-owned subsidiaries. The Company's customers are businesses operating in a variety of industries in locations throughout the United States. However, a considerable portion of the Company's revenues and accounts receivable are related to transactions with customers located in the State of Florida. PRINCIPLES OF COMBINATION The accompanying combined financial statements include the accounts of the Company, HR One, PIP and RX One after elimination of all material intercompany balances and transactions. USE OF ESTIMATES In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheets and affect revenue and expense for the periods presented. Actual results could differ significantly from those estimates. CASH AND CASH EQUIVALENTS The Company considers its holdings of highly liquid debt and money market instruments to be cash equivalents if the securities mature within 90 days from the date of acquisition or contain an investor put option which can be exercised at par within 90 days of acquisition. These investments are carried at cost, which approximates fair value. F-30 92 RESOURCE ONE, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) PROPERTY AND EQUIPMENT Property and equipment are carried at cost and are depreciated using straight line and accelerated methods over their estimated useful lives which range as follows: YEARS ------ Computer equipment and software.............................. 3 - 10 Office furniture and equipment............................... 5 - 10 Leasehold improvements....................................... 10 Expenditures for 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. INCOME TAXES The Company uses the liability method of accounting for deferred income taxes. Consequently, income tax expense consists of Federal and state income taxes currently payable or refundable, and those deferred because of temporary differences between the financial statement and tax bases of assets and liabilities, net of any related valuation allowance. The effective tax expense rate differs from the combined statutory Federal and state rate primarily due to Federal income tax credits generated during the years ended December 31, 1994 and 1995 and the nine months ended September 30, 1996. For the year ended December 31, 1995, HR One elected S corporation status under the Internal Revenue Code. Consequently, in lieu of corporate income tax expense for that year, the shareholder of the corporation was taxed on HR One's taxable income. F-31 93 RESOURCE ONE, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SEPARATE COMPANY FINANCIAL INFORMATION: Revenues, net income and other changes in stockholders' equity of the separate companies for the periods presented were as follows: HR ONE PIP RX ONE COMBINED ----------- ---------- -------- ----------- For the year ended December 31, 1994: Revenues......................... $ 9,975,120 $2,011,620 $ -- $11,986,740 Net income..................... 72,076 157,326 -- 229,402 Purchase and retirement of treasury stock.............. -- 2,605 -- 2,605 Distributions to shareholders................ -- 411,481 -- 411,481 For the year ended December 31, 1995: Revenues......................... $16,897,280 $1,851,934 $ -- $18,749,214 Net income..................... 144,649 119,294 -- 263,943 Purchase and retirement of treasury stock.............. 60,000 -- -- 60,000 Distributions to shareholders................ 156,185 -- -- 156,185 For the nine months ended September 30, 1996: Revenues......................... $22,101,897 $1,361,221 $ 1,602 $23,464,720 Net income (loss).............. 42,528 27,809 (13,989) 56,348 Purchase and retirement of treasury stock.............. -- -- -- -- Distributions to shareholders................ -- -- -- -- NOTE 3 -- PROPERTY AND EQUIPMENT: Property and equipment consist of the following: DECEMBER 31, ----------------------- SEPTEMBER 30, 1994 1995 1996 --------- --------- ------------- Computer equipment and software............... $ 532,412 $ 467,021 $ 510,549 Office furniture and equipment................ 158,605 163,668 162,064 Leasehold improvements........................ 10,582 10,582 10,582 -------- -------- -------- 701,599 641,271 683,195 Less accumulated depreciation................. (535,590) (492,848) (533,726) -------- -------- -------- $ 166,009 $ 148,423 $ 149,469 ======== ======== ======== Depreciation expense amounted to $108,182, $90,228 and $52,262 for years ended December 31, 1994 and 1995, and the nine months ended September 30, 1996, respectively. F-32 94 RESOURCE ONE, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 -- NOTES PAYABLE: Notes payable are summarized as follows: DECEMBER 31, --------------------- SEPTEMBER 30, 1994 1995 1996 -------- -------- ------------- Various installment notes payable monthly through December 1997, interest rates ranging from 7% to 8.5%, collateralized by stock and equipment..................................... $163,377 $100,998 $ 7,577 Less amount payable within one year............. 94,529 70,233 -- -------- -------- ------ Amount payable after one year................... $ 68,848 $ 30,765 $ 7,577 ======== ======== ====== Interest paid totaled $6,152, $13,332 and $3,219 for years ended December 31, 1994 and 1995 and the nine months ended September 30, 1996, respectively. NOTE 5 -- COMMITMENTS AND CONTINGENCIES: LEASE COMMITMENTS The Company leases its office space and certain equipment under noncancelable operating lease agreements. Annual remaining minimum rentals required by these leases are as follows: YEAR ENDING SEPTEMBER 30, AMOUNT -------------------------------------------------------- --------- 1997.................................................... $ 197,596 1998.................................................... 110,163 1999.................................................... 56,367 2000.................................................... 57,931 2001.................................................... 9,655 -------- $ 431,712 ======== Rental expense for years ended December 31, 1994 and 1995 and the nine months ended September 30, 1996 approximated $141,000, $155,000 and $155,000, respectively. CONCENTRATION OF CREDIT RISK The Company extends credit, in the normal course of business, to a variety of corporate entities located throughout the United States. Although the Company's trade receivables are typically not collateralized, historically, no significant credit related losses have been incurred. As of December 31, 1994, December 31, 1995 and September 30, 1996, the Company had cash balances on deposit with federally insured financial institutions which exceeded federally insured limits by approximately $10,000, $120,000 and $137,000, respectively. The Company also has an investment account balance with a local bank in South Miami. As of December 31, 1994 and 1995, and September 30, 1996, the account balance totaled approximately $240,000, $244,000 and $146,000, respectively. Such deposits are not covered by Federal depositor insurance; however, they are secured by U.S. Government securities. LEGAL MATTERS The Company is party to litigation arising in the normal course of business. Management, after consultation with legal counsel, does not believe that the resolution of any such matters will have a material effect on the Company's financial position or results of operations. F-33 95 RESOURCE ONE, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6 -- INCOME TAXES: The components of income tax expense included in the accompanying statements of income consist of the following: NINE MONTHS ENDED YEAR ENDED SEPTEMBER DECEMBER 31, 30, ------------------- ------------ 1994 1995 1996 ------- ------- ------------ Current expense: Federal................................................ $80,625 $53,198 $ 19,148 State.................................................. 13,568 10,336 4,273 Deferred benefit......................................... -- -- (2,347) ------- ------- ------- Total income tax expense....................... $94,193 $63,534 $ 21,074 ======= ======= ======= At December 31, 1994 and 1995, there were no deferred tax assets or liabilities. At September 30, 1996, the Company had gross deferred tax assets totaling $2,347 and no deferred tax liabilities. Income taxes paid during the years ended December 31, 1994 and 1995 and the nine months ended September 30, 1996 totaled approximately $92,000, $44,000 and $86,000, respectively. NOTE 7 -- STOCKHOLDERS' EQUITY: On August 31, 1994, PIP entered into an agreement with one of its stockholders to repurchase the 2,500 shares of common stock owned by that individual. The purchase price paid for the shares totaled $178,680. In connection with this transaction, PIP issued a note payable for the purchase price. The note bore interest at 7% with principal and interest payable monthly until maturity on September 1, 1996. This note was paid off on January 31, 1996. On January 1, 1995, HR One entered into an agreement with one of its stockholders to repurchase the 50,000 shares of common stock owned by that individual. The purchase price paid for the shares totaled $60,000. In connection with this transaction, HR One issued a note payable for the purchase price. The note bore interest at 8% payable monthly and was due in a single payment on December 31, 1997. This note was paid off during 1996. NOTE 8 -- SALARY SAVINGS PLAN: The Company has adopted a salary savings plan (401K) which covers substantially all employees age twenty-one or over who have completed ninety days of service. Eligible employees may elect to contribute a portion of their earnings to the plan. Matching contributions are made by the Company to the plan on a discretionary basis. No contributions were made by the Company to the plan during the years ended December 31, 1994 or 1995 or during the nine months ended September 30, 1996. NOTE 9 -- SUBSEQUENT EVENT: Effective October 1, 1996, 100% of the Company's outstanding common stock was purchased by NovaCare Employee Services, Inc., a Delaware corporation. F-34 96 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders Employee Services of America, Inc. and Subsidiaries Bradenton, Florida We have audited the accompanying combined balance sheet of Employee Services of America, Inc. and subsidiaries and Employers' Risk Management, Inc. and Employee Benefits Management, Inc. (collectively referred to as the "Group") as of January 31, 1997 and the related combined statements of income, changes in shareholders' equity, and cash flows for the one month ended January 31, 1997. These financial statements are the responsibility of the Group's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the combined financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the combined financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of Employee Services of America, Inc. and subsidiaries and Employers' Risk Management, Inc. and Employee Benefits Management, Inc. as of January 31, 1997 and the results of their operations and their cash flows for the one month ended January 31, 1997 in conformity with generally accepted accounting principles. Varnadore, Tyler, Hoffner, King, Hawthorne, Hammer, & Stathis, P.A. Bradenton, FL April 17, 1997 F-35 97 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED BALANCE SHEET JANUARY 31, 1997 ASSETS Current assets: Cash and cash equivalents.................................................... $ 552,987 Accounts receivable: Trade, net of allowance for doubtful accounts of $117,147................. 294,411 Unbilled.................................................................. 2,379,970 Recoverable income taxes..................................................... 106,011 Deferred income taxes........................................................ 420,405 Other assets................................................................. 176,529 ---------- Total current assets................................................. 3,930,313 Equipment and leasehold improvements, net.................................... 505,322 Other assets................................................................. 102,334 ---------- $4,537,969 ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of financing arrangement..................................... $ 8,702 Accounts payable and accrued expenses........................................ 1,115,716 Accrued salaries and wages................................................... 2,043,471 Workers' compensation premiums payable....................................... 757,967 Income taxes payable......................................................... 117,533 ---------- Total current liabilities............................................ 4,043,389 Financing arrangement, net of current portion.................................. 27,136 Client deposits................................................................ 315,135 Deferred income taxes.......................................................... 8,457 Workers compensation agreement................................................. 300,000 ---------- Total liabilities.................................................... 4,694,117 Shareholders' deficiency: Common stock, $.01 par value, authorized 2,400,000 shares.................... 12,862 Additional paid-in capital................................................... 430,310 Accumulated deficit.......................................................... (599,320) ---------- Total shareholders' deficiency....................................... (156,148) ---------- $4,537,969 ========== The accompanying Notes to Financial Statements are an integral part of these statements. F-36 98 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENT OF INCOME FOR THE ONE MONTH ENDED JANUARY 31, 1997 Revenues...................................................................... $12,453,429 Direct costs: Salaries, wages and employment taxes of worksite employees.................. 11,024,429 Health care and workers' compensation....................................... 745,396 ----------- Total direct costs.................................................. 11,769,825 ----------- Gross profit........................................................ 683,604 Operating expenses: Administrative personnel.................................................... 268,834 Other general and administrative............................................ 177,454 Sales and marketing......................................................... 106,172 Depreciation and amortization............................................... 12,000 ----------- Total operating expenses............................................ 564,460 ----------- Income (loss) from operations....................................... 119,144 Interest income (expense):.................................................... (662) ----------- Income (loss) before income taxes................................... 118,482 Provision (benefit) for income taxes.......................................... (59,288) ----------- Net income (loss)............................................................. $ 177,770 =========== The accompanying Notes to Financial Statements are an integral part of these statements. F-37 99 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENT OF SHAREHOLDERS' EQUITY FOR THE ONE MONTH ENDED JANUARY 31, 1997 COMMON STOCK ADDITIONAL RETAINED SHARES/ ($.01 PAID-IN EARNINGS COMMON PAR VALUE) CAPITAL (DEFICIT) ---------- ---------- ---------- --------- Balance at January 1, 1997.................. 1,286,200 $ 12,862 $430,310 $(777,090) Net income................................ -- -- -- 177,770 --------- ------- -------- --------- Balance at January 31, 1997................. 1,286,200 $ 12,862 $430,310 $(599,320) ========= ======= ======== ========= The accompanying Notes to Financial Statements are an integral part of these statements. F-38 100 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENT OF CASH FLOWS FOR THE ONE MONTH ENDED JANUARY 31, 1997 CASH FLOWS FROM OPERATING ACTIVITIES: Net income.................................................................... $ 177,770 Adjustments to reconcile net income to net cash flows provided by operating activities Depreciation and amortization............................................... 12,000 Provision for uncollectible accounts........................................ 6,000 Deferred tax asset.......................................................... (107,276) Changes in assets and liabilities: Accounts receivable...................................................... (129,869) Recoverable income taxes................................................. (19,511) Other assets............................................................. 811,132 Accounts payable and accrued expenses.................................... (258,796) Payroll taxes and other deductions payable............................... 254,556 Accrued salaries and wages............................................... (751,463) Income taxes payable..................................................... 70,553 Workers' compensation premiums payable................................... 423,975 Client deposits.......................................................... (6,681) --------- Net cash flows provided by operating activities..................... 482,390 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment............................................ (11,301) --------- Net cash flows used in investing activities......................... (11,301) CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on capital lease obligations............................... (800) --------- Net cash flows used in financing activities......................... (800) Net increase (decrease) in cash............................................... 470,289 Cash and cash equivalents at beginning of period.............................. 82,698 --------- Cash and cash equivalents at end of period.................................... $ 552,987 ========= The accompanying Notes to Financial Statements are an integral part of these statements. F-39 101 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations: Employee Services of Florida, Inc., Easy Staff, DAT Sales and Consulting, Inc. and Boyd's Employee Services are licensed as professional employer organizations (PEO) engaged in providing human resource management and personnel administration services to a variety of small to medium sized companies located primarily in Florida. The client companies include retail and service industries. The PEO's do not have a concentration of customers in any one industry. They assign their employees to clients and allocate the direction of and control over the leased employees between the clients and the PEO's. Employee leasing companies are regulated in the State of Florida and are required to satisfy certain licensing requirements. Managers' Resource provides payroll processing services to companies outside of the Group. Employers' Risk Management, Inc. provides workers' compensation management services to America. Employee Benefits Management, Inc. provides the management of all insurance products for all of the profits and commissions therefrom. Principles of Combination: The accompanying combined financial statements include the accounts of Employee Services of America, Inc. (America) and its subsidiaries, combined with Employers' Risk Management, Inc. (Risk) and Employee Benefits Management, Inc. (Benefits) (on a combined basis "the Group"). The wholly owned subsidiaries of America include Employee Services of Florida, Inc., Easy Staff, Inc., DAT Sales and Consulting, Inc., Employee Services, Inc. of North Carolina, Boyd's Employee Services, Inc. and Managers' Resource, Inc. All significant intercompany balances and transactions are eliminated in the combination. America, Risk and Benefits are related through common ownership and common management. America acquired all of the outstanding common stock of the above named subsidiaries in May 1996. Because the subsidiaries are controlled by a common group of shareholders, the transaction was accounted for as a combination of interests, at historical costs, which is similar to a pooling of interests. Use of Estimates in the Preparation of Financial Statements: The preparation of financial statements in conformity with generally accepted accounting principles 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. Cash and Cash Equivalents: The Group considers investments with an original maturity of three months or less and money market investments to be cash equivalents. Revenues: Revenues and the related cost of wages, salaries, and employment taxes from professional employer services related to worksite employees are recognized in the period in which the employee performs the service. Because the Group is at risk for all of its direct costs, independently of whether payment is received from its clients, and consistent with industry practice, all amounts billed to clients for gross salaries and wages, related employment taxes, and health care and workers' compensation coverage are recognized as revenue by the Group. Reserves for doubtful accounts are established when the Group determines that collection from a client is unlikely. Leasing revenue earned but not billed is reported as accrued (unbilled) revenue and direct costs performed related to those revenues are reported as accrued salaries and wages. Concentration of Credit Risk: The Group maintains cash balances at various times during the year in excess of the $100,000 guaranteed by the Federal Deposit Insurance Corporation. Concentration of credit risk for trade accounts receivable is minimized since the majority of accounts receivable are due from small businesses located throughout Florida. A deposit is collected from certain clients depending on their credit history and method of paying for leasing services. If there is an outstanding balance when services are terminated, the client deposit is applied. F-40 102 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) Equipment and Leasehold Improvements: Equipment and leasehold improvements are stated at cost. Depreciation is provided using the straight-line basis over the estimated useful lives of the assets. Income Taxes: The Group records income tax expense using the liability method of accounting for deferred income taxes. Under the liability method, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial statement and income tax bases of the Group's assets and liabilities. A valuation allowance is recorded when it is more likely than not that any or all of a deferred tax asset will not be realized. The provision for income taxes includes taxes currently payable plus the net change during the year in deferred tax assets and liabilities recorded by the Group. Recently issued Accounting Pronouncements: In October 1995, the Financial Accounting Standards Board issued "Statement of Financial Accounting Standards No. 123," Accounting for Stock-Based Compensation ("SFAS 123"). SFAS 123 defines a fair value based method of accounting for employee stock options and similar instruments and must be adopted or the proforma income statement effects must be disclosed in notes to the financial statements no later than the first quarter of fiscal year 1997. The Group intends to elect disclosure of the proforma income statement effects of SFAS 123, therefore the new Statement will not affect the Group's financial position or results of operations. In March 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of " ("SFAS 121"), which the Group is required to adopt no later than the first quarter of fiscal year 1997. SFAS 121 establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets to be held and used and for long-lived assets and certain intangibles to be disposed of. Management does not believe the adoption of SFAS 121 will have a material effect on the Group's financial position or results of operations. 2. EQUIPMENT AND LEASEHOLD IMPROVEMENT Property and equipment consist of the following at January 31: 1997 -------- Furniture and fixtures............................................ $124,240 Machinery and equipment........................................... 330,474 Leasehold improvements............................................ 21,114 Vehicles.......................................................... 40,994 -------- 516,822 Less: accumulated depreciation.................................... 11,500 -------- Total equipment and leasehold improvement.................... $505,322 ======== F-41 103 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) 3. CAPITAL LEASE OBLIGATIONS The Group leases a phone system and a vehicle under agreements which are classified as capital leases. The future minimum lease payments required under the capital leases at January 31, 1997 are as follows: 1997............................................................... $ 8,702 1998............................................................... 12,104 1999............................................................... 12,104 2000............................................................... 11,096 ------- Total future minimum lease payments................................ 44,006 Amounts representing interest...................................... 8,168 ------- Present value of net minimum lease payments........................ 35,838 Less current portion............................................... 8,702 ------- Long term portion.................................................. $27,136 ======= 4. WORKERS' COMPENSATION CLAIMS RESERVE The Group maintains a workers' compensation policy which provides coverage to all leased employees for work-related injuries. The Group is liable for losses on claims up to certain deductible amounts. During 1996, the policy had a maximum premium cap. The Group estimates that total premiums and deductible will exceed the cap and the maximum liabilities have been recorded. 5. PROVISION FOR INCOME TAXES Income taxes are provided for tax effects of transactions reported in the financial statements and consist of taxes currently payable for the period, plus or minus the net change in deferred tax assets and liabilities. Deferred income tax assets and liabilities are computed for differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. A valuation allowance was established to reduce the deferred tax assets to the amount that will more likely be realized. The provision for income taxes includes the following: Current Provision Federal................................................ $ 40,750 State.................................................. 4,650 --------- 45,400 --------- Deferred Provision Federal................................................ (93,950) State.................................................. (10,738) --------- (104,688) --------- Provision for income taxes (benefit)........... $ (59,288) ========= F-42 104 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) Net deferred tax assets consist of the following: Current deferred tax assets: Workers' compensation payable................................... $293,000 Net operating loss carryforward................................. 130,199 Change in cash to accrued tax accounting........................ 21,000 Tips tax credit and other....................................... 11,206 Valuation allowance............................................. (35,000) ------- 420,405 Current deferred tax liabilities: Workers' compensation participation receivable.................. -- ------- Net current deferred tax assets................................. $420,405 ======= Long-term deferred tax assets: Workers' compensation payable................................... $120,000 Valuation allowance............................................. (59,000) ------- 61,000 ------- Long-term deferred tax liabilities: Depreciation.................................................... 69,457 Change in cash to accrued tax accounting........................ -- ------- 69,457 ------- Net long-term deferred tax asset (liability)............ $ (8,457) ======= The tips tax credit carryforward is available to offset future income taxes and will expire in the year ending December 31, 2110. 6. COMMON STOCK AND STOCK OPTIONS At January 31, 1997, America, Risk and Benefits were each authorized to issue 800,000 shares of $.01 par value common stock and America was authorized to issue 500,000 shares of preferred stock. At January 31, 1997, America, Risk and Benefits had each issued and outstanding 428,746 shares of common stock. No preferred stock was issued and outstanding. At January 31, 1997, two shareholders of the Group held options to purchase shares of the Group's common stock. The options offer the right to purchase a total of 82,500 shares of common stock of each company in the Group at $1 per share at any time through March 19, 1998. At January 31, 1997, three shareholders of the Group held options to purchase 64,311 shares of Employee Services of America, Inc. at $3 per share. 7. 401(k) RETIREMENT PLANS In 1995, the Group adopted a 401(k) Matching Retirement Plan (the Plan) which covers all non-leased employees that have completed one hour of service. The Group provides a 50% matching contribution based on the amount of elective contributions made to the Plan by employees -- not to exceed 5% of the employee's compensation for the plan year. The matching percentage is subject to the discretion of the Board of Directors. The Group also maintains matched and unmatched plans for leased employees. F-43 105 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) 8. RELATED PARTY TRANSACTIONS In 1995, a stockholder was loaned $39,886, bearing interest at 7.5% per annum, payable on demand. In addition, $30,225 was advanced to a stockholder and a total of $4,320 plus accrued interest of $11,994 is due from various stockholders which is not evidenced by formal note agreements and bears no interest. An insurance agency, that is partially owned by one stockholder, is the agent of record for the Group's liability and workers' compensation insurance policies. As such, the insurance agency receives a commission from insurance companies. The Group also entered into an agreement with the insurance agency which provides compensation when specific loss ratios are attained. The Group purchases various products and services from certain clients in the ordinary course of business. The Group also provides employee leasing services to certain clients that are solely and partially owned by the stockholders of the Group. 9. COMMITMENTS AND CONTINGENCIES Operating Leases: The Group conducts its operations in nine leased facilities and also leases certain equipment under noncancellable operating leases. The total future minimum rental payments are $251,341 and $11,928 in 1997 and 1998, respectively. The minimum rental payments of certain leased facilities are subject to inflationary increases based upon the Consumer Price Index which cannot be reasonably calculated in advance. Commitment: The Group entered in an agreement with an insurance agency, that is partially owned by one stockholder, to provide consulting services during a three year period commencing January 1, 1995. Management estimates the total commitment under this agreement was approximately $174,000. Litigation: The Group is engaged in legal actions arising in the ordinary course of business. The management of the Group and legal counsel believe that the outcome will not have a material effect on the financial statements. 10. SUBSEQUENT EVENTS In February 1997, America and its subsidiaries, Benefits and Risk, were sold to NovaCare Employee Services, Inc. (a subsidiary of NovaCare, Inc.) F-44 106 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders Employee Services of America, Inc. and Subsidiaries Bradenton, Florida We have audited the accompanying combined balance sheets of Employee Services of America, Inc. and subsidiaries and Employers' Risk Management, Inc. and Employee Benefits Management, Inc. (collectively referred to as the "Group") as of December 31, 1996, 1995, and 1994, and the related combined statements of income, changes in shareholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the combined financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the combined financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of Employee Services of America, Inc. and subsidiaries and Employers' Risk Management, Inc. and Employee Benefits Management, Inc. as of December 31, 1996, 1995 and 1994, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Varnadore, Tyler, Hoffner, King, Hawthorne, Hammer, & Stathis, P.A. Bradenton, FL March 8, 1997 F-45 107 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED BALANCE SHEETS DECEMBER 31, 1994, 1995, AND 1996 1994 1995 1996 ----------- ----------- ---------- ASSETS Current assets: Cash and cash equivalents.......................... $ 85,781 $ 34,488 $ 82,698 Accounts receivable: Trade, net of allowance for doubtful accounts of $60,000 and $116,514, respectively............ 739,053 364,950 170,542 Unbilled........................................ 1,256,739 2,001,236 3,186,604 Recoverable income taxes........................... -- -- 86,500 Deferred income taxes.............................. 10,000 55,755 311,323 Other assets....................................... 334,971 233,422 180,927 ---------- ----------- ----------- Total current assets....................... 2,426,550 2,689,851 4,018,594 Equipment and leasehold improvements, net.......... 244,502 445,617 505,521 Deferred income taxes.............................. -- 57,745 -- Other assets....................................... 93,625 131,730 102,934 ---------- ----------- ----------- $ 2,764,671 $ 3,324,943 $4,627,049 ========== =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of financing arrangement........... $ -- $ 9,050 $ 6,742 Accounts payable and accrued expenses.............. 1,707,227 1,152,300 1,119,956 Accrued salaries and wages......................... 1,067,626 1,678,241 2,794,934 Workers' compensation premiums payable and claims reserve......................................... 354,412 163,543 326,197 Income taxes payable............................... -- 110,512 46,980 ---------- ----------- ----------- Total current liabilities.................. 3,129,265 3,113,646 4,294,809 Financing arrangement, net of current portion........ -- 36,609 29,896 Client deposits...................................... 421,006 399,686 321,816 Deferred income taxes................................ -- -- 6,651 Workers compensation agreement....................... 659,409 497,255 307,795 ---------- ----------- ----------- Total liabilities.......................... 4,209,680 4,047,196 4,960,967 Shareholders' deficiency: Common stock, $.01 par value, authorized 2,400,000 shares.......................................... 59,883 12,959 12,862 Additional paid-in capital......................... 378,884 423,092 430,310 Accumulated deficit................................ (1,883,776) (1,154,850) (777,090) Treasury stock..................................... -- (3,454) -- ---------- ----------- ----------- Total shareholders' deficiency............. (1,445,009) (722,253) (333,918) ---------- ----------- ----------- $ 2,764,671 $ 3,324,943 $4,627,049 ========== =========== =========== The accompanying Notes to Financial Statements are an integral part of these statements. F-46 108 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 1994 1995 1996 ----------- ------------ ------------ Revenues.......................................... $76,675,792 $104,352,905 $139,196,718 Direct costs: Salaries, wages and employment taxes of worksite employees.................................... 68,313,065 92,183,659 124,213,841 Health care and workers' compensation........... 4,969,562 6,389,198 8,690,547 Other direct costs.............................. 25,803 122,960 70,521 ----------- ------------ ------------ Total direct costs...................... 73,308,430 98,695,817 132,974,909 ----------- ------------ ------------ Gross profit............................ 3,367,362 5,657,088 6,221,809 Operating expenses: Administrative personnel........................ 1,744,894 2,704,837 3,200,486 Other general and administrative................ 1,063,954 1,393,516 1,527,054 Sales and marketing............................. 555,378 735,758 988,918 Depreciation and amortization................... 60,420 87,578 117,011 ----------- ------------ ------------ Total operating expenses................ 3,424,646 4,921,689 5,833,469 ----------- ------------ ------------ Loss (income) from operations........... (57,284) 735,399 388,340 Interest expense (income):........................ -- -- (55,555) ----------- ------------ ------------ Loss (income) before income taxes....... (57,284) 735,399 332,785 Benefit (provision) for income taxes.............. (679) 6,473 (50,881) ----------- ------------ ------------ Net loss (income)................................. $ (56,605) $ 728,926 $ 383,666 =========== ============ ============ The accompanying Notes to Financial Statements are an integral part of these statements. F-47 109 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996 COMMON STOCK ADDITIONAL RETAINED SHARES/ ($.01 PAID-IN EARNINGS TREASURY COMMON PAR VALUE) CAPITAL (DEFICIT) STOCK --------- ---------- ---------- ----------- -------- Balance at January 1, 1994.............. 984,700 $ 59,883 $226,424 $(1,827,171) $ -- Net loss.............................. -- -- -- (56,605) -- Contributed capital................... -- -- 152,460 -- -- --------- -------- -------- ----------- ------- Balance at December 31, 1994............ 984,700 59,883 378,884 (1,883,776) -- Net income............................ -- -- -- 728,926 -- Recapitalization -- change in par value.............................. -- (50,036) 50,036 -- -- Common stock issued................... 311,200 3,112 -- -- -- Treasury stock acquired............... -- -- -- -- (3,454) Distribution.......................... -- -- (5,828) -- -- --------- -------- -------- ----------- ------- Balance at December 31, 1995............ 1,295,900 12,959 423,092 (1,154,850) (3,454) Net income............................ -- -- -- 383,666 -- Capital contributed................... -- -- 7,218 -- -- Treasury stock canceled............... (9,700) (97) -- (5,906) 3,454 --------- -------- -------- ----------- ------- Balance at December 31, 1996............ 1,286,200 $ 12,862 $430,310 $ (777,090) $ -- ========= ======== ======== =========== ======= The accompanying Notes to Financial Statements are an integral part of these statements. F-48 110 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES COMBINED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996 1994 1995 1996 --------- --------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income...................................... $ (56,605) $ 728,926 $ 383,666 Adjustments to reconcile net (loss) income to net cash flows provided by operating activities Depreciation and amortization................... 60,420 87,576 117,021 Provision for uncollectible accounts............ 2,723 102,932 70,521 Loss on disposal of fixed assets................ -- -- 33,832 Deferred tax asset.............................. -- (103,494) (191,172) Changes in assets and liabilities: Accounts receivable.......................... (832,025) (475,355) (1,061,481) Recoverable income taxes..................... -- -- (86,500) Other assets................................. (5,425) (237,346) 79,685 Accounts payable and accrued expenses........ 68,288 268,014 65,702 Payroll taxes and other deductions payable... 150,661 (37,522) (36,044) Accrued salaries and wages................... 373,910 610,615 1,116,693 Income taxes payable......................... -- 110,512 (63,532) Benefit premiums payable..................... 803,043 (806,367) (63,002) Workers' compensation premiums payable....... (855,880) (40,932) (26,806) Client deposits.............................. 2,183 (21,320) (77,870) --------- --------- ----------- Net cash flows (used in) provided by operating activities.................... (288,707) 186,239 260,713 --------- --------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment..................... (115,973) (218,630) (189,336) Purchase of intangible assets.......................... (7,949) (16,821) (18,815) --------- --------- ----------- Net cash flows used in investing activities.............................. (123,922) (235,451) (208,151) --------- --------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on capital lease obligations........ -- (2,081) (9,021) Proceeds from issuance of common stock and additional paid-in capital...................................... 50,000 -- 4,669 --------- --------- ----------- Net cash flows provided by (used in) financing activities.................... 50,000 (2,081) (4,352) --------- --------- ----------- Net (decrease) increase in cash........................ (362,629) (51,293) 48,210 Cash and cash equivalents at beginning of year......... 448,410 85,781 34,488 --------- --------- ----------- Cash and cash equivalents at end of year............... $ 85,781 $ 34,488 $ 82,698 ========= ========= =========== SUPPLEMENTAL DISCLOSURES: Interest paid........................................ $ -- $ -- $ 55,555 ========= ========= =========== Income taxes paid.................................... $ -- $ -- $ 174,200 ========= ========= =========== The accompanying Notes to Financial Statements are an integral part of these statements. F-49 111 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations: Employee Services of Florida, Inc., Easy Staff, DAT and Boyd's Employee Services are licensed as professional employer organizations (PEO) engaged in providing human resource management and personnel administration services to a variety of small to medium sized companies located primarily in Florida. The client companies include retail and service industries. The PEO's do not have a concentration of customers in any one industry. They assign their employees to clients and allocate the direction of and control over the leased employees between the clients and the PEO's. Employee leasing companies are regulated in the State of Florida and are required to satisfy certain licensing requirements. Employee Services, Inc. of North Carolina has been inactive during the entire three year period ended December 31, 1996. Managers' Resource provides payroll processing services to companies outside of the Group. Employers' Risk Management, Inc. provides workers' compensation management services to America. Employee Benefits Management, Inc. provides the management of all insurance products for all of the profits and commissions therefrom. Principles of Combination: The accompanying combined financial statements include the accounts of Employee Services of America, Inc. (America) and its subsidiaries, combined with Employers' Risk Management, Inc. (Risk) and Employee Benefits Management, Inc. (Benefits) (on a combined basis "the Group"). The wholly owned subsidiaries of America include Employee Services of Florida, Inc., Easy Staff, Inc., DAT Sales and Consulting, Inc., Employee Services, Inc. of North Carolina, Boyd's Employee Services, Inc. and Managers' Resource, Inc. All significant intercompany balances and transactions are eliminated in the combination. America, Risk and Benefits are related through common ownership and common management. America acquired all of the outstanding common stock of the above named subsidiaries in May 1996. Because the subsidiaries are controlled by a common group of shareholders, the transaction was accounted for as a combination of interests, at historical costs, which is similar to a pooling of interests. Use of Estimates in the Preparation of Financial Statements: The preparation of financial statements in conformity with generally accepted accounting principles 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. Cash and Cash Equivalents: The Group considers investments with an original maturity of three months or less and money market investments to be cash equivalents. Revenues: Revenues and the related cost of wages, salaries, and employment taxes from professional employer services related to worksite employees are recognized in the period in which the employee performs the service. Because the Group is at risk for all of its direct costs, independently of whether payment is received from its clients, and consistent with industry practice, all amounts billed to clients for gross salaries and wages, related employment taxes, and health care and workers' compensation coverage are recognized as revenue by the Group. Reserves for doubtful accounts are established when the Group determines that collection from a client is unlikely. Leasing revenue earned but not billed is reported as accrued (unbilled) revenue and direct costs performed related to those revenues are reported as accrued salaries and wages. Concentration of Credit Risk: The Group maintains cash balances at various times during the year in excess of the $100,000 guaranteed by the Federal Deposit Insurance Corporation. At December 31, 1996 there was approximately $619,000 in a bank which was in excess of the federally insured limits. Concentration of credit risk for trade accounts receivable is minimized since the majority of accounts receivable are due from small businesses located throughout Florida. A deposit is collected from certain clients depending on their F-50 112 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) credit history and method of paying for leasing services. If there is an outstanding balance when services are terminated, the client deposit is applied. Equipment and Leasehold Improvements: Equipment and leasehold improvements are stated at cost. Depreciation is provided using the straight-line basis over the estimated useful lives of the assets. Income Taxes: The Group records income tax expense using the liability method of accounting for deferred income taxes. Under the liability method, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial statement and income tax bases of the Group's assets and liabilities. A valuation allowance is recorded when it is more likely than not that any or all of a deferred tax asset will not be realized. The provision for income taxes includes taxes currently payable plus the net change during the year in deferred tax assets and liabilities recorded by the Group. Effective January 1, 1995, Easy Staff, DAT, Risk and Benefits changed their tax status from an S corporation to a C corporation under the provisions of the Internal Revenue Code. Employee Services of Florida, Employee Services, Inc. of North Carolina and Managers' Resource, Inc. were originally formed and organized as C corporations. As a C corporation, each company is liable for income taxes on their income. Recently issued Accounting Pronouncements: In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 defines a fair value based method of accounting for employee stock options and similar instruments and must be adopted or the proforma income statement effects must be disclosed in notes to the financial statements no later than the first quarter of fiscal year 1997. The Group intends to elect disclosure of the proforma income statement effects of SFAS 123, therefore the new Statement will not affect the Group's financial position or results of operations. In March 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of " ("SFAS 121"), which the Group is required to adopt no later than the first quarter of fiscal year 1997. SFAS 121 establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets to be held and used and for long-lived assets and certain intangibles to be disposed of. Management does not believe the adoption of SFAS 121 will have a material effect on the Group's financial position or results of operations. Reclassifications: Certain reclassifications have been made in the 1994 and 1995 financial statements to conform to the 1996 presentation. 2. WORKERS' COMPENSATION PARTICIPATION RECEIVABLE The Group had a guaranteed rate agreement with a workers' compensation carrier which provides compensation if certain loss ratios are not exceeded. Under the provisions of the agreement, $737,241 was payable to the Group at December 31, 1995. During 1996, $369,000 of this amount was collected. The remaining balance was reduced by a settlement with the carrier upon termination of the contract. F-51 113 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) 3. EQUIPMENT AND LEASEHOLD IMPROVEMENT Property and equipment consist of the following at December 31: 1994 1995 1996 --------- -------- --------- Furniture and fixtures................... $ 126,039 $155,813 $ 162,374 Machinery and equipment.................. 169,202 298,276 437,903 Leasehold improvements................... 36,699 17,033 22,295 Vehicles................................. 77,043 53,371 50,546 --------- -------- --------- 408,983 524,493 673,118 Less: accumulated depreciation........... (164,481) (78,876) (167,597) --------- -------- --------- Total equipment and leasehold improvement............................ $ 244,502 $445,617 $ 505,521 ========= ======== ========= 4. CAPITAL LEASE OBLIGATIONS The Group leases a phone system and a vehicle under agreements which are classified as capital leases. The future minimum lease payments required under the capital leases at December 31, 1996 are as follows: 1997....................................................... $14,314 1998....................................................... 12,104 1999....................................................... 12,104 2000....................................................... 11,096 ------- Total future minimum lease payments........................ 49,618 Amounts representing interest.............................. 12,980 ------- Present value of net minimum lease payments................ 36,638 Less current portion....................................... 6,742 ------- Long term portion.......................................... $29,896 ======= 5. WORKERS' COMPENSATION CLAIMS RESERVE The Group maintains a workers' compensation policy which provides coverage to all leased employees for work-related injuries. The Group is liable for losses on claims up to certain deductible amounts. During 1996, the policy had a maximum premium cap. The Group estimates that total premiums and deductible will exceed the cap and the maximum liabilities have been recorded. During 1995, the policy maximum premium cap was substantially higher than 1996 and was not met and workers' compensation claims reserves of $465,893 were accrued based upon claims reported as of December 31, 1995 as well as an estimated liability for claims incurred but not reported. At December 31, 1996 the majority of these claims have been settled and the claims reserves remaining are not material. 6. PROVISION FOR INCOME TAXES Income taxes are provided for tax effects of transactions reported in the financial statements and consist of taxes currently payable for the period, plus or minus the net change in deferred tax assets and liabilities. Deferred income tax assets and liabilities are computed for differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect F-52 114 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) taxable income. A valuation allowance was established to reduce the deferred tax assets to the amount that will more likely be realized. The provision for income taxes includes the following: 1994 1995 1996 ----- --------- --------- Current Provision Federal................................... $(679) $ 101,987 $ 122,241 State..................................... -- 14,998 31,148 ----- --------- --------- (679) 116,985 153,389 ----- --------- --------- Deferred Provision Federal................................... -- (96,344) (178,081) State..................................... -- (14,168) (26,189) ----- --------- --------- -- (110,512) (204,270) ----- --------- --------- Provision for income taxes........ $(679) $ 6,473 $ (50,881) ===== ========= ========= Net deferred tax assets consist of the following: 1994 1995 1996 ------- --------- -------- Current deferred tax assets: Workers' compensation payable............ $ -- $ 352,822 $166,771 Net operating loss carryforward.......... 10,006 -- 113,644 Change in cash to accrued tax accounting............................ -- 22,855 20,973 Tips tax credit and other................ -- 46,944 94,247 Valuation allowance...................... -- (71,421) (84,312) -------- --------- ------- 10,006 351,200 311,323 Current deferred tax liabilities: Workers' compensation participation receivable............................ -- (295,445) -- -------- --------- ------- Net current deferred tax assets.......... $10,006 $ 55,755 $311,323 ======== ========= ======= Long-term deferred tax assets: Workers' compensation payable............ $ -- $ 193,929 $ 61,000 Net operating loss carryforward.......... -- 6,447 -- Change in cash to accrued tax accounting............................ -- 43,316 -- Tips tax credit.......................... -- 24,007 -- Other.................................... -- 1,040 -- Valuation allowance...................... -- (193,929) -- -------- --------- ------- -- 74,810 61,000 -------- --------- ------- Long-term deferred tax liabilities: Depreciation............................. -- 11,418 67,651 Change in cash to accrued tax accounting............................ -- 5,647 -- -------- --------- ------- -- 17,065 67,651 -------- --------- ------- Net long-term deferred tax asset (liability).................... $ -- $ 57,745 $ (6,651) ======== ========= ======= The tips tax credit carryforward is available to offset future income taxes and will expire in the year ending December 31, 2110. F-53 115 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) 7. COMMON STOCK AND STOCK OPTIONS At December 31, 1995 and 1996, America, Risk and Benefits were each authorized to issue 800,000 shares of $.01 par value common stock and America was authorized to issue 500,000 shares of preferred stock. At December 31, 1995, America, Risk and Benefits had each issued and outstanding 428,746 shares of common stock, net of 4,836 shares held as treasury stock. During 1996, the treasury stock was canceled and America, Risk and Benefits each had issued and outstanding 428,746 shares of common stock at December 31, 1996. No preferred stock was issued and outstanding. At December 31, 1995, two shareholders of the Group held options to purchase shares of the Group's common stock. The options offer the right to purchase a total of 82,500 shares of common stock of each company in the Group at $1 per share at any time through March 19, 1998. At December 31, 1996, three shareholders of the Group held options to purchase 64,311 shares of Employee Services of America, Inc. at $3 per share. 8. 401(k) RETIREMENT PLANS In 1995, the Group adopted a 401(k) Matching Retirement Plan (the Plan) which covers all non-leased employees that have completed one hour of service. The Group provides a 50% matching contribution based on the amount of elective contributions made to the Plan by employees -- not to exceed 5% of the employee's compensation for the plan year. The matching percentage is subject to the discretion of the Board of Directors. The Group paid matching contributions of $39,089 and $37,830 for the periods ended December 31, 1995 and 1996, respectively. The Group also maintains matched and unmatched plans for leased employees. 9. RELATED PARTY TRANSACTIONS In 1995, a stockholder was loaned $39,886, bearing interest at 7.5% per annum, payable on demand. In addition, $30,225 was advanced to a stockholder and a total of $4,320 plus accrued interest of $11,994 is due from various stockholders which is not evidenced by formal note agreements and bears no interest. An insurance agency, that is partially owned by one stockholder, is the agent of record for the Group's liability and workers' compensation insurance policies. As such, the insurance agency receives a commission from insurance companies. The Group also entered into an agreement with the insurance agency which provides compensation when specific loss ratios are attained. The Group purchases various products and services from certain clients in the ordinary course of business. The Group also provides employee leasing services to certain clients that are solely and partially owned by the stockholders of the Group. 10. COMMITMENTS AND CONTINGENCIES Operating Leases: The Group conducts its operations in nine leased facilities and also leases certain equipment under noncancellable operating leases. The total future minimum rental payments are $281,536, $251,341 and $11,928 in 1996, 1997 and 1998, respectively. The minimum rental payments of certain leased facilities are subject to inflationary increases based upon the Consumer Price Index which cannot be reasonably calculated in advance. Commitment: The Group entered in an agreement with an insurance agency, that is partially owned by one stockholder, to provide consulting services during a three year period commencing January 1, 1995. Management estimates the total commitment under this agreement was approximately $174,000. The amount payable to the insurance agency at December 31, 1996 for consulting services is $7,800. F-54 116 EMPLOYEE SERVICES OF AMERICA, INC. AND SUBSIDIARIES NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) Litigation: The Group is engaged in legal actions arising in the ordinary course of business. The management of the Group and legal counsel believe that the outcome will not have a material effect on the financial statements. 11. SUBSEQUENT EVENTS In February 1997, America and its subsidiaries, Benefits and Risk were sold to NovaCare Employee Services, Inc. (a subsidiary of NovaCare, Inc.) F-55 117 INDEPENDENT AUDITORS' REPORT To the Board of Directors The TPI Group, Ltd. Queensbury, New York We have audited the accompanying consolidated balance sheet of The TPI Group, Ltd. and subsidiaries as of January 31, 1997 and the related consolidated statements of operations, stockholders' equity and cash flows for the one month period then ended. These consolidated financial statements are the responsibility of the management of The TPI Group, Ltd. Our responsibility is to express an opinion on the consolidated financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects the financial position of The TPI Group, Ltd. and subsidiaries as of January 31, 1997 and the results of their operations and their cash flows for the one month period then ended, in conformity with generally accepted accounting principles. LAZAR, LEVINE & COMPANY LLP New York, New York April 11, 1997 F-56 118 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET AS OF JANUARY 31, 1997 ASSETS Current Assets: Cash and cash equivalents.................................................... $ 2,634 Cash -- restricted........................................................... 290,000 Accounts Receivable: Trade, net of allowance for doubtful accounts of $362,097................. 817,076 Unbilled.................................................................. 1,833,930 Due from former shareholders................................................. 74,938 Miscellaneous receivables and deposits....................................... 176,398 Prepaid expenses and other current assets.................................... 364,846 ------------ Total Current Assets........................................................... 3,559,822 Property and Equipment, Net.................................................... 593,568 Other Assets, Net.............................................................. 9,909 ------------ $ 4,163,299 ============ LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current Liabilities: Cash overdraft............................................................... $ 522,270 Current portion of financing arrangements.................................... 624,818 Accounts payable and accrued expenses........................................ 4,269,368 Payroll taxes payable........................................................ 2,702,957 Current portion of reserve for workers' compensation claims.................. 628,181 Income taxes payable......................................................... 22,228 Other current liabilities.................................................... 109,290 ------------ Total Current Liabilities...................................................... 8,879,112 Long-Term Liabilities: Financing arrangements, net of current portion............................... 43,764 Reserve for workers' compensation claims -- net of current portion........... 429,482 ------------ Total Liabilities.............................................................. 9,352,358 ------------ Commitments and Contingencies Stockholders' Equity (Deficit): Preferred stock -- 9% cumulative convertible $.01 par value -- 4,850 shares authorized, issued and outstanding........................................ 49 Common stock -- $.01 par value, 11,111 shares authorized, 6,261 shares issued and outstanding........................................................... 63 Additional paid-in capital................................................... 4,934,989 Accumulated deficit.......................................................... (10,124,160) ------------ Total Stockholders' Equity (Deficit)........................................... (5,189,059) ------------ $ 4,163,299 ============ The accompanying notes are an integral part of these consolidated financial statements. F-57 119 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS FOR THE ONE MONTH PERIOD ENDED JANUARY 31, 1997 Revenues......................................................................... $7,823,722 Payroll and Payroll Related Costs................................................ 7,514,248 ---------- Gross Profit..................................................................... 309,474 ---------- Operating Expenses: Administrative personnel and payroll related costs............................. 169,515 General and administrative expenses............................................ 98,698 Sales and marketing expenses................................................... 98,584 Depreciation and amortization.................................................. 9,176 ---------- Total Operating Expenses......................................................... 375,973 ---------- (Loss) From Operations........................................................... (66,499) ---------- Other Expenses: Interest and penalties......................................................... 273,229 Loss on disposal of fixed assets............................................... 12,000 ---------- Total Other Expenses............................................................. 285,229 ---------- (Loss) Before Provision for Income Taxes......................................... (351,728) Provision for income taxes..................................................... 13,848 ---------- Net (Loss)....................................................................... $ (365,576) ========== The accompanying notes are an integral part of these consolidated financial statements. F-58 120 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY FOR THE ONE MONTH PERIOD ENDED JANUARY 31, 1997 SHARES ADDITIONAL ------------------ PREFERRED STOCK COMMON STOCK PAID-IN ACCUMULATED PREFERRED COMMON ($.01 PAR VALUE) ($.01 PAR VALUE) CAPITAL DEFICIT --------- ------ ---------------- ---------------- ---------- ------------ Balance at December 31, 1996.......... -- 6,261 $ -- $ 63 $ 85,038 $ (9,758,584) Conversion of note to preferred stock............. 4,850 -- 49 -- 4,849,951 -- Net loss............ -- -- -- -- -- (365,576) ----- ----- --- --- ---------- ------------ Balance at January 31, 1997.......... 4,850 6,261 $ 49 $ 63 $4,934,989 $(10,124,160) ===== ===== === === ========== ============ The accompanying notes are an integral part of these consolidated financial statements. F-59 121 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE ONE MONTH PERIOD ENDED JANUARY 31, 1997 Increase (Decrease) in Cash and Cash Equivalents: Cash Flows From Operating Activities: Net loss....................................................................... $(365,576) Adjustments to reconcile net (loss) to net cash (used in) operating activities: Depreciation and amortization............................................... 9,176 Loss on disposition of assets............................................... 12,000 Changes in assets and liabilities: (Increase) in receivables................................................... (750,746) (Increase) in prepaid expenses and other current assets..................... (48,343) Increase in accounts payable and accrued expenses........................... 289,888 Increase in payroll taxes payable........................................... 740,860 Increase in other current liabilities....................................... 11,747 --------- Net cash (used in) operating activities................................ (100,994) --------- Cash Flows From Investing Activities: Additions to property and equipment............................................ (16,857) Increase in other assets....................................................... (2,416) --------- Net cash (used in) investing activities................................ (19,273) --------- Cash Flows From Financing Activities: Payments of financing arrangements............................................. (3,682) Increase in former shareholders loans receivable............................... (62,138) Increase in bank overdrafts.................................................... 187,921 --------- Net cash provided by financing activities.............................. 122,101 --------- Net Increase in Cash and Cash Equivalents........................................ 1,834 Cash and cash equivalents, beginning of period................................. 800 --------- Cash and Cash Equivalents, End of Period......................................... $ 2,634 ========= Supplemental Disclosure of Cash Flow Information: Cash paid during the period for: Interest.................................................................... $ 7,600 Income taxes................................................................ -- Non-Cash Items: On January 31, 1997, approximately $4,850,000 of debt was converted to preferred stock. The accompanying notes are an integral part of these consolidated financial statements. F-60 122 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE ONE MONTH PERIOD ENDED JANUARY 31, 1997 NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (a) NATURE OF OPERATIONS: The TPI Group, Ltd., "the Company," is a holding company which owns 100% of the capital stock (see Principles of Consolidation below) of the following corporations: TPI Staffing, Inc., Queensbury, New York Temporary Payroll Incentives, Inc., Queensbury, New York TPI Payroll Processing Services, Inc., Queensbury, New York Staffing Technologies, Inc., Queensbury, New York Herotech, Inc., Queensbury, New York Trans-Partnering Innovations, Inc., Boston, Massachusetts The Company and its subsidiaries are primarily involved in providing professional staffing, payroll and insurance benefit services to small and medium sized companies in a variety of industries, including manufacturing, retail and hospitality. The main office is located in Queensbury, New York with satellite offices in several Atlantic Coast States. The Company does not have a concentration of customers in any one industry; however, during January 1997 a significant portion of the Company's revenues were generated in New York. (b) PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of The TPI Group, Ltd. and its subsidiaries, TPI Staffing, Inc., Temporary Payroll Incentives, Inc., TPI Payroll Processing Services, Inc., Staffing Technologies, Inc., Herotech, Inc. and Trans-Partnering Innovations, Inc. All material intercompany balances and transactions have been eliminated. (c) USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain 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 amounts could differ from those estimates. (d) CONCENTRATION OF CREDIT RISK: The Company maintains the majority of its cash accounts in one commercial bank. The total cash balances are secured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. (e) PROPERTY AND EQUIPMENT: Property and equipment are stated at cost. Depreciation is provided on straight-line or accelerated methods at rates based on the estimated useful lives. Depreciation expense for the month ended January 31, 1997 was $9,036. Expenditures for major renewals and betterments that extend the useful lives of fixed assets are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Equipment operated under leases which transfer to the Company substantially all benefits and risks associated with the assets are capitalized and an asset and liability are recorded at the present value, or fair value if appropriate, of minimum payments over the term of the lease. Amortization of the asset is determined F-61 123 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) using the straight-line or accelerated methods. Expenses associated with all other leases (operating leases) are charged to expense as incurred. (f) AMORTIZATION: Organization costs are being amortized over a 60 month period. Amortization expense for the month ended January 31, 1997 was $140. (g) INCOME TAXES: Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of certain assets and liabilities for financial and tax reporting. The deferred taxes represent the future tax return consequences of those differences, which will either be taxable when the assets and liabilities are recovered or settled. (h) CASH AND CASH EQUIVALENTS: For purposes of the statements of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. (i) RESERVE FOR CLAIMS: The Company's workers' compensation benefits and certain of its health care benefits are provided under large deductible insured plans. The Company records reserves for workers' compensation and health care claims costs based on actuarial calculations using the Company's loss history of workers' compensation and health care claims. In all cases regarding workers' compensation and health care claims, reserves are established at the time a participant files a claim. Furthermore, the Company, in determining its reserves, includes reserves for estimated claims incurred but not reported. At January 31, 1997, the Company has classified as current the estimated amounts of reserves established for claims expected to be paid within one year. The Company's estimates of its claims reserves, including its estimate of incurred but not reported claims, are based primarily on its loss history. The ultimate cost of heath care and workers' compensation claims will depend on actual costs incurred in settling the claims and may differ from the amounts reserved by the Company for those claims. NOTE 2 -- CASH -- RESTRICTED: Beginning in 1995, the Company placed $250,000 on deposit with a bank as collateral for a letter of credit in favor of its workers' compensation insurance carrier relating to the issuance of a workers' compensation insurance policy. During 1996, the Company placed $40,000 on deposit with a bank as collateral for a letter of credit required on a general insurance bond. NOTE 3 -- MISCELLANEOUS RECEIVABLES AND DEPOSITS: At January 31, 1997, miscellaneous receivables and deposits consisted of the following: Deposits with insurance company required to fund possible workers' compensation claims of prior years............. $152,396 Other miscellaneous receivables........................... 24,002 -------- $176,398 ======== F-62 124 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 -- FIXED ASSETS: Fixed assets consist of the following: Leasehold improvements................................... $ 291,735 Furniture and equipment.................................. 503,845 Vehicles................................................. 71,942 Assets held under capital leases......................... 71,138 -------- 938,660 Less: accumulated depreciation and amortization.......... (345,092) -------- $ 593,568 ======== At January 31, 1997, land with an appraised value of $50,000 was transferred to certain former shareholders in payment of compensation due them at December 31, 1996. NOTE 5 -- ACCRUED EXPENSES: Included in accrued expenses as of January 31, 1997 is an accrual for approximately $1,080,500 representing late payment penalties and interest due to taxing authorities for late payment of withholding and unemployment taxes for the fourth quarter of 1995, all four quarters of 1996 and the month of January 1997. These amounts, together with the corresponding tax liabilities have been or are expected to be paid in 1997. NOTE 6 -- FINANCING ARRANGEMENTS: (a) NOTE PAYABLE -- DEMAND: At January 31, 1997, the Company had a $600,000 demand note, payable to a bank, at an interest rate of prime plus 1% per annum (9 1/4% at January 31, 1997). This note which was collateralized by letters of credit supplied to the bank by certain former shareholders of the Company, was repaid in February 1997. (b) OTHER NOTES PAYABLE: Various notes, payable monthly, with interest rates ranging from 6.99% to 10%, collateralized by certain equipment... $10,864 Note payable to a related party, payable with interest only at rates from 9.5% to 10%, collateralized by a mortgage................................................. 40,000 ------- Totals................................................... 50,864 Less: current portion.................................... 10,864 ------- Long-term portion........................................ $40,000 ======= Maturities of long-term debt are as follows: YEAR ENDING DECEMBER 31, AMOUNT ----------------------------------------------------------- ------- 1997....................................................... $10,864 1998....................................................... -- 1999....................................................... -- 2000....................................................... -- Beyond..................................................... 40,000 ------- Total...................................................... $50,864 ======= F-63 125 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (c) CAPITALIZED LEASE OBLIGATIONS: Capitalized lease obligations at January 31, 1997 consisted of the following: Leases collateralized by computer equipment with monthly payments totaling $1,370 including interest at rates from 10.5% to 23.7%........................................................... $ 17,718 ======== Capitalized leased equipment consisted of the following: Computer equipment................................................ $ 71,138 Less: accumulated depreciation.................................... (34,579) -------- Total Book Value............................................. $ 36,559 ======== The following is a schedule by years of future minimum lease payments under capital leases, together with the present value of the net minimum lease payments as of January 31, 1997. AMOUNT ------- 1997............................................................... $14,205 1998............................................................... 5,409 ------- Total minimum payments........................................ $19,614 ======= Total minimum payments............................................. $19,614 Less: amounts representing interest................................ 1,896 ------- Present value of net minimum lease payments........................ 17,718 Less: current portion.............................................. 13,954 ------- Long-term portion............................................. $ 3,764 ======= NOTE 7 -- PROVISION FOR INCOME TAXES: Current: Federal.................................................. $ -- States................................................... 13,848 ------- Total Current Taxes........................................ 13,848 ------- Net Operating Loss (NOL) Carryforwards: Federal.................................................. -- States................................................... -- ------- Total Tax Benefits......................................... -- ------- SubTotal................................................... 13,848 ------- Deferred: Federal.................................................. -- States................................................... -- ------- Total Deferred Taxes....................................... -- ------- Total Income Tax........................................... $13,848 ======= F-64 126 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The tax effects of the temporary differences that give rise to deferred tax assets, as of January 31, 1997, are as follows: 1996 ----------- Net Operating Loss Carryforwards........................ $ 2,320,000 Less: valuation allowance............................... (2,320,000) ----------- Net deferred tax assets................................. $ -- ========== The Company has available at January 31, 1997, unused operating loss carryforwards of approximately $5,800,000 which may be applied against future taxable income expiring in various years beginning in 2005 through 2011. At an assumed tax rate of 40%, these carryforwards may result in deferred tax assets of approximately $2,320,000. Since there is no assurance that the Company will generate future taxable income to utilize this asset, a 100% valuation allowance has been provided as of January 31, 1997. Effective January 31, 1997, a corporation purchased 100% of the outstanding capital stock of the Company (see Note 12). According to I.R.C. Section 382, if an ownership change of more than 50% of a loss corporation occurs, the taxable income of that loss corporation for any post-change tax year can be offset by existing net operating loss carryforwards only to the extent of the fair market value of the old loss corporation's capital stock multiplied by the long-term tax-exempt bond rate. On the date of the change in ownership the estimated amount of net operating loss carryforwards that still exists is still to be determined. NOTE 8 -- LEASES: The Company leases vehicles for two and three year terms under operating leases. The Company also leases other equipment on an as-needed basis. Vehicle and other equipment rental expense was $3,642 for the one month period ended January 31, 1997. The following is a schedule of future minimum rental payments required under the above operating leases as of January 31, 1997. 1997...................................................... $ 54,714 1998...................................................... 31,410 1999...................................................... 11,748 2000...................................................... 11,748 2001...................................................... 1,124 -------- $110,744 ======== The Company leases office space in various locations other than its main office in Queensbury, New York (see Note 9c). Annual rentals aggregate approximately $85,000. NOTE 9 -- RELATED PARTY TRANSACTIONS: (a) The following balances existed at January 31, 1997, as a result of related party transactions between the Company, its former shareholders and individuals related to the former shareholders of the Company: DESCRIPTION ---------------------------------------------------------- Due from former shareholders.............................. $74,938 Long-term debt............................................ 40,000 Interest expense.......................................... 325 Rent expense.............................................. 2,866 F-65 127 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) All the material details related to the balances and terms of the above transactions are contained in other disclosures herein. (b) The Company has guaranteed loans made by a financial institution to four of its shareholders and an employee of the Company as detailed below: Two separate loans to four of its former shareholders which mature on July 1, 2001 and June 1, 2008 and have a balance at January 31, 1997 of $36,317 and $158,622, respectively. A loan made to one of the Company's employees maturing November 15, 2000 with a balance of $13,449 at January 31, 1997. (c) In July 1993, the Company entered into a five year lease agreement, aggregating approximately $35,000 per year, for office space in Queensbury, New York in a building owned by the Company's former shareholders. Prior to entering this agreement the Company leased the office space on a month-to-month basis. Total rent expense paid for the Queensbury office for the month ended January 31, 1997 was $2,866. NOTE 10 -- PREFERRED STOCK: On April 12, 1996, the Company received a loan from an investment group/shareholder of $4,850,000. This note which bears interest at 10% per annum, had a maturity date of April 12, 1997. As part of the note agreement, the investment group had an option to convert the entire note balance including interest into 4,850 shares of senior convertible cumulative 9% preferred stock, at $.01 par value on or prior to December 31, 1996. The date of conversion of the note was extended to the date of the sale of the Company (see Note 12) at which point, the investment group exercised its option to convert its entire note balance to preferred stock and waived any and all interest associated with the note. NOTE 11 -- CONTINGENCY: The Company is a defendant in a lawsuit related to unlawful discharge from employment and for intentional infliction of emotional distress. The plaintiff seeks the sum of $10,000,000 for compensation and punitive damages. The plaintiff is a former employee of a client of the Company who believes her termination from employment was a violation of the "FMLA" Family and Medical Leave Act. This case is in the preliminary stages of investigation, but management believes that the lawsuit has no merit and it intends to vigorously defend its position. The Company is also involved in various other legal proceedings arising in the ordinary course of business. It is the opinion of the Company's counsel that the outcome of these actions is not expected to have a material adverse effect on the Company's financial position or results of operations. NOTE 12 -- SALE OF THE COMPANY: On January 31, 1997, the shareholders of the Company sold all the outstanding shares of capital stock of the Company to NovaCare Employee Services, Inc., a subsidiary of NovaCare, Inc., a New York Stock Exchange Company. NOTE 13 -- EMPLOYMENT AGREEMENTS: Effective as of January 31, 1997, the Company entered into employment agreements with six key employees. The aggregate annual salaries of these six employees is $535,000. These agreements have no specific expiration dates. As of March 1, 1997, all six of the above employees have agreed to a 20% reduction in their base salaries. F-66 128 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 -- JOINT VENTURE ARRANGEMENT: A joint venture arrangement was established for the Connecticut and White Plains offices. Effective November 1, 1995, the joint venture arrangement was amended whereby the Company receives an amount equal to 2.5% of gross billings of the two aforementioned offices. Management of these offices receives the gross profit generated by these offices, reduced by the Company's above fee, from which all overhead expenses will be paid. The amounts generated from this joint venture for January 1997 were immaterial. F-67 129 INDEPENDENT AUDITORS' REPORT To The Board of Directors The TPI Group, Ltd. Queensbury, New York We have audited the accompanying consolidated balance sheets of The TPI Group, Ltd. and subsidiaries as of December 31, 1996, 1995 and 1994, and the related consolidated statements of operations, stockholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the management of The TPI Group, Ltd. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects the financial position of The TPI Group, Ltd. and subsidiaries as of December 31, 1996, 1995 and 1994 and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. LAZAR, LEVINE & COMPANY LLP New York, New York March 7, 1997 F-68 130 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1994 1995 1996 ----------- ----------- ----------- ASSETS Current Assets: Cash and cash equivalents......................... $ 4,164 $ 2,534 $ 800 Cash -- restricted................................ -- 340,000 290,000 Accounts Receivable: Trade, net of allowance for doubtful accounts of $8,606, $58,614 and $362,097, respectively................................. 161,591 151,354 234,780 Unbilled....................................... 971,853 1,769,019 1,675,011 Factored....................................... -- 535,624 -- Due from shareholders............................. -- -- 12,800 Miscellaneous receivables and deposits............ 567,258 422,880 167,866 Prepaid expenses and other current assets......... 28,460 262,276 316,503 ---------- ---------- ---------- Total Current Assets................................ 1,733,326 3,483,687 2,697,760 Property and Equipment, Net......................... 499,974 680,926 646,747 Other Assets, Net................................... 16,128 157,364 7,633 ---------- ---------- ---------- Total Assets........................................ $ 2,249,428 $ 4,321,977 $ 3,352,140 ========== ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current Liabilities: Cash overdraft.................................... $ 265,265 $ 255,125 $ 334,349 Current portion of financing arrangements......... 438,867 1,732,892 627,182 Loans payable -- shareholders..................... 25,508 14,016 -- Accounts payable and accrued expenses............. 1,990,134 2,867,944 4,029,479 Payroll taxes payable............................. 1,437,798 3,553,657 1,962,097 Current portion of reserve for workers' compensation claims............................ -- 202,333 628,181 Income taxes payable.............................. 4,399 4,560 8,380 Other current liabilities......................... 105,927 198,968 111,391 ---------- ---------- ---------- Total Current Liabilities........................... 4,267,898 8,829,495 7,701,059 Long-Term Liabilities: Financing arrangements -- net of current portion........................................ 86,256 64,750 4,895,082 Reserve for workers' compensation claims -- net of current portion................................ -- 294,806 429,482 ---------- ---------- ---------- Total Liabilities................................... 4,354,154 9,189,051 13,025,623 Commitments and Contingencies Stockholders' Equity (Deficit): Common stock -- $0.01 par value, 11,111 shares authorized, 6,261 shares issued and outstanding for 1996, 200 shares no par value authorized, 100 shares issued and outstanding for 1994 and 1995........................................... 85,101 85,101 63 Additional paid-in capital........................ -- -- 85,038 Accumulated deficit............................... (2,189,827) (4,952,175) (9,758,584) ---------- ---------- ---------- Total Stockholders' Equity (Deficit)................ (2,104,726) (4,867,074) (9,673,483) ---------- ---------- ---------- Total Liabilities and Stockholders' Equity (Deficit)......................................... $ 2,249,428 $ 4,321,977 $ 3,352,140 ========== ========== ========== The accompanying notes are an integral part of these consolidated financial statements. F-69 131 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, ------------------------------------------- 1994 1995 1996 ----------- ----------- ----------- Revenues............................................ $49,659,775 $72,067,276 $83,433,759 Payroll and Payroll Related Costs................... 48,720,337 70,355,295 81,812,101 ----------- ----------- ----------- Gross Profit........................................ 939,438 1,711,981 1,621,658 ----------- ----------- ----------- Operating Expenses: Administrative personnel and payroll related costs.......................................... 488,125 858,659 1,658,987 General and administrative expenses............... 1,119,425 1,467,824 1,777,698 Sales and marketing expenses...................... 475,629 674,233 866,526 Provision for doubtful accounts................... 38,833 71,755 487,121 Depreciation and amortization..................... 105,306 179,364 618,309 ----------- ----------- ----------- Total Operating Expenses............................ 2,227,318 3,251,835 5,408,641 ----------- ----------- ----------- (Loss) From Operations.............................. (1,287,880) (1,539,854) (3,786,983) ----------- ----------- ----------- Other Expenses: Interest and penalties............................ 128,700 1,164,046 965,035 Other expenses, net............................... -- 54,721 40,543 ----------- ----------- ----------- Total Other Expenses................................ 128,700 1,218,767 1,005,578 ----------- ----------- ----------- (Loss) Before Provision for Income Taxes............ (1,416,580) (2,758,621) (4,792,561) Provision for income taxes........................ 22,764 3,727 13,848 ----------- ----------- ----------- Net (Loss).......................................... $(1,439,344) $(2,762,348) $(4,806,409) =========== =========== =========== The accompanying notes are an integral part of these consolidated financial statements. F-70 132 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 ADDITIONAL SHARES/ COMMON PAID-IN ACCUMULATED COMMON STOCK CAPITAL DEFICIT ------ -------- ---------- ----------- Balance at January 1, 1994................... 100 $ 85,101 $ -- $ (750,483) Net loss................................... -- -- -- (1,439,344) ------ ------- ------- ----------- Balance at December 31, 1994................. 100 85,101 -- (2,189,827) Net loss................................... -- -- -- (2,762,348) ------ ------- ------- ----------- Balance at December 31, 1995................. 100 85,101 -- (4,952,175) Amendment of par value and exchange of stock................................... 6,161 (85,038) 85,038 -- Net loss................................... -- -- -- (4,806,409) ------ ------- ------- ----------- Balance at December 31, 1996................. 6,261 $ 63 $ 85,038 $(9,758,584) ====== ======= ======= =========== The accompanying notes are an integral part of these consolidated financial statements. F-71 133 THE TPI GROUP, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1994 1995 1996 ----------- ----------- ----------- Increase (Decrease) in Cash and Cash Equivalents: Cash Flows From Operating Activities: Net loss.......................................... $(1,439,344) $(2,762,348) $(4,806,409) Adjustments to reconcile net (loss) to net cash (used in) operating activities: Depreciation and amortization.................. 105,306 179,364 618,309 Provision for doubtful accounts................ 4,042 71,755 487,121 Deferred tax benefits.......................... 22,985 -- -- Cost of reserve for workers' compensation claims....................................... -- 497,139 560,524 Loss on disposal of fixed assets............... -- -- 8,710 Changes in assets and liabilities: (Increase) decrease in cash -- restricted...... -- (340,000) 50,000 (Increase) decrease in receivables............. (915,222) (1,394,308) 318,384 Decrease (increase) in prepaid expenses and other current assets......................... 116,281 (233,816) (58,512) Increase in accounts payable and accrued expenses..................................... 788,498 877,810 1,161,535 Increase (decrease) in payroll taxes payable... 717,882 2,115,859 (1,591,560) Increase (decrease) in other current liabilities.................................. 36,201 93,202 (83,757) ----------- ----------- ----------- Net cash (used in) operating activities... (563,371) (895,343) (3,335,655) ----------- ----------- ----------- Cash Flows From Investing Activities: Additions to property and equipment............... (63,389) (275,227) (95,688) Increase in other assets, net..................... (11,291) (70,798) (336,289) ----------- ----------- ----------- Net cash (used in) investing activities... (74,680) (346,025) (431,977) ----------- ----------- ----------- Cash Flows From Financing Activities: Proceeds from financing arrangements.............. 469,000 1,619,370 5,450,000 Payments of financing arrangements................ (124,906) (358,000) (1,736,510) Increase in shareholders loans receivable......... -- -- (12,800) Increase (decrease) in shareholders' loans payable........................................ 15,991 (11,492) (14,016) Increase (decrease) in bank overdrafts............ 256,606 (10,140) 79,224 ----------- ----------- ----------- Net cash provided by financing activities.............................. 616,691 1,239,738 3,765,898 ----------- ----------- ----------- Net (Decrease) in Cash and Cash Equivalents......... (21,360) (1,630) (1,734) Cash and cash equivalents, beginning of year...... 25,524 4,164 2,534 ----------- ----------- ----------- Cash and Cash Equivalents, End of Year.............. $ 4,164 $ 2,534 $ 800 =========== =========== =========== Supplemental Disclosure of Cash Flow Information: Cash paid during the year for: Interest.................................. $ 39,776 $ 293,821 $ 403,415 Income taxes.............................. 3,433 892 10,029 The accompanying notes are an integral part of these consolidated financial statements. F-72 134 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (a) NATURE OF OPERATIONS: The TPI Group, Ltd., "the Company," is a holding company which owns 100% of the capital stock (see Principles of Consolidation below) of the following corporations: TPI Staffing, Inc., Queensberry, New York Temporary Payroll Incentives, Inc., Queensbury, New York TPI Payroll Processing Services, Inc., Queensbury, New York Staffing Technologies, Inc., Queensbury, New York Herotech, Inc., Queensbury, New York Trans-Partnering Innovations, Inc., Boston, Massachusetts The Company and its subsidiaries are primarily involved in providing professional staffing, payroll and insurance benefit services to small and medium sized companies in a variety of industries, including manufacturing, retail and hospitality. The main office is located in Queensbury, New York with satellite offices in several Atlantic Coast States. The Company does not have a concentration of customers in any one industry; however, during 1994, 1995 and 1996 a significant portion of the Company's revenues were generated in New York. (b) PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of The TPI Group, Ltd. and its subsidiaries, TPI Staffing, Inc., Temporary Payroll Incentives, Inc., TPI Payroll Processing Services, Inc., Staffing Technologies, Inc., Herotech, Inc. and Trans-Partnering Innovations, Inc. All material intercompany balances and transactions have been eliminated. At all times since inception, there has been common ownership of the above corporations amongst the existing shareholders of The TPI Group, Ltd. At January 1, 1995, the shareholders entered into an agreement whereby the individual owners of the companies agreed to exchange their respective shares of capital stock in these corporations for capital stock in The TPI Group, Ltd. As a result of this agreement, The TPI Group, Ltd. became the sole stockholder and parent in these corporations. Because the companies are controlled by a common group of shareholders, the transaction was accounted for as a combination of interests, at historical cost, similar to a pooling of interests. This transaction has been retroactively reflected as if it had taken place at the beginning of 1993 and accordingly, consolidated financial statements have been prepared for each year. Prior years' financial statements have been reclassified to conform with current year's presentation. (c) USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain 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 amounts could differ from those estimates. F-73 135 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (d) CONCENTRATION OF CREDIT RISK: The Company maintains the majority of its cash accounts in one commercial bank. The total cash balances are secured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. (e) PROPERTY AND EQUIPMENT: Property and equipment are stated at cost. Depreciation is provided on straight-line or accelerated methods at rates based on the estimated useful lives. Depreciation expense for the years ended December 31, 1994, 1995 and 1996 was $92,020, $105,424 and $132,289, respectively. Expenditures for major renewals and betterments that extend the useful lives of fixed assets are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Equipment operated under leases which transfer to the Company substantially all benefits and risks associated with the assets are capitalized and an asset and liability are recorded at the present value, or fair value if appropriate, of minimum payments over the term of the lease. Amortization of the asset is determined using the straight-line or accelerated methods. Expenses associated with all other leases (operating leases) are charged to expense as incurred. (f) AMORTIZATION: Costs associated with the acquisition of a customer list have been capitalized and are being amortized over a five year period on a straight-line basis. At December 31, 1996 these costs were fully amortized. Costs associated with the acquisition of a loan factoring agreement have been capitalized and are being amortized on a straight-line basis over the life of the agreement. The agreement was terminated on April 12, 1996 and all remaining costs associated with the agreement were expensed (see Note 6). The total amortization expenses for the years ended December 31, 1994, 1995 and 1996 were $13,286, $73,940 and $486,020, respectively. (g) INCOME TAXES: Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of certain assets and liabilities for financial and tax reporting. The deferred taxes represent the future tax return consequences of those differences, which will either be taxable when the assets and liabilities are recovered or settled. (h) CASH AND CASH EQUIVALENTS: For purposes of the statements of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. (i) RESERVE FOR CLAIMS: The Company's workers' compensation benefits and certain of its health care benefits are provided under large deductible insured plans. The Company records reserves for workers' compensation and health care claims costs based on actuarial calculations using the Company's loss history of workers' compensation and health care claims. In all cases regarding workers' compensation and health care claims, reserves are established at the time a participant files a claim. Furthermore, the Company, in determining its reserves, includes reserves for estimated claims incurred but not reported. F-74 136 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1995 and 1996, the Company has classified as current the estimated amounts of reserves established for claims expected to be paid within one year. The Company's estimates of its claims reserves, including its estimate of incurred but not reported claims, are based primarily on its loss history. The ultimate cost of heath care and workers' compensation claims will depend on actual costs incurred in settling the claims and may differ from the amounts reserved by the Company for those claims. NOTE 2 -- CASH -- RESTRICTED: Beginning in 1995, the Company placed $250,000 on deposit with a bank as collateral for a letter of credit in favor of its workers' compensation insurance carrier relating to the issuance of a workers' compensation insurance policy. During 1996, the Company placed $40,000 on deposit with a bank as collateral for a letter of credit required on a general insurance bond. During 1995, the Company had an agreement with one of its clients whereby the client kept $90,000 in a separate bank account, in the Company's name, as collateral against its outstanding receivable. The Company reflected this amount on its balance sheet as restricted cash and as a corresponding escrow liability. During 1996, the $90,000 was no longer required to be maintained in a separate account. NOTE 3 -- MISCELLANEOUS RECEIVABLES AND DEPOSITS: At December 31, 1996, miscellaneous receivables and deposits consisted of the following: 1996 -------- Deposits with insurance company required to fund possible workers' compensation claims of prior years.............................. $152,396 Other miscellaneous receivables................................... 15,470 -------- $167,866 ======== NOTE 4 -- FIXED ASSETS: Fixed assets consist of the following: 1994 1995 1996 --------- --------- --------- Land.................................... $ 61,000 $ 61,000 $ 61,000 Leasehold improvements.................. 236,338 291,735 291,735 Furniture and equipment................. 158,513 391,360 486,988 Vehicles................................ 121,377 103,216 71,942 Assets held under capital leases........ 35,375 46,523 71,138 --------- --------- --------- 612,603 893,834 982,803 Less: accumulated depreciation and amortization.......................... (112,629) (212,908) (336,056) --------- --------- --------- $ 499,974 $ 680,926 $ 646,747 ========= ========= ========= F-75 137 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5 -- ACCRUED EXPENSES: Included in accrued expenses as of December 31, 1995 is an accrual for $584,254 representing late payment penalties and interest due to the Internal Revenue Service for late payment of federal withholding taxes for the quarters ended September 30, and December 31, 1995. Included in accrued expenses as of December 31, 1996 is an accrual for $815,000 representing late payment penalties and interest due to the Internal Revenue Service for late payment of federal withholding and unemployment taxes for the fourth quarter of 1995 and all four quarters of 1996. These amounts, together with the corresponding tax liabilities, have been or are expected to be paid in 1997. NOTE 6 -- FINANCING ARRANGEMENTS: (a) NOTE PAYABLE -- DEMAND: At December 31, 1994, the Company had a $100,000 demand note payable to a bank, with an interest rate of 10.5% per annum. The note which was collateralized by accounts receivable and contract rights, was repaid in February 1995. At December 31, 1996, the Company had a $600,000 demand note, payable to a bank, at an interest rate of prime plus 1% per annum (9 1/4% at December 31, 1996). This note which was collateralized by letters of credit supplied to the bank by certain shareholders of the Company, was repaid in February 1997. (b) NOTE PAYABLE -- FACTORING AGREEMENT: On October 4, 1995, the Company entered into a factoring agreement with Reservoir Capital Corporation (RCC), whereby the Company sold to RCC selected accounts receivable. RCC purchased from the Company 75% of the balance of the selected receivables up to a maximum outstanding balance of $2,250,000. All cash collected on these receivables was deposited daily into a bank account of RCC. With the cash deposited into their account, RCC first reduced that portion of the receivable which they purchased, next paid to itself a processing fee of 1% of the total receivable plus interest at an annual rate of Wall Street prime plus 5% of the outstanding receivable balance, and finally returned to the Company the remaining portion of cash collected. This note was collateralized by the accounts receivable of the Company. At December 31, 1995, the outstanding balance of the RCC factoring agreement was $1,630,519, and the related factored receivables were $2,174,025. On April 12, 1996, the agreement with RCC was terminated and the loan was paid in full. (c) OTHER NOTES PAYABLE: 1994 1995 1996 -------- -------- ------- Various notes payable monthly with interest rates ranging from 6.99% to 10%, collateralized by certain equipment................................. $ 80,475 $ 46,160 $12,590 Note payable to a related party, payable with interest only at rates from 9.5% to 10%, collateralized by a mortgage...................... 40,000 40,000 40,000 Note payable -- bank, guaranteed by a related party, payable in monthly principal installments of $20,000 plus interest at the prime rate published by the Wall Street Journal plus 2% per annum maturing February, 1996........................... 274,729 69,000 -- ------- -------- -------- Totals............................................ 395,204 155,160 52,590 Less: current portion............................. 308,948 95,655 12,590 ------- -------- -------- Long-term portion................................. $ 86,256 $ 59,505 $40,000 ======= ======== ======== F-76 138 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Maturities of long-term debt are as follows: YEAR ENDING DECEMBER 31, AMOUNT ----------------------------------------------------------- ------- 1997....................................................... $12,590 1998....................................................... -- 1999....................................................... -- 2000....................................................... -- Beyond..................................................... 40,000 ------- Total................................................. $52,590 ======= (d) CAPITALIZED LEASE OBLIGATIONS: Capitalized lease obligations at December 31, 1994, 1995 and 1996 consisted of the following: 1994 1995 1996 ------- -------- -------- Leases collateralized by computer equipment with monthly payments totaling $1,370 including interest at rates of 10.5% to 23.7%. The leases began to expire in November 1995...................................................... $29,919 $ 11,963 $ 19,674 ======== ======== ======== Capitalized leased equipment consisted of the following: Computer equipment.......................................... $35,375 $ 46,523 $ 71,138 Less: accumulated depreciation.............................. (9,905) (20,625) (33,651) -------- -------- -------- Total Book Value.................................. $25,470 $ 25,898 $ 37,487 ======== ======== ======== The following is a schedule by years of future minimum lease payments under capital leases, together with the present value of the net minimum lease payments as of December 31, 1996. YEAR ENDING DECEMBER 31, AMOUNT --------------------------------------------------------------------------- ------- 1997....................................................................... $16,191 1998....................................................................... 5,409 ------- Total minimum payments........................................... $21,600 ======= Total minimum payments..................................................... $21,600 Less: amounts representing interest........................................ 1,926 ------- Present value of net minimum lease payments................................ 19,674 Less: current portion...................................................... 14,592 ------- Long-term portion................................................ $ 5,082 ======= (e) NOTE PAYABLE -- INVESTMENT GROUP/SHAREHOLDER: On April 12, 1996, the Company received a loan from an investment group/shareholder of $4,850,000. This note bears interest at 10% per annum, and matures on April 12, 1997. As part of the note agreement, the investment group could convert the entire note balance including interest into 4,850 shares of senior convertible cumulative 9% preferred stock, at $.01 par value on or prior to December 31, 1996. (Extended to the date of sale of the Company -- see Note 13b). F-77 139 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7 -- PROVISION FOR INCOME TAXES: 1994 1995 1996 ------- ------ ------- Current: Federal...................................... $ -- $ -- $ -- States....................................... 4,135 3,727 13,848 ------- ------ ------- Total Current Taxes............................ 4,135 3,727 13,848 ------- ------ ------- Net Operating Loss (NOL) Carryforwards: Federal...................................... (2,839) -- -- States....................................... (1,507) -- -- ------- ------ ------- Total Tax Benefits............................. (4,346) -- -- ------- ------ ------- SubTotal....................................... (211) 3,727 13,848 ------- ------ ------- Deferred: Federal...................................... 15,014 -- -- States....................................... 7,961 -- -- ------- ------ ------- Total Deferred Taxes........................... 22,975 -- -- ------- ------ ------- Total Income Tax............................... $22,764 $3,727 $13,848 ======= ====== ======= The tax effects of the temporary differences that give rise to deferred tax assets, as of December 31, 1994, 1995 and 1996 are as follows: 1994 1995 1996 --------- ----------- ----------- Net Operating Loss Carryforwards..... $ 310,000 $ 1,244,000 $ 2,290,000 Less: valuation allowance............ (310,000) (1,244,000) (2,290,000) ---------- ------------ ------------ Net deferred tax assets.............. $ -- $ -- $ -- ========== ============ ============ The Company has available at December 31, 1994, 1995 and 1996 unused operating loss carryforwards of approximately $777,000, $3,111,000 and $5,725,000, respectively, which may be applied against future taxable income expiring in various years beginning in 2005 through 2011. At an assumed tax rate of 40%, these carryforwards may result in deferred tax assets of approximately $310,000, $1,244,000 and $2,290,000, respectively. Since there is no assurance that the Company will generate future taxable income to utilize this asset, a 100% valuation allowance has been provided as of December 31, 1994, 1995 and 1996. Subsequent to the balance sheet date, a corporation purchased 100% of the outstanding stock of the Company (see Note 13). According to I.R.C. Section 382, if an ownership change of more than 50% of a loss corporation occurs, the taxable income of that loss corporation for any post-change tax year can be offset by existing net operating loss carryforwards only to the extent of the fair market value of the old loss corporation's capital stock multiplied by the long-term tax exempt bond rate. On the date of the change in ownership the estimated amount of net operating loss carryforwards that still exists is still to be determined. NOTE 8 -- LEASES: Beginning in 1994, the Company leased several vehicles for two and three year terms under operating leases. The Company also leases other equipment on an as-needed basis. Vehicle and other equipment rental expense was $14,288, $55,338 and $71,864 for the years ended December 31, 1994, 1995 and 1996, respectively. F-78 140 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following is a schedule of future minimum rental payments required under the above operating leases as of December 31, 1996. YEAR ENDED DECEMBER 31, ---------------------------------------------------------- 1997...................................................... $ 58,356 1998...................................................... 31,410 1999...................................................... 11,748 2000...................................................... 11,748 2001...................................................... 1,124 -------- $114,386 ======== The Company leases office space in various locations other than its main office in Queensbury, New York (see Note 10c). Annual rentals aggregate approximately $85,000. NOTE 9 -- JOINT VENTURE ARRANGEMENT: A joint venture arrangement has been established for the Connecticut and White Plains offices. Management personnel of these offices agreed to reimburse the Company for the excess of expenses over revenue from the date that those offices were opened in 1994 through December 31, 1995. The total expense reimbursement for 1995 was $66,128 which was reflected in other receivables. Effective November 1, 1995 and throughout 1996, this joint venture arrangement has been amended whereby the Company is to receive an amount equal to 2.5% of gross billings of the two aforementioned offices. Management of these offices is to receive the gross profit generated by these offices, reduced by the Company's above fee, from which all overhead expenses will be paid. NOTE 10 -- RELATED PARTY TRANSACTIONS: (a) The following balances existed at December 31, 1994, 1995 and 1996, as a result of related party transactions between the Company, its shareholders and individuals related to the shareholders of the Company: DESCRIPTION 1994 1995 1996 -------------------------------------------- ------- ------- ---------- Due from shareholders....................... $ -- $ -- $ 12,800 Loans payable, shareholders................. 25,508 14,016 4,850,000 Long-term debt.............................. 40,000 40,000 40,000 Interest expense............................ 3,900 3,900 4,665 Rent expense................................ 36,755 33,427 35,061 All the material details related to the balances and terms of the above transactions are contained in other disclosures herein. (b) The Company has guaranteed loans made by a financial institution to four of its shareholders and an employee of the Company as detailed below: Two separate loans to four of its shareholders which mature on July 1, 2001 and June 1, 2008 and have a balance as of December 31, 1996 of $36,317 and $158,622, respectively. A loan made to one of the Company's employees maturing November 15, 2000 with a balance of $13,692 at December 31, 1996. (c) In July 1993, the Company entered into a five year lease agreement, aggregating approximately $35,000 per year, for office space in Queensbury, New York, in a building owned by the Company's F-79 141 THE TPI GROUP, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) shareholders. Prior to entering this agreement the Company leased the office space on a month-to-month basis. Total rent expense paid for the Queensbury office for the years ended December 31, 1994, 1995 and 1996 was $36,755, $33,427 and $35,061, respectively. NOTE 11 -- CAPITAL STOCK: In April 1996, the Company amended its Certificate of Incorporation to increase the authorized shares of capital stock from 200 shares of common stock without par value to (i) 11,111 shares of common stock at $.01 par value and (ii) 4,850 shares of senior convertible cumulative 9% preferred stock at $.01 par value. The Company also issued 6,261 shares of its $.01 par value common stock in exchange for the 200 shares of no par value stock outstanding. None of the shares of preferred stock are issued and outstanding as of December 31, 1996 (see Note 13b). NOTE 12 -- CONTINGENCY: The Company is a defendant in a lawsuit related to unlawful discharge from employment and for intentional infliction of emotional distress. The plaintiff seeks the sum of $10,000,000 for compensation and punitive damages. The plaintiff is a former employee of a client of the Company who believes her termination from employment was a violation of the "FMLA" Family and Medical Leave Act. This case is in the preliminary stages of investigation, but management believes that the lawsuit has no merit and it intends to vigorously defend its position. The Company is also involved in various other legal proceedings arising in the ordinary course of business. It is the opinion of the Company's counsel that the outcome of these actions is not expected to have a material adverse effect on the Company's financial position or results of operations. NOTE 13 -- SUBSEQUENT EVENTS: (a) SALE OF THE COMPANY: On January 31, 1997, the shareholders of the Company sold all the outstanding shares of capital stock of the Company to NovaCare Employee Services, Inc., a subsidiary of NovaCare, Inc., a New York Stock Exchange Company. (b) NOTE PAYABLE/PREFERRED STOCK: In conjunction with the above mentioned sale, the investment group (see Note 6e) exercised its option to convert its entire note balance to preferred stock and waived any and all interest associated with the note. (c) Effective as of January 31, 1997, the Company entered into employment agreements with six key employees. The aggregate annual salaries of these six employees is $535,000. These agreements have no specific expiration dates. As of March 1, 1997, all six of the above employees have agreed to a 20% reduction in their base salaries. F-80 142 NOVACARE EMPLOYEE SERVICES VALUES We believe that the most important and differentiating quality of outstanding organizations is a set of values that inspires, unites and sustains them. Values are constant and enduring and precede business plans, policies, procedures, practices, performance and outcomes. The Company's values are: CREDO: Helping Make Life a Little Better PURPOSE: To be the brand, service and performance leader in the PEO industry by effectively creating a more satisfying, more productive relationship between employers and employees BELIEFS: Respect for the Individual Service to the Customer Pursuit of Excellence Commitment to Personal Integrity Our values are the basis on which we build our business, our careers and our reputation. It is our belief that a strong commitment to these values and a philosophy of "caring for and about people" will enable us to provide a level of service that will build the businesses of our clients and enhance the careers of our employees. [NOVACARE EMPLOYEE SERVICES PHOTO OF INDIVIDUALS] [NOVACARE EMPLOYEE SERVICES LOGO] 143 [NOVACARE EMPLOYEE SERVICES LOGO]