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VERTICAL HEALTH SOLUTIONS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
(Edgar Glimpses Via Acquire Media NewsEdge) AND RESULTS OF OPERATIONS
Cautionary Note Regarding Forward-Looking Statements
The Securities and Exchange Commission, or SEC, encourages companies to disclose
forward-looking information so that investors can better understand a company's
future prospects and make informed investment decisions. Certain statements
that we may make from time to time, including, without limitation, statements
contained in this Quarterly Report on Form 10-Q, constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. These statements may be made directly in this Quarterly Report, and
they may also be made a part of this Quarterly Report by reference to other
documents filed with the SEC, which is known as "incorporation by reference."
Words such as "may," "anticipate," "estimate," "expects," "projects," "intends,"
"plans," "believes" and words and terms of similar substance used in connection
with any discussion of future operating or financial performance, identify
forward-looking statements. All forward-looking statements are management's
present expectations of future events and are subject to a number of risks and
uncertainties that could cause actual results to differ materially from those
described in the forward-looking statements. These risks and uncertainties
include, among other things: our need for additional capital to fund our sales
and marketing efforts, continued work on our research and development programs;
our inability to further identify, develop and achieve commercial success for
new products and technologies; the development of competing diagnostic products;
our ability to protect our proprietary technologies; patent-infringement claims;
risks of new, changing and competitive technologies and regulations in the
United States and internationally; and other factors discussed under the heading
Item 1A "Risk Factors" in this Quarterly Report on Form 10-Q.
In light of these assumptions, risks and uncertainties, the results and events
discussed in the forward-looking statements contained in this Quarterly Report
or in any document incorporated by reference might not occur. You are cautioned
not to place undue reliance on forward-looking statements, which speak only as
of the date of this Quarterly Report or the date of the document incorporated by
reference in this Quarterly Report. We are not under any obligation, and we
expressly disclaim any obligation, to update or alter any forward-looking
statements, whether as a result of new information, future events or otherwise,
except as may be required by applicable law. All subsequent forward-looking
statements attributable to Vertical Health Solutions, Inc., referred to herein
as VHS, VHS's wholly-owned subsidiary, OnPoint Medical Diagnostics, Inc.,
referred to herein as OnPoint, or to any person authorized to act on our behalf
are expressly qualified in their entirety by the cautionary statements contained
or referred to in this section.
13
Overview
OnPoint was founded to commercialize MRI quality assurance software and
technologies originally developed by Mayo Clinic. The company is dedicated to
leveraging technology and intelligent systems to assist the global healthcare
industry in delivering the highest quality medical images possible - safely,
consistently and efficiently. OnPoint's enterprise quality assurance solution is
deployed in the cloud and delivered in a "Software as a Service", or SaaS,
utility computing model, which provides anytime, anywhere access to the
technology.
Our flagship product for MRI is focused on automating the quality control
measures required for accreditation by American College of Radiology, with
real-time dashboards, analytics and trending to make sure scanners are providing
the best possible images of patients.
Through September 30, 2012, we have signed contracts with customers which have
or will result in revenue totaling $100,440. Since our inception in February
2009, we have incurred losses and negative cash flows from operations, and such
losses have continued subsequent to September 30, 2012. As of September 30,
2012, we had an accumulated deficit of $(7,920,351) and anticipate incurring
additional losses while we ramp up our sales and marketing efforts. We expect to
spend significant resources over the next several years to secure new customers,
develop strategic partnerships, and to fund future research and development. In
order to achieve profitability, we must continue to develop software products
and technologies that can be commercialized by us or through existing and future
collaborations.
Marketing and Sales
Our software is sold on a per scanner per month basis, with appropriate volume
discounts. It is deployed in the cloud so activation costs for new customers are
minimal and our software, implementation, training, sales, marketing and
customer support will leverage technology and automation. Currently, we can get
a new customer fully implemented and trained remotely in less than one hour.
This allows us to offer programs such as 30-day free trials for our software to
the market.
In January 2012, we launched an inside sales (telemarketing) campaign through
the Reier Group, a sales organization that helps companies develop business and
grow revenue. They provide lead generation, lead management, and assist with
improving closing cycles. In the third quarter of 2012, one resource from the
Reier Group was engaged in the inside sales effort. Our long-term plan is to
develop these capabilities internally, but we will continue to sell primarily
through an inside sales organization as it minimizes our cost of sales and
allows centralized control for customizing and delivering unique marketing
programs.
As of November 5, 2012, OnPoint has 38 medical imaging providers sending quality
assurance imaging studies to the OnPoint cloud and is actively managing over
60,000 images online for its customers. We are developing strategic partnerships
to assist with the sales and marketing of our products. We have successfully
completed pilots with two significant partnerships. Additional capital will be
required to fully-engage with these partners and execute the agreed upon next
steps.
We intend to develop additional models for MRI as well as quality control
systems for other modalities (Computed Tomography, or CT, Mammography,
Ultrasound and others), all of which have similar accreditation requirements and
quality control challenges.
Financings
During the three months ended September 30, 2012, we issued $890,000 in
convertible promissory notes. These notes have a three year term and accrue
interest at a rate of 6% per annum and are convertible into common stock at
$0.25 per share. Interest is due at maturity. These notes will mature on various
dates in August and September 2015. In connection with the issuance of these
notes, we also issued to the investors ten-year warrants to purchase, in the
aggregate, 890,000 shares of our common stock. These warrants have an exercise
price of $1.25 per share.
Results of Operations
Three months ended September 30, 2012 compared to September 30, 2011
Revenue and Costs of Revenue
For the quarter ended September 30, 2012, we recognized revenue of $3,791 on
contracts, which have terms of 12 to 36 months,. Costs of revenue for the
quarter ended September 30, 2012 of $61,326 consisted of employee compensation
allocated to revenue generating efforts of $7,150; consulting costs of $8,000;
$25,000 of royalty payments due to Mayo; and $21,176 of amortization expense
related to software development costs and software technology license. In 2011
periods, prior to the Company starting to generate revenue, comparable expenses
were classified as General and Administrative expense.
14
Operating Expenses
Our general and administrative expenses consist primarily of compensation paid
to employees and related benefit expenses for business development, financial,
legal and other administrative functions. In addition, we incur external costs
for professional fees for legal, patent and accounting services. We expect that
our general and administrative expenses, both internal and external, will
increase as we continue with our sales and marketing efforts.
Research and Development Expenses. Our research and development expenses were
$67,870 for the three months ended September 30, 2012 and $0 for the three
months ended September 30, 2011. The Company had previously capitalized research
and development costs related to the development of the Company's software
product after technological feasibility was proven.
General and Administrative Expenses. Our general and administrative expenses
were $341,880 for the three months ended September 30, 2012 compared to $307,355
for the three months ended September 30, 2011.
Investor Relations Expense. Investor relations expense represents a non-cash
charge to earnings for the fair value of warrants issued to certain warrant
holders according to adjustment provisions in their original equity offering
agreement, as discussed in Note 8; Stockholders' Equity (Deficit). Investor
relations expense was $819,118 and $0 for the three months ended September 30,
2012 and 2011, respectively.
Merger Related Costs. Our merger related costs were $0 for the three months
ended September 30, 2012, compared to $26,677 for the three months ended
September 30, 2011.
Interest Expense. Interest expense was $300,203 for the three months ended
September 30, 2012 compared to $21,839 for the three months ended September 30,
2011.
Components of interest expense consisted of the following for the three and nine
months ended September 30, 2012 and 2011, respectively:
Three Months Ended Nine Months Ended
September 30, September 30,
2012 2011 2012 2011
Components of interest expense:
Amortization of warrant discount on
long-term promissory notes $ 115,634 $ - $ 154,919 $ -
Accrued interest on 2010 and 2011
convertible notes 4,465 8,327 18,214 60,354
Amortization of warrant discount on 2012
convertible notes 139,951 - 209,653 -
Accrued interest on long-term promissory notes
and short-term convertible notes 9,071 - 27,412 -
Amortization of deferred debt financing
costs 20,024 13,512 52,341 280,260
Accrued interest on 2012 convertible notes 11,058 - 18,450 -
Interest expense recognized on warrant
derivative liability - - 133,966 -
$ 300,203 $ 21,839 $ 614,955 $ 340,614
Beneficial Conversion Expense. We recognized a non-cash charge to earnings of
$809,533 during the quarter ended September 30, 2012 on the conversion of
long-term promissory notes, which are discussed in Note 5; Long-Term Promissory
Notes. The $809,533 represents the difference between the fair value of the
Company's stock issued at conversion and the carrying value of the debt
principal and related accrued interest converted.
Nine months ended September 30, 2012 compared to September 30, 2011
Revenue and Costs of Revenue
For the nine month period ended September 30, 2012, we recognized revenue of
$9,330 on contracts totaling $50,130. We also recognized $56,983 in service
contract revenue for services performed during the nine months ended September
30, 2012. Costs of revenue for the nine month period ended September 30, 2012 of
$206,366 consisted of employee compensation allocated to revenue generating
efforts of $22,000, consulting expense of $34,728, $75,000 of royalty payments
due to Mayo, and $74,638 of amortization expense related to software development
costs and software technology license. In 2011 periods, prior to the Company
starting to generate revenue, comparable expenses were classified as General and
Administrative expense.
Operating Expenses
Research and Development Expenses.Our research and development expenses were
$199,781 for the nine months ended September 30, 2012 and $0 for the nine months
ended September 30, 2011. The Company had previously capitalized research and
development costs related to the Company's software product after technological
feasibility was proven.
General and Administrative Expenses. Our general and administrative expenses
were $1,087,769 for the nine months ended September 30, 2012 compared to
$851,836 for the nine months ended September 30, 2011. Contributors to the
increase over the comparable prior year period are increases in employee
salaries and marketing costs.
Investor Relations Expense. Investor relations expense represents a non-cash
charge to earnings for the fair value of warrants issued to certain warrant
holders according to adjustment provisions in their original equity offering
agreement, as discussed in Note 8; Stockholders' Equity (Deficit). Investor
relations expense was $819,118 and $0 for the nine months ended September 30,
2012 and 2011, respectively.
Merger Related Costs. Our merger related costs were $0 for the nine months ended
September 30, 2012, compared to $350,394 for the nine months ended September 30,
2011.
Interest Expense. Interest expense was $614,955 for the nine months ended
September 30, 2012 compared to $340,614 for the nine months ended September 30,
2011.
Beneficial Conversion Expense. We recognized a non-cash charge to earnings of
$809,533 during the nine months ended September 30, 2012 on the conversion of
long-term promissory notes, which are discussed in Note 5; Long-Term Promissory
Notes. The $809,533 represents the difference between the fair value of the
Company's stock issued at conversion and the carrying value of the debt
principal and related accrued interest converted.
15
Liquidity and Capital Resources
At September 30, 2012, we had cash of $461,440 and negative working capital of
$12,002. Through September 30, 2012, we have funded substantially all of our
operations and capital expenditures through private placements of equity and
convertible notes securities totaling $4,187,300. Based on our current
operating plan, the Company has enough funds for operations to December 31,
2012.
For the nine months ended September 30, 2012, compared to the nine months ended
September 30, 2011, we have used $1,066,808 and $896,312 cash in operations,
respectively. This was in increase of $170,496. Significant contributors to the
increased use of cash in operations include; an overall increase in net loss of
$2,106,710, offset by non-cash operating expenses of (a) an increase in debt
discount amortization of $364,572, (b) an increase in stock based compensation
of $726,956, and (c) an increase in beneficial conversion expense of $809,533.
Investing activities consisting of a decrease in restricted cash providing
$50,591 of cash over the comparable prior period; and, capitalized software
costs used $(367,956) of cash during the comparable prior year period. Finally,
cash provided from financing activities increased by $247,669 ($1,334,169 for
2012 compared to $1,086,500 for 2011), which is primarily due to increased
amounts of convertible note issuances of $771,000, offset by a decrease of stock
issuances of ($466,088).
Our outstanding 2010-2011 convertible notes have a mandatory conversion feature
whereby the outstanding principal amount automatically, and without any further
action by the note holders, convert to common stock. In addition, the holders of
such convertible notes have the option to convert the accrued but unpaid
interest on such convertible notes into shares of common stock. Therefore, the
only financial obligation associated with these notes would occur if the note
holders elect to receive accrued interest in cash in lieu of shares of our
common stock. As of September 30, 2012, note holders converted $1,215,000 of
convertible notes plus accrued interest of $97,277, leaving $132,500 in
principal outstanding.
In February 2012, we entered into an 8% convertible note financing agreement
with certain investors, which provided $216,000 of funding during the quarter
ended March 31, 2012. We subsequently received additional committed funds of
$90,000 in April 2012 and $100,000 in May 2012, for a total funding amount of
$406,000. In connection with the notes, we incurred legal costs of $8,109 and
finders' fees of $38,600, which were to be paid out of the net proceeds to third
party selling agents. Total debt financing costs of $46,709 were capitalized and
are being amortized over the term of the related convertible notes using the
effective interest rate method. Interest is payable on a quarterly basis.
In August and September 2012, we entered into a 6% convertible note financing
agreement with certain investors, which provided $890,000 of funding during the
quarter ended September 30, 2012. In connection with the notes, we incurred
finders' fees of $115,700, which were to be paid out of the net proceeds to
third party selling agents. Total debt financing costs of $475,914 were
capitalized and will be amortized over the term of the related convertible notes
using the effective interest rate method. Interest is payable at maturity which
is three years after issuance.
On August 21, 2012, one $50,000 convertible note was converted to 200,000 shares
of common stock.
If all of the holders of convertible notes elect to receive accrued interest in
cash, we would be obligated to make the following interest payments:
Date Payment
October 2012 $ 8,118
December 2012 5,521
January 2013 8,187
April 2013 8,009
July 2013 8,098
August 2013 50,428
September 2013 106,200
Total $ 194,561
Our outstanding term debt of $265,000, which was scheduled to mature in either
November 2013 ($50,000) or December 2013 ($215,000) was converted to equity on
September 28, 2012. The debt holders each agreed to convert their outstanding
principal and all accrued interest to shares of the Company's common stock at a
conversion rate of $0.25. As a result, 1,060,000 shares were issued to satisfy
the $265,000 in principal, and another 113,236 shares were issued to satisfy
$28,308 of accrued interest through the conversion date of September 28, 2012.
Under our existing license agreement with Mayo, we have an obligation to pay a
minimum royalty of $100,000 per year to Mayo for year ending December 31, 2012,
and each year thereafter. As of September 30, 2012, we have $125,000 of such
royalty payment accrued. The 2011 payment is past due and we currently have a
verbal agreement to make all payments when funding and cash flows allow.
16
We continue to expend cash resources on research and development activities.
Without further financing, we expect that expenditures in connection with our
research and development efforts will have a material negative impact on our
short term liquidity position.
In order to fully launch the sales and marketing efforts to penetrate the
marketplace with our product, fully fund ongoing research and development
efforts, and build our internal operations, we are seeking to raise additional
capital during the remainder of 2012. A capital raise could include the securing
of funds through new strategic partnerships or collaborations, the sale of
common stock or other equity securities or the issuance of debt. We require
operating capital from external sources such as strategic partnerships or
collaborations, the sale of common stock or other equity securities or the
issuance of debt to sustain the business as we ramp up our sales and marketing
efforts and secure new customers. We cannot assure you that any such capital
raising transaction will be available to us as needed, or on favorable terms. We
are subject to those risks associated with any software company. In addition, we
operate in an environment of rapid technological change and we are largely
dependent on the services of our employees and consultants. We cannot assure you
that future development projects will be successful, that future products will
be commercially viable, or that we will be able to attract and retain the
necessary employees and consultants to complete development and commercialize
products.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations
are based on our financial statements, which have been prepared in accordance
with United States generally accepted accounting principles, or GAAP. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, the
disclosure of contingent assets and liabilities at the date of the financial
statements, and reported amounts of revenue and expenses during the reporting
period. On an ongoing basis, we evaluate our judgments and estimates, including
those related to long-lived assets, accrued liabilities, share-based payments
and income taxes. We base our judgment and estimates on historical experience
and various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities. Actual results may differ from
these estimates under different assumptions or conditions.
While our significant accounting policies are described in more detail in Note 2
to our financial statements, we believe the following accounting policies to be
critical to the judgments and estimates used in the preparation of our financial
statements:
Software Development Costs
Costs related to research, design and development of software products prior to
establishment of technological feasibility, are charged to research and
development expense as incurred. Software development costs are capitalized
beginning when a product's technological feasibility has been established and
ending when a product is available for general release to customers. Capitalized
software development costs will be amortized over the estimated economic life of
the underlying products, which will generally range from two to six years.
Minimum Royalty Payments
The Company's policy is to recognize the minimum royalty payments based on the
occurrence of the Company's sales activity. If it is determined that the minimum
obligation will not be met, an accrual will be recorded accordingly. During the
quarter ended September 30, 2012, the Company determined that the minimum
obligation would not be met through a percentage of our sales and therefore,
during the nine month period ended September 30, 2012, the Company has accrued
$75,000 of royalty payments. The total accrual for unpaid royalties was $125,000
at September 30, 2012.
Revenue Recognition
The Company is a development stage company and had not generated any revenue
from inception (February 1, 2009) through December 31, 2011. The Company began
generating a nominal amount of revenue during the quarter ended March 31, 2012.
Software subscription revenue under existing contracts is recorded as deferred
revenue upon execution of a software subscription agreement. Revenue is then
recognized monthly on a straight-line basis over the life of the subscription
agreement, which is typically 12 months.
17
The Company also earned revenue on a service contract with a sole customer
during the quarter ended March 31, 2012. The service contract for $10,000 was
recognized as revenue as the services were performed during March, 2012.
During the quarter ended June 30, 2012, the Company sold $46,983 of software to
a sole customer, and fully recognized the related revenue during the three month
period ended June 30, 2012.
Income Taxes
We account for income taxes using the asset and liability approach which
requires the recognition of deferred tax assets and liabilities for the tax
consequences of temporary differences between the tax bases of assets and
liabilities and their carrying amounts for financial reporting purposes using
enacted tax rates in effect for the years in which the differences are expected
to reverse. Valuation allowances are established when necessary to reduce
deferred tax assets to the amount expected to be realized.
We account for income taxes pursuant to Financial Accounting Standards Board
guidance specifically related to uncertain tax positions. This guidance presents
a more-likely-than-not threshold for financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. We
believe our income tax filing positions and deductions will be sustained upon
examination and, accordingly, no accrual related to uncertain tax positions has
been recorded at September 30, 2012 and December 31, 2011. Our remaining open
tax years subject to examination include the periods 2009, 2010 and 2011. This
standard also provides guidance on derecognition of income tax assets and
liabilities, classification of current and deferred income tax assets and
liabilities, accounting for interest and penalties associated with tax
positions, accounting for income taxes in interim periods and income tax
disclosures.
We have recorded a full valuation allowance against our deferred tax assets at
September 30, 2012 and December 31, 2011.
Stock-Based Compensation
We recognize expense for stock-based compensation based on the fair value of the
awards granted. The fair value of stock options is estimated at the date of
grant using the Black-Scholes option valuation model. We make assumptions about
complex and subjective variables and the related tax impact. These variables
include, but are not limited to, our stock price volatility and stock option
exercise behaviors. For volatility, we are currently using comparable public
companies. We recognize the compensation cost for stock-based awards on a
straight-line basis over the requisite service period for the entire award.
Debt Issued with Warrants
We account for the issuance of debt and related warrants by allocating the debt
proceeds between the debt and warrants based on the relative estimated fair
values of the debt security without regard for the warrants and the estimated
fair value of the warrants themselves. The amount allocated to the warrants
would then be reflected as both an increase to equity, and as a debt discount
that would be amortized over the term of the debt. However, in circumstances
where warrants must be accounted for as a liability, the full estimated fair
value of the warrants is established as both a liability and a debt discount. In
some cases, if the value of the warrants is greater than the principal amount
received, an immediate interest expense charge is recorded for the excess.
In accounting for convertible debt instruments, the proceeds from issuance of
the convertible notes are first allocated between the convertible notes and the
warrants. If the amount allocated to convertible notes results in an effective
per share conversion price less than the fair value of the Company's common
stock on the date of issuance, the intrinsic value of this beneficial conversion
feature is recorded as a further discount to the convertible debt with a
corresponding increase to additional paid in capital. The beneficial conversion
feature discount is equal to the difference between the effective conversion
price and the fair value of the Company's common stock.
Derivative Financial Instruments
Derivative liabilities are required to be accounted for at fair value. As such,
each balance sheet date, all such outstanding derivative liabilities are
reported at the period end's estimated fair value, and changes in that estimate
from the prior period end are reflected as a gain or loss in the consolidated
statement of operations. The Company utilizes a Black-Scholes option pricing
model to estimate fair values of its derivative liabilities.
18
These derivative liabilities are also marked-to-market prior to any related
exercises, modifications, or extinguishments, with any necessary changes in fair
value from the prior balance sheet date being reflected as a gain or loss in the
consolidated statement of operations. The carrying value of the liability is
eliminated upon extinguishment, converted to equity upon an exercise, or
adjusted as may be necessary in a modification.
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