REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholder
VeriChip Corporation,
We have audited the accompanying balance sheets of VeriChip Corporation (the “Company”), a wholly owned subsidiary of Applied Digital Solutions,
Inc., as of December 31, 2004 and 2003, and the related statements of operations, capital deficit and cash flows for each of the years in the three-year period ended December 31, 2004. Our audits also included the financial statement
schedules listed in Item 16(b). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of
the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 financial statements enumerated above present fairly, in all material respects, the financial position of VeriChip Corporation as of
December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, the schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Eisner LLP
New York, New York
November 23, 2005,
With respect to the eighth and twentieth paragraphs of Note 1.
1. Organization
and Significant Accounting Policies
Organization
VeriChip Corporation (the “Company”) is a Delaware corporation
formed in November 2001. The Company’s operations began in January 2002. The Company issued 13,333,333 shares of its common stock to its parent company, Applied Digital Solutions, Inc., referred to as Applied Digital or Parent Company, upon the
commencement of its operations. Applied Digital owns 100% of the outstanding shares of the Company’s common stock. Prior to the expansion of the Company’s business through two acquisitions during the first half of 2005, as discussed in
Note 13, the Company’s activities consisted primarily of developing the markets for its radio frequency identification, or RFID, systems using the implantable VeriChip.
The implantable VeriChip is a human-implantable microchip that uses RFID technology and that can be used in a variety of
patient identification and security applications. Each implantable VeriChip contains a unique identification number that is read by the Company’s scanner. In October 2004, the U.S. Food and Drug Administration, or FDA, cleared the
Company’s VeriMed patient identification system for medical use in the United States. The Company’s VeriMed patient identification system is used to rapidly and accurately provide physicians with a patient’s pre-approved data which
can include a patient’s name, primary care physician, emergency contact and other pertinent pre-approved data, such as personal health records.
VeriChip is not an FDA-regulated medical device with regard to its use in security applications. The security applications for VeriChip are marketed under
the VeriGuard brand name. The Company’s VeriGuard system is used to identify individuals and permit access into restricted areas.
Through December 31, 2004, the Company has been dependent upon the financial support of Applied Digital. See Note 11 for information concerning the amount
due to Parent Company and the conversion of such borrowing into a line of credit with Applied Digital.
The Company obtains the implantable VeriChip and related scanners from Digital Angel Corporation, or Digital Angel, under the terms of an exclusive supply
and license agreement. The terms of the supply and license agreement are discussed in Note 11. Digital Angel is a majority-owned subsidiary of Applied Digital and it owns the patents related to the implantable VeriChip. Through December 31,
2004, all research and development efforts related to the implantable VeriChip have been performed by Digital Angel.
Through December 31, 2004, the Company’s revenues, which were minimal, were derived solely from the Company’s VeriGuard system, and the
Company operated in one segment. As a result of the two acquisitions during the first half of 2005, which are more fully discussed in Note 13, on July 1, 2005, the Company began operating in two business segments: (i) Healthcare and (ii)
Security and Industrial. Accordingly, the Company’s operations for all periods have been presented in the Company’s two business segments.
Revenues, when generated, and operating costs associated with the Company’s VeriMed patient identification system are included in the Company’s
Healthcare segment. Revenue and operating costs associated with the Company’s VeriGuard system are included in the Company’s Security and Industrial segment.
On December 12, 2005, the Company’s board of directors proposed and the Company’s shareholder approved a
2-for-3 reverse stock split, which was effectuated on December 20, 2005. All share
amounts reflected in these financial statements have been adjusted for the reverse stock split. In addition, on December 12, 2005, the Company’s
board of directors proposed and the Company’s shareholder approved the authorization of 5.0 million shares of blank check preferred stock and an increase in the Company’s authorized shares of its common stock from 50.0 million to
70.0 million shares. These changes were also effectuated on December 20, 2005.
Significant Accounting Policies
Use
Of Estimates
The preparation of financial statements in
conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Included in
these estimates are assumptions about allowances for inventory obsolescence, bad debt reserves and equipment lives, among others. Although these estimates are based on the knowledge of current events and actions the Company may undertake in the
future, they may ultimately differ from actual results.
Inventories
Inventories consist of human implantable microchips and
scanners (finished goods). Inventories are valued at the lower of cost or market, determined by the first-in, first-out method. The Company monitors and analyzes inventory for potential obsolescence and slow-moving items based upon the aging of the
inventory and the inventory turns by product. Inventory items designated as slow moving are written down to reflect their estimated net realizable value. Inventory items designated as obsolete are written off. Allowance for slow moving inventory was
approximately $0.1 million, $0 and $0 as of December 31, 2004, 2003 and 2002, respectively.
Equipment
Equipment is
carried at cost less accumulated depreciation computed using straight-line methods. Equipment is depreciated over periods ranging from 3 to 5 years. Repairs and maintenance, which do not extend the useful life of the asset, are charged to expense as
incurred.
Advertising Costs
The Company expenses production costs of print advertisements on the first
date the advertisements take place. Advertising expense included in selling, general and administrative expense was approximately $0.1 million, $19,000 and $1,000 in 2004, 2003 and 2002, respectively.
Revenue Recognition
In general the Company recognizes revenue after products are shipped to customers and title has transferred, provided that a
purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectability is reasonably assured. If uncertainties regarding customer
acceptance exist, revenue is recognized when such uncertainties are resolved.
Revenues from the sale of VeriChip microchips and scanners are recorded in the statement of operations at the gross amounts, with a separate corresponding entry for the cost of sales. Because of minimal sales volumes
to date (all of which have been to distributors), the Company’s management cannot, as yet, reasonably estimate the amount of returns. Accordingly, the Company does not at this time recognize revenues from direct sales to its distributors until
the products are shipped and title has transferred, all the above mentioned conditions have been satisfied, and the period of time the distributor
has to return products (as provided in the applicable agreement) has expired. Once the amount of returns can be reasonably estimated, revenues (net of
expected returns) will be recognized in accordance with the Company’s general accounting policy for product sales. When the Company commences consignment sales of its VeriChip microchips and scanners, the Company intends to recognize revenues
from such sales after receipt of notification from the distributor that a product sale has been made to its customer, provided that a purchase order has been received or a contract has been executed with the customer, the sales price is fixed and
determinable and the period of time the customer has to return the products (as provided in the applicable agreement) has expired and collectability is reasonably assured. As of December 31, 2004, deferred VeriChip product revenue was de
minimus.
Originally, the Company entered into distributorship
agreements whereby the distributor would pay an up-front fee in exchange for the exclusive right to market, promote and sell VeriChip products within the agreed upon territory. Under this arrangement, the distribution fee was not creditable against
or applied towards amounts due for any products subsequently ordered by the distributor. During 2003, the Company amended its existing contracts to stipulate that $1.00 of up-front money would be allocated to a distribution fee, and the remaining
amounts were customer deposits, which could be applied against future purchases of VeriChip microchips and scanners. Therefore, distributor fees were never recognized as revenue.
Stock-Based Compensation
The Company accounts for its employee stock-based compensation plans in accordance with the Accounting Principles Board (“APB”) Opinion
No. 25,
Accounting for Stock Issued to Employees
, or APB 25, and Financial Accounting Standards Board Interpretation No. 44,
Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion
No. 25
, or FIN 44. In accordance with this accounting literature, no compensation cost is recognized for any of the Company’s fixed stock options granted to directors and employees when the exercise price of each option equals or
exceeds the fair value of the underlying common stock on the grant date. As of December 31, 2004, the Company has not granted any options to employees at a price less than fair value on the date of grant. When options are granted to officers
and directors at a price less than the fair market value on the date of grant, compensation expense is required to be calculated based on the intrinsic value (i.e., the difference between the exercise price and the fair market value on the date of
grant), and the compensation expense must be recognized over the vesting period of the options. If the options are fully vested, the expense is recognized immediately. Changes in the terms of stock option grants, such as extending the vesting period
of the options or changes in the exercise price generally have an accounting consequence. Accordingly, compensation expense is measured in accordance with APB 25, such that compensation expense is measured and recognized over the vesting period. If
the modified grant is fully vested, any additional compensation cost is recognized immediately. The Company accounts for equity instruments issued to non-employees and non-directors, including employees of Applied Digital, in accordance with the
provisions of Statement of Financial Accounting Standard, or SFAS, No. 123,
Accounting for Stock-based Compensation,
or FAS 123. The Company recognized $0.3 million, $0.7 million and $0.1 million of expense during 2004, 2003 and 2002,
respectively, associated with such options, including $12,000 and $0.2 million during 2004 and 2003, respectively, related to a severance agreement.
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004),
Share-Based Payment,
or FAS 123R,
which replaces FAS 123 and supersedes APB 25. The impact of FAS 123R is more fully described under the section titled Impact of Recently Issued Accounting Standards.
As of December 31, 2004, the Company had one stock option plan. The following table illustrates the
effect on net loss and loss per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for options granted under its plan:
Year Ended December 31,
2004
2003
2002
(in thousands, except per
share amounts)
Net loss available to common stockholder, as reported
$(2,011
)
$(1,710
)
$(1385
)
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax
effects
(134
)
(56
)
(90
)
Pro forma net loss available to common stockholder
$(2,145
)
$(1,766
)
$(1,475
)
Loss per share:
Basic and Diluted—as reported
$(0.15
)
$(0.13
)
$(0.10
)
Basic and Diluted—pro forma
$(0.16
)
$(0.13
)
$(0.11
)
The weighted average
per share fair value of grants made in 2004, 2003 and 2002 for the Company’s stock options was $0.22, $0.23, and $0.05, respectively. The fair values of the options granted were estimated on the grant date using the Black-Scholes valuation
model based on the following weighted-average assumptions:
2004
2003
2002
Estimated option life
5.5 years
5.5 years
5.5 years
Risk free interest rate
3.88
%
2.99
%
4.88
%
Expected volatility
68.84
%
76.00
%
76.00
%
Expected dividend yield
0.00
%
0.00
%
0.00
%
On December 12,
2005, the Company’s board of directors approved a proposal which provides for the vesting on December 30, 2005 of all of the Company’s outstanding and unvested stock options previously awarded to employees and directors and to one
employee of Applied Digital (to the extent not already vested on that date), provided, however, that the grantee that acquires any shares pursuant to such an option (the vesting of which has been accelerated) shall not be permitted to sell such
shares until the earlier of: (i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.
The purpose of accelerating the vesting of the employees’ and directors’ options was to enable the Company to
avoid recognizing in its statement of operations compensation expense associated with the options in future periods. As a result of the acceleration, the Company expects to avoid recognition of up to approximately $0.6 million of compensation
expense in its statement of operations over the course of the original vesting period, substantially all of which is expected to be avoided in 2006. Such expense will be included in the Company’s pro forma stock-based compensation footnote
disclosure in the quarter ended December 31, 2005. FIN 44 requires the Company to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when such options are in the money on the date of the change, that
would allow an employee to vest an option that would have otherwise been forfeited based on the original terms of the awards. The Company would be required to begin to recognize compensation expense over the new expected vesting period based on
estimates of the number of options that employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have been vested over the next six
months, with a smaller percentage vesting over the next thirty-three months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of the 1.0 million stock
options that were affected by the acceleration of vesting, substantially all of the $4.4 million of the intrinsic value of the newly vested options is attributable to the
Company’s executive officers and directors. The Company is unable to estimate the number of options that its employees and directors will ultimately
retain that otherwise would have been forfeited, absent the acceleration. Based on the current circumstance, the high concentration of options awarded to officers and directors and the Company’s historical turnover rates, no compensation
expense resulting from the new measurement date will be recognized by the Company on December 30, 2005. The Company will recognize compensation expense in future periods, should a benefit be realized by the holders of the aforementioned
options, which they would not otherwise have been entitled to receive.
Income Taxes
The Company accounts for income
taxes under the asset and liability approach for the financial accounting and reporting for income taxes. Deferred taxes are recorded based upon the tax impact of items affecting financial reporting and tax filings in different periods. A valuation
allowance is provided against net deferred tax assets where the Company determines realization is not currently judged to be more likely than not. Currently, the Company files a consolidated federal income tax return with Applied Digital. In the
event that Applied Digital’s ownership is reduced below 80%, the Company would be required to file a separate federal income tax return. See Note 6.
Loss Per Common Share and Common Share Equivalent
Basic loss per common share is computed by dividing loss by the weighted average number of common shares outstanding for the period. Diluted loss per
common share is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares issuable upon exercise of stock options and warrants.
Impact of Recently Issued Accounting Standards
In January 2003, the FASB issued Interpretation No. 46,
Consolidation
of Variable Interest Entities—an Interpretation of ARB No. 51
, or FIN 46, which addresses consolidation of variable interest entities. FIN 46 expands the criteria for consideration in determining whether a variable interest entity
should be consolidated by a business entity, and requires existing unconsolidated variable interest entities (which include, but are not limited to, special purpose entities, or SPEs) to be consolidated by their primary beneficiaries if the entities
do not effectively disperse risks among parties involved. In October 2003, the FASB issued Staff Position No. 46-6 which deferred the effective date for applying the provisions of FIN 46 for interests held by public entities in variable
interest entities or potential variable interest entities created before February 1, 2003. In December 2003, the FASB issued a revision to FIN 46. Under the revised interpretation, the effective date was delayed to periods ending after
March 15, 2004 for all variable interest entities, other than SPEs. The adoption of FIN 46 did not have an impact on the Company’s financial condition, results of operations or cash flows.
In December 2004, the FASB issued FAS 123R, which replaces FAS 123 and
supersedes APB 25. FAS 123R requires that all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under
FAS 123 will no longer be an alternative to financial statement recognition. The provisions of FAS 123R will become effective for the Company on January 1, 2006. Under FAS 123R, the Company must determine the appropriate fair value model to be
used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retrospective options. The Company is currently
evaluating the requirements of FAS 123R. As discussed above under the heading Stock Based Compensation, all of the Company’s outstanding employee stock options will be vested upon adoption on January 1, 2006, and, therefore, the Company
does not expect that the initial adoption of FAS 123R will have a material impact on its consolidated results of operations and earnings (loss) per share. However, going forward, as the Company grants more options, it expects that the impact may be
material. The Company has not yet determined the method of adoption, and it has not determined whether the adoption
will result in amounts that are similar to the current pro forma disclosures required under FAS 123, although it anticipates that the amounts may be greater
due to increases in personnel during 2005. In addition, the Company has not yet determined the impact of FAS 123R on its compensation policies or plans, if any.
In November 2004, the FASB issued SFAS No. 151,
Inventory Costs, an amendment of ARB N
o. 43, Chapter 4, or FAS 151. FAS 151
amends Accounting Research Bulletin No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, FAS 151
requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. The Company is required to adopt FAS 151 beginning January 1, 2006. The Company believes the adoption of FAS 151
will not have a material impact on the results of its operations, financial position or cash flows.
In December 2004, the FASB issued SFAS No. 153,
Exchanges of Nonmonetary Assets
, or FAS 153. This Statement amends Opinion 29 to eliminate the
exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future
cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company believes the adoption of FAS
153 will not have a material impact on the results of its operations or financial position.
In May 2005, the FASB issued SFAS No. 154,
Accounting Changes and Error Corrections a replacements of APB No. 20 and FAS No. 3
, or FAS 154. FAS 154 changes the requirements for the accounting for
and reporting of a change in accounting principle. FAS 154 also applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement
does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. FAS 154 is effective for all accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. The Company has not yet adopted the provisions of FAS 154 and it has not yet determined the impact on its financial statements, if any.
2. Equipment
Equipment consists of the following:
December 31,
2004
2003
(in thousands)
Equipment
$255
$223
Less: Accumulated depreciation
(124
)
(76
)
$131
$147
Depreciation expense
charged against income amounted to approximately $48,000, $44,000 and $33,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
3. Fair Value of Financial Instruments
The carrying amounts of cash, accounts receivable and accounts payable approximate fair values because of the short-term maturity of these instruments.
The fair value of the amount due to Parent Company, which is carried at its face amount plus accrued interest at the prime rate, could not reasonably be estimated because it resulted from related party transactions with its Parent Company. On
December 27, 2005, the Company and Applied Digital converted the amount due to Parent Company into a revolving line of credit under the terms of a loan agreement, security agreement and a revolving line of credit note, which are more fully described
in Note 11.
On August 21, 2002, the Company issued to IBM Credit Corporation a warrant to acquire 1,232,667 shares of the Company’s common stock at an
exercise price of $0.075 per share, which represented management’s estimate of fair value at the time of grant. The warrant was issued in connection with an amendment to a credit agreement between Applied Digital, certain of its subsidiaries
and IBM Credit Corporation. The warrant was exercisable on the date of grant and expires on August 21, 2007. The fair value of the warrant of approximately $44,000 was reflected as a deemed dividend to Applied Digital. The fair value of the
warrant was determined using the Black-Scholes valuation model and the following assumptions:
Warrant life
5 years
Risk free interest rate
3.31
%
Expected volatility
50.00
%
Expected dividend yield
0.00
%
In February 2002, the
Company’s board of directors approved the VeriChip Corporation 2002 Flexible Stock Plan (or the VeriChip 2002 Plan). Under the VeriChip 2002 Plan, the number of shares for which options, SARs or performance shares may be granted is 5.9 million.
As of December 31, 2004, approximately 3.0 million options, net of forfeitures, have been granted to directors, officers and employees under the VeriChip 2002 Plan, and all of the options granted were outstanding as of December 31, 2004.
At December 31, 2004, 2.5 million options, net of forfeitures, have been granted to employees of Applied Digital and consultants, all of which were outstanding under the VeriChip 2002 Plan as of December 31, 2004. The options vest
from one to two years from the date of grant and expire up to nine years from the vesting date. As of December 31, 2004, no SARs have been granted under the VeriChip 2002 Plan.
On May 6, 2005, the Company’s board of directors approved the VeriChip Corporation 2005 Flexible Stock Plan (or
the VeriChip 2005 Plan). Applied Digital’s shareholders approved the VeriChip 2005 Plan on June 11, 2005. Under the VeriChip 2005 Plan, the number of shares for which options, SARs or performance shares may be granted is 0.8 million.
A summary of stock option activity for 2004, 2003 and 2002 is
as follows (in thousands, except weighted-average exercise price):
2004
2003
2002
Number
of
Options
Weighted-
Average
Exercise
Price
Number
of
Options
Weighted-
Average
Exercise
Price
Number
of
Options
Weighted-
Average
Exercise
Price
Outstanding on January 1
4,161
$
0.12
4,604
$
0.08
–
$
0.00
Granted
2,023
0.57
540
0.38
4,604
0.08
Exercised
–
0.00
–
0.00
–
0.00
Forfeited
(707
)
0.95
(983
)
0.08
–
0.00
Outstanding on December 31
5,477
0.18
4,161
0.12
4,604
0.08
Exercisable on December 31
4,054
0.11
2,894
0.08
–
0.00
Shares available on December 31 for options that may be granted
The following table summarizes information about stock options at December 31, 2004 (in thousands,
except weighted-average amounts):
Outstanding Stock Options
Exercisable Stock
Options
Range of
Exercise
Prices
Shares
Weighted-
Average
Remaining
Contractual
Life
Weighted-
Average
Exercise
Price
Shares
Weighted-
Average
Exercise
Price
$0.00 to $0.10
3,571
3.9
$0.08
3,571
$0.08
$0.11 to $0.20
67
7.5
0.26
0
0.00
$0.21 to $0.30
1,833
6.6
0.38
483
0.38
$0.61 to $0.70
6
9.2
0.98
0
0.00
5,477
4.9
$0.18
4,054
$0.11
The Company granted
options to certain of its employees and directors to purchase shares of the Company’s common stock. The options were granted at exercise prices equal to the value of the underlying common stock on the date of each grant, as determined by the
Company’s management. The Company’s management determined these values principally based upon internal valuation estimates. The assumptions used by the Company’s management included:
•
the Company’s projected operating performance;
•
risk and the non-liquid nature of the Company’s common stock; and
•
trends and comparable valuations in the broad market for privately-held and public companies, including Applied Digital.
There are inherent uncertainties in making estimates about forecasts of
future operating results and identifying comparable companies and transactions that may be indicative of the fair value of the Company’s securities. The Company believes that the estimates of the fair value of its common stock at each option
grant date were reasonable under the circumstances.
The
Company has also granted nonqualified stock options to employees of Applied Digital and other non-employees who have provided services to it. For these options, the Company recognized stock-based expense as the options vested of approximately $0.3
million, $0.7 million and $0.1 million for the years ended December 31, 2004, 2003 and 2002, respectively, based on an estimate of their fair value on the date of grant using the Black-Scholes option pricing model, which required the Company to
make several key judgments including:
•
the estimated value of the Company’s common stock;
•
the expected life of issued stock options;
•
the expected volatility of the Company’s stock price; and
•
the expected dividend yield to be realized over the life of the stock option.
The Company prepared these estimates based upon its historical experience, the stock price volatility of comparable publicly-traded companies,
including Applied Digital, and its best estimation of future conditions.
Selling, general and administrative expense consists of:
2004
2003
2002
(in thousands)
Salaries and benefits
(1)
$
866
$
1,146
$
187
Legal and accounting
373
251
418
Sales and marketing
194
151
216
Travel and entertainment
107
100
108
Insurance
97
76
45
Professional and consulting
62
30
205
Depreciation and amortization
48
44
33
Other
183
179
108
$
1,930
$
1,977
$
1,320
(1)
Included in salaries and benefits is $0.3 million, $0.7 million and $0.1 million of compensation expense for the years 2004, 2003 and 2002, respectively, associated with stock
options granted to employees of Applied Digital and consultants.
6. Income Taxes
The provision for income taxes
consists of:
2004
2003
2002
Current expense:
United States at statutory rates
$
–
$
–
$
–
Current income tax provision
Deferred:
United States
–
–
–
Deferred income taxes provision
–
–
–
$
–
$
–
$
–
The tax effects of
temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following:
The valuation allowance for deferred tax assets increased by approximately $0.8 million and
$0.5 million in 2004 and 2003, respectively, due mainly to the generation of net operating losses. The valuation allowance was provided for net deferred tax assets that exceeded the level of existing deferred tax liabilities and the
Company’s projected pre-tax income.
Currently, the
Company files a consolidated federal income tax return with Applied Digital. Upon completion of the initial public offering of the Company’s common stock, it is anticipated that Applied Digital’s ownership will be less than 80%. If that is
the case, the Company will be required to file a separate federal income tax return.
At December 31, 2004, the Company had US federal net operating loss carryforwards of approximately $3.9 million for income tax purposes that expire in various amounts from 2022 through 2024. The net operating
losses were allocated in accordance with Treasury Regulation § 1.1502-21T(b)(2)(iv). The valuation allowance has been provided primarily related to the uncertainty regarding the use of certain of the Company’s net operating loss
carryforwards.
Based upon the change of ownership rules under
IRC section 382, if in the future the Company issues common stock or additional equity instruments convertible into shares of the Company’s common stock, which result in the Company’s ownership change exceeding the 50% limitation
threshold, all of the Company’s net operating loss carryforwards may be significantly limited as to the amount of use in any particular year.
The reconciliation of the effective tax rate with the statutory federal income tax benefit rate is as follows:
2004
2003
2002
%
%
%
Statutory tax/(benefit) rate
(34
)
(34
)
(34
)
State income taxes, net of federal benefits
(4
)
(4
)
(4
)
Change in deferred tax asset valuation allowance
38
38
38
–
–
–
7. Loss Per Share
A reconciliation of the numerator and denominator of basic and diluted
loss per share is provided as follows:
2004
2003
2002
(in thousands, except per
share amounts)
Numerator:
Numerator for basic loss per share -
Net loss
$
(2,011
)
$
(1,710
)
$
(1,341
)
Deemed dividend
–
–
(44
)
Net loss available to common stockholder
$
(2,011
)
$
(1,710
)
$
(1,385
)
Denominator:
Denominator for basic and diluted loss per share – weighted-average shares outstanding (1)
13,333
13,333
13,333
Loss per share –
Basic and Diluted
$
(0.15
)
$
(0.13
)
$
(0.10
)
(1)
The weighted-average shares listed below were not included in the computation of diluted loss per share for the years ended December 31, 2004, 2003 and 2002, because to do so
would have been anti-dilutive.
On March 4, 2002, the Company entered into an
exclusive supply and license agreement with Digital Angel an affiliate, regarding the Company’s human-implantable microchip and RFID technology. Digital Angel is the Company’s sole supplier of the implantable microchips relating to the
Company’s business. The Company’s exclusivity rights under the agreement can be terminated if it does not purchase certain prescribed minimum quantities or it defaults in any obligation under the agreement, including the payment of money,
and the default is not cured within 90 days after receipt of written notice. On December 27, 2005, the agreement was amended and restated. The amended and restated agreement is more fully discussed in Note 11.
9. Profit Sharing Plan
Applied Digital has a 401(k) Plan for the benefit of eligible United States employees. Certain of the Company’s
employees participate in the 401(k) Plan. Applied Digital has made no contributions to the 401(k) Plan.
10. Legal Proceedings
The Company is a party to various legal actions as either plaintiff or defendant. The Company does not believe that these actions will result in any loss to it, and accordingly, no provision has been made in the accompanying financial
statements.
Metro Risk
On January 10, 2005, the Company commenced an action in the Circuit
Court for Palm Beach County, Florida, against Metro Risk Management Group, LLC, or Metro Risk. In this suit, the Company claims that Metro Risk breached the parties’ three international distribution agreements by failing to meet required
minimum purchase obligations. On July 1, 2005, Metro Risk asserted a counterclaim against the Company for breach of contract and fraud. Metro Risk seeks unspecified damages, lost profits and attorneys’ fees. Currently, the Company has
pending a motion to strike Metro Risk’s answer, affirmative defenses, allegations within the counterclaim and other claims. Given the early stage of the case and because discovery has not yet begun, counsel is currently unable to assess the
Company’s exposure to loss.
11. Related Party Transactions
Under a shared and transition services agreement, Applied
Digital has provided certain general and administrative services to the Company including, accounting, finance and legal services, telephone, rent and other miscellaneous items. The costs of these services, which are included in the Company’s
statement of operations in selling, general and administrative expense, was determined based on estimated utilization. Management believes that the fees charged for these services are reasonable and consistent with what the expenses would have been
on a stand-alone basis. The cost of these services to the Company was approximately $0.4 million, $0.3 million and $0.2 million in 2004, 2003 and 2002, respectively.
On December 27, 2005, the Company entered into a transition services agreement with Applied Digital under which Applied
Digital has agreed to provide the Company with certain administrative
transition services, including payroll, legal, finance, accounting, information technology, tax services, and services related to this offering. As
compensation for these services, the Company has agreed to pay Applied Digital (i) approximately $62,000 per month for fixed costs allocable to these services, (ii) Applied Digital’s reasonable out-of-pocket direct expenses incurred
in connection with providing these services that are not included in the agreement as a monthly fixed cost, (iii) Applied Digital’s expenses incurred in connection with services provided to the Company in connection with the initial public
offering of the Company’s common stock, and (iv) any charges by third party service providers that may or may not be incurred as part of the offering and that are attributable to transition services provided to or for the Company.
The term of the agreement continues until such time as the
Company requests Applied Digital to cease performing such services, provided that Applied Digital is not obligated to continue to provide the transition services for more than two years. Except for any request by the Company that Applied Digital
cease to perform transition services, the agreement may not be terminated by either party except in the event of a material default in Applied Digital’s delivery of the transition services or in the Company’s payment for those services.
Applied Digital has funded and financed the Company’s
operations since inception, which has resulted in an amount due to Parent Company totaling $4.2 million and $2.9 million at December 31, 2004 and 2003, respectively. Included in the amount due to Parent Company is interest expense of
approximately $0.1 million, $0.1 million and $21,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The interest rate used to compute such interest was based upon the Wall Street Journal’s prime interest rate in effect
during the applicable periods.
On December 27, 2005, the
Company and Applied Digital converted the amounts due to Parent Company into a revolving line of credit under the terms of a loan agreement, security agreement and a revolving line of credit note. The note provides for advances up to $8.5 million,
interest on the unpaid principal balance outstanding from time to time equal to the prime rate of interest as published in the Wall Street Journal and a stated balloon payment of principal and interest due on December 27, 2010. Notwithstanding the
stated maturity date, Applied Digital, at its sole discretion has the option to extend the note on the first renewal date of June 27, 2007 and on each of the renewal anniversary dates until the stated maturity date. In addition, if a change in the
Company’s ownership or management occurs, as defined in the loan agreement, or the Company completes the initial public offering of its common stock, a balloon payment of principal and interest is due within two business days of the event. The
loan is subordinated to the obligations of the Company under the credit agreement with the Royal Bank of Canada, and is collateralized by security interests in all property and assets of the Company except as otherwise encumbered by the rights of
the Royal Bank of Canada under its credit agreement with VCI.
The Company executed an exclusive eleven year supply and license agreement dated March 4, 2002 with Digital Angel, a majority-owned subsidiary of Applied Digital covering the manufacturing and purchasing of its implantable microchip.
The agreement included a license for the use of the VeriChip technology in the Company’s identified markets. The Company’s purchases of product under the supply and license agreement were approximately $0.1 million, $0.6 million and $0.1
million for the years ended December 31, 2004, 2003 and 2002, respectively. On December 27, 2005, the Company and Digital Angel amended the agreement as discussed below.
On December 27, 2005, the Company entered into an amended and restated supply, license and development agreement with
Digital Angel. Under this agreement, Digital Angel is the Company’s sole supplier of microchips relating to the Company’s business. The Company has been granted an exclusive, worldwide, license to use Digital Angel’s human-implantable
microchip and RFID technology for the primary purpose of secure human identification. This microchip and technology are used in the Company’s VeriMed and VeriGuard systems. The agreement continues until March 2013, and, as long as the Company
continues
to meet minimum purchase requirements, the agreement will automatically renew on an annual basis until the expiration of the last of Digital Angel’s
patents covering the supplied products. The agreement may be terminated prior to its stated term under specified events, including as a result of a bankruptcy event of the other party or an uncured default. In addition, the Company only retains its
exclusive right to distribute the microchips if it takes delivery and pays for a minimum number of microchips every year. Further, the agreement provides that Digital Angel shall, at the Company’s option, furnish and operate a computer database
to provide data collection, storage and related services for the Company’s customers for a fee as provided. A termination of the Company’s supply, license and development agreement by Digital Angel or the loss of the Company’s
exclusive license due to failure to meet its minimum commitment or for any other reason could have a material adverse effect on the Company’s business. In addition, a key patent related to the implantable VeriChip will expire on May 8, 2010,
which may have a detrimental impact on the Company’s future growth and profitability.
12. Segment Information
Through December 31, 2004, the Company’s revenues, which have been minimal, were derived solely from the Company’s VeriGuard system, and the Company operated in one segment. In October 2004, upon FDA clearance of the
implantable VeriChip for its medical applications, the Company exited the development stage. As a result of the two acquisitions during the first half of 2005, which are more fully discussed in Note 13, on July 1, 2005, the Company
began operating in two business segments: (i) Healthcare and (ii) Security and Industrial. Accordingly, the Company’s operations for all periods presented have been presented in the Company’s two business segments.
Revenues, when generated, and operating costs associated with the
Company’s VeriMed patient identification system are included in the Company’s Healthcare segment. Revenues and operating costs associated with the Company’s VeriGuard system are included in the Company’s Security and Industrial
segment.
The accounting policies of the operating segments are
the same as those described in the summary of significant accounting policies. The Company evaluates performance based on stand-alone operating results as presented below:
During 2004, one of
the Company’s customers, Cyberteck, accounted for approximately 29% of revenues. No other customer accounted for 10% or more of 2004 revenues. During 2003, four customers, Soluset, La Font, Metro Risk and DATA, accounted for 24%, 15%, 25% and
18% of revenues, respectively. No other customer accounted for 10% or more of 2003 revenues.
Revenues are attributed to geographic areas based on the location of the assets producing the revenue. During the years ended December 31, 2004, 2003 and 2002, all of the Company’s assets were located in the U.S.
and, accordingly, all of its revenue is considered to be derived in the U.S.
13. Subsequent Events
The Company made two
significant acquisitions during the first half of 2005, as described in the following table (in thousands):
Company Acquired
Date
Acquired
Acquisition
Price
Goodwill
and Other
Intangibles
Acquired
Other Net
Assets and
Liabilities
Business Description
VCI, formerly eXI Wireless Inc.
3/31/05
$
13,311
$
12,579
$
732
Provider of infant protection, wander prevention and asset location and identification systems combining automated RFID identification and real-time location technologies.
Instantel Inc.
6/10/05
$
25,272
$
26,300
$
(1,028
)
Manufacturer of remote monitoring products including infant protection and wander prevention systems and vibration monitors.
VeriChip Inc.
Effective March 31, 2005, Applied Digital acquired VCI through a plan of
arrangement under which Applied Digital paid CDN$1.60 for each outstanding share of VCI (a total of 10,265,178 VCI common shares were outstanding on March 31, 2005) payable in shares of Applied Digital’s common stock based on the daily
weighted-average closing price of its common stock quoted for the ten consecutive trading days that ended three trading days before the closing. The resulting exchange ratio was 3.0295 shares of VCI’s common stock for each share of Applied
Digital’s common stock. Accordingly, Applied Digital issued 3,388,407 shares of its common stock valued at approximately $11.7 million to VCI’s
shareholders. In addition, all existing VCI options and warrants outstanding were converted pro rata, based upon the exchange ratio, into options or warrants
exercisable into shares of Applied Digital’ common stock. The value of the options and warrants exchanged was approximately $0.7 million. Included in the purchase price was approximately $0.9 million of acquisition costs consisting primarily of
a finder’s fee and legal and accounting related services that were direct costs of the acquisition. The total cost of the acquisition was approximately $13.3 million.
Effective March 31, 2005, Applied Digital contributed VCI to the Company, under the terms of an exchange agreement
between Applied Digital and the Company dated June 9, 2005, in consideration for approximately 3.3 million shares of the Company’s common stock.
The acquisition of VCI was accounted for under the purchase method of accounting. The required purchase accounting adjustment, including the allocation
of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, has been made based upon preliminary valuations prepared by independent third party consultants. The excess of purchase price over the fair
value of the assets and liabilities of VCI was recorded as goodwill of approximately $6.0 million. The intangible assets totaling approximately $6.6 million are comprised of patents, trademarks, customer relationships and distribution network. These
intangibles assets are being amortized over periods ranging from 4 to 12.3 years. The trademarks have indefinite lives.
VCI, based in Vancouver, Canada, has developed patient wandering, maternity ward infant protection and asset / location and identification systems
uniquely combining automated identification and real-time location technologies.
Instantel Inc.
On June 10, 2005, the
Company’s subsidiary, VCI, entered into a share purchase agreement by and among Instantel, Instantel Holding Company s.ar.l., Perceptis, L.P., VCI, the Company and Applied Digital to acquire 100% of the common stock of Instantel. Applied
Digital funded the acquisition with such funding being recorded as a capital contribution from Applied Digital to the Company. Under the terms of the Agreement, Instantel became a wholly-owned subsidiary of VCI.
The purchase price for Instantel was $25.0 million. The purchase price is
payable in two payments. The first payment of $22.0 million was paid in cash at the closing of the transaction. The second payment is required to be made on the earlier of (i) the closing of the Company’s initial public offering or (ii)
September 30, 2006, subject to extension until December 31, 2006. On the closing of the Company’s initial public offering, Perceptis is entitled to receive from the Company a number of shares of the Company’s common stock with an aggregate
market value of $2.0 million valued at the close of business on the date of the second payment and a number of shares of Applied Digital common stock with an aggregate market value of $1.0 million valued at the close of business on the date of the
second payment. If the closing of the initial public offering of the Company’s common stock does not occur by December 31, 2006, Perceptis may elect to receive from the Company either a number of shares of Applied Digital common stock with an
aggregate market value of $3.0 million or a cash payment of $2.5 million. Perceptis has anti-dilution protections as provided in the share purchase agreement and the second payment obligation is guaranteed by Applied Digital. Associated with the
guaranty, a number of shares of Applied Digital common stock with an aggregate market value of $3.0 million valued on the date of closing was placed in escrow for the benefit of Perceptis to secure the guarantee by Applied Digital of the
Company’s performance of the payment obligations. The Company is obligated to reimburse Applied Digital either in stock or cash or a combination of both for any Applied Digital stock issued in connection with the second payment obligation.
In addition, the Company incurred $0.3 million in acquisition
costs consisting primarily of legal and accounting related services that are direct costs of the acquisition.
Instantel, is an Ottawa, Canada-based manufacturer of remote monitoring products in the areas of
healthcare security and vibration monitoring for a diverse customer base.
The Instantel acquisition was accounted for under the purchase method of accounting. The required purchase accounting adjustments, including the allocation of the purchase price to the assets acquired and liabilities
assumed based on their respective fair values, have been made based upon preliminary valuations prepared by independent third party consultants. The excess of purchase price over the estimated fair value of the assets acquired and liabilities
assumed of Instantel was recorded as goodwill of $11.3 million. In addition, the Company has recorded intangible assets of $14.2 million comprised of patents, trademarks, customer relationships and distribution network. These intangibles assets are
being amortized over periods ranging from 8.4 to 11.8 years. The trademarks have indefinite lives.
In considering the benefits of the VCI and Instantel acquisitions, management recognized the strategic complement of these
businesses’ technologies and customer bases with the Company’s existing RFID implantable microchip business.
The purchase price allocations for the VCI and Instantel acquisitions are preliminary and are subject to change. The results of VCI and Instantel have
been included in the unaudited Consolidated Statements of Operations since their respective dates of acquisition. Unaudited pro forma results of operations for the year ended December 31, 2004 are included below. Such pro forma information assumes
that the above acquisitions had occurred as of January 1, 2004, and revenue is presented in accordance with the Company’s accounting policies. This summary is not necessarily indicative of what the Company’s results of operations
would have been had VCI and Instantel been combined entities during such periods, nor does it purport to represent results of operations for any future periods.
(In thousands, except per share amounts)
Year Ended
December 31,
2004
Net operating revenue
$
19,846
Net loss
$
(1,314
)
Net loss per common share – basic and diluted
$
(0.08
)
14. Summarized Quarterly Data
(Unaudited)
(in thousands, except per share amounts)
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Full
Year
2004
Total revenue
$
118
$
38
$
23
$
68
$
247
Gross profit
(1)
62
22
11
(47
)
48
Net loss
(368
)
(429
)
(556
)
(658
)
(2,011
)
Basic and diluted net loss per share
(2)
$
(0.03
)
$
(0.03
)
$
(0.04
)
$
(0.05
)
$
(0.15
)
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Full
Year
2003
Total revenue
$
–
$
148
$
123
$
274
$
545
Gross profit
–
112
76
157
345
Net loss
(799
)
(496
)
(122
)
(293
)
(1,710
)
Basic and diluted net loss per share
(2)
$
(0.06
)
$
(0.04
)
$
(0.01
)
$
(0.02
)
$
(0.13
)
(1)
Included in gross profit for the fourth quarter of 2004 was an allowance for slow moving inventory of approximately $0.1 million.
(2)
Loss per share is computed independently for each of the quarters presented.
Accounts receivable (net of allowance for doubtful accounts of $55 in 2005 and $– in 2004)
5,275
–
Inventories, net of allowance for slow moving inventory of $403 in 2005 and $79 in 2004)
2,420
89
Deferred tax asset
131
–
Prepaid expenses and other current assets
456
40
TOTAL CURRENT ASSETS
10,385
152
EQUIPMENT, NET
792
131
GOODWILL
18,067
–
INTANGIBLE ASSETS, NET
20,124
–
$
49,368
$
283
LIABILITIES AND STOCKHOLDER’S EQUITY (CAPITAL DEFICIT)
CURRENT LIABILITIES
Accounts payable
$
1,187
$
30
Accrued expenses
1,458
4
Income tax payable
279
–
Distributor deposits
–
23
Deferred revenue
784
17
Due to Parent Company
6,709
4,221
TOTAL CURRENT LIABILITIES
10,417
4,295
LONG-TERM DEFERRED TAX LIABILITY
5,996
–
DEFERRED PURCHASE PRICE OBLIGATION
3,000
–
TOTAL LIABILITIES
19,413
4,295
COMMITMENTS AND CONTINGENCIES
STOCKHOLDER’S EQUITY (CAPITAL DEFICIT)
Preferred stock: Authorized 5,000 shares in 2005
–
–
Common stock: Authorized 50,000 shares in 2005 and 35,000 shares in 2004, of $.0015 par value; 16,667 shares issued and outstanding in 2005
and 13,333 shares issued and outstanding in 2004
25
20
Additional paid-in-capital
37,716
1,030
Accumulated deficit
(7,749
)
(5,062
)
Accumulated other comprehensive loss
(37
)
–
TOTAL STOCKHOLDER’S EQUITY (CAPITAL DEFICIT)
29,955
(4,012
)
$
49,368
$
283
See the accompanying
notes to condensed consolidated financial statements.
1. Basis of Presentation and Significant Accounting Policies
Basis of Presentation
VeriChip Corporation (the “Company”) is a Delaware corporation, formed in November 2001. The Company commenced operations in January 2002. The Company’s parent company is Applied Digital Solutions, Inc., or Applied Digital or
Parent Company.
The Company develops, markets and sells radio
frequency identification, or RFID, systems used for the identification, location and protection of people and assets. The Company’s VeriMed patient identification system uses the implantable VeriChip, a human-implantable RFID microchip that can
be used in a variety of patient identification and security applications. Each implantable VeriChip contains a unique verification number that is read when it is scanned by the Company’s scanner. In October 2004, the U.S. Food and Drug
Administration, or FDA, cleared the Company’s VeriMed patient identification system for medical use in the United States.
The Company obtains the implantable VeriChip and related scanners from Digital Angel Corporation, or Digital Angel, under the terms of an exclusive supply
and license agreement. The terms of the license agreement are discussed in Note 13. Digital Angel is a majority-owned subsidiary of Applied Digital and it owns the patents related to the implantable VeriChip. Through December 31, 2004, all
research and development efforts related to the implantable VeriChip were performed by Digital Angel.
The accompanying unaudited condensed consolidated financial statements of the Company as of September 30, 2005, and December 31, 2004 (the
December 31, 2004 financial information included in this report has been extracted from the Company’s audited financial statements), and for the nine-months ended September 30, 2005 and 2004 have been prepared in accordance with
accounting principles generally accepted in the United States, for interim financial information and Article 10 of Regulation S-X under the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of the Company’s management, all adjustments (including normal recurring adjustments) considered necessary to present
fairly the consolidated financial statements have been made.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 sales and expenses during the reporting period. Actual results could differ from those estimates.
The unaudited condensed consolidated statements of operations for the
nine-months ended September 30, 2005 and 2004 are not necessarily indicative of the results that may be expected for the entire year. These statements should be read in conjunction with the financial statements and related notes thereto
included in the Company’s audited financial statements for the year ended December 31, 2004.
Effective March 31, 2005, Applied Digital acquired VeriChip Inc., or VCI, formerly eXI Wireless, Inc., and contributed VCI to the Company under the
terms of an exchange agreement as more fully discussed in Note 4. In addition, on June 10, 2005, Instantel Inc., or Instantel, became a wholly-owned subsidiary of VCI under the terms of a share purchase agreement as more fully discussed in Note
4. VCI and Instantel offer infant protection systems, wander prevention systems and asset location and identification systems. The results of operations of VCI and Instantel are included in the financial statements as of their respective dates of
acquisition. The acquisitions are more fully described in Note 4.
On December 12, 2005, the Company’s board of directors proposed, and the Company’s
stockholder approved, a 2-for-3 reverse stock split, which was effectuated on December 20, 2005. All share amounts reflected in these financial statements have been adjusted for the reverse stock split. In addition, on December 12, 2005,
the Company’s board of directors proposed, and the Company’s stockholder approved, the authorization of 5.0 million shares of blank check preferred stock and an increase in the authorized shares of the Company’s common stock from
50.0 million to 70.0 million. These changes were also effectuated on December 20, 2005.
Significant Accounting Policies
Principles of Consolidation
The financial
statements include the accounts of the Company and its wholly-owned subsidiaries.
Foreign Currencies
Effective March 31,
2005, Applied Digital contributed VCI, a foreign subsidiary located in Canada, to the Company. From April 1, 2005 until June 30, 2005, the subsidiary used its local currency as its functional currency. Results of operations and cash flow
were translated at average exchange rates during the period, and assets and liabilities were translated at end of period exchange rates. Translation adjustments resulting from this process are included in accumulated other comprehensive income
(loss) in the statement of stockholder equity (deficit).
On
July 1, 2005 the functional currency changed from the local currency to the reporting currency. This was done as the result of a functional currency determination test that showed that the majority of VCI’s business operations were
transacted in the reporting currency. Translation adjustments for the period April 1, to June 30, 2005 were not removed from equity, and will remain in equity until a sale or substantially complete liquidation of the investment in VCI. The
translated amounts for nonmonetary assets at the end of the period became the accounting basis for those assets in the period of the change and subsequent periods.
Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than
the functional currency are included in the results of operations as incurred. These amounts are not material to the consolidated financial statements.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Inventories
Inventories consist of raw materials, work in process, and finished goods. The majority of the items are associated with the
Company’s Healthcare segment. Inventory is valued at the lower of cost or market, determined by the first-in, first-out method. The Company monitors and analyzes inventory for potential obsolescence and slow-moving items based upon the aging of
the inventory and the inventory turns by product. Inventory items designated as slow moving are reserved to reflect their estimated net realizable value. Inventory items designated as obsolete are written off. Allowance for slow moving inventory was
approximately $0.5 million and $0.1 million as of September 30, 2005 and December 31, 2004, respectively.
Equipment
Equipment is carried at cost, net of government assistance received, less accumulated depreciation computed using the straight-line method. Leasehold
improvements are depreciated over 5 years, software
is depreciated over 2 years, and equipment is depreciated over periods ranging from 3 to 5 years. Repairs and maintenance, which do not extend the useful
life of the asset, are charged to expense as incurred. Gains and losses on sales and retirements are reflected in the consolidated statements of operations.
Goodwill and Other Intangible Assets
The Company follows Statement of Financial Accounting Standards (“SFAS”) No. 142,
Goodwill and Intangible Assets
(“FAS
142”). Intangible assets deemed to have an indefinite life under FAS 142, such as goodwill, are not amortized, but instead reviewed at least annually for impairment. Intangible assets with finite lives are amortized over their estimated
economic lives. Other than goodwill, the Company’s only other intangible assets with an indefinite life are trademarks valued at approximately $5.0 million as of September 30, 2005. Annually, the Company plans to test its goodwill and
intangible assets for impairment as a part of its annual business planning cycle.
Revenue Recognition
The Company follows the
revenue recognition guidance in Staff Accounting Bulletin, or SAB 101 and SAB 104. The Company’s revenue recognition policies by segment are as follows:
Revenue Recognition Policy for VeriMed and VeriGuard Systems and Services
The Company is currently marketing the implantable VeriChip, insertion kits and scanners under the name VeriMed. The VeriMed patient identification
system will be sold primarily through authorized Group Purchasing Organizations, or GPOs, and distributors for use in medical applications. These GPOs and distributors are separate legal and economic entities, and the Company does not have any
ownership interest in any of the GPOs or distributors. Additionally, the Company has recently hired sales staff to market VeriMed directly to hospitals, and physicians. The sale of the VeriMed patient identification system will include the
implantable VeriChip, scanners, insertion kits and patient registration forms. These items are sold to the GPOs and distributors with a limited warranty period. With the exception of one GPO agreement, these are not consignment sales. The hospitals,
doctors and physicians in turn market the product to the patients. Following the implantation of a VeriChip, the patient will be given the option of completing a registration form and forwarding it to the Company’s authorized affiliated
database administrator, Digital Angel, or to an independent third party database provider. It is the Company’s intention to charge a small fee for this registration service. It is the Company’s intention to also offer a more comprehensive
database for an additional fee.
Product Sales
Revenues from the sale of the implantable VeriChip kits and
scanners are recorded at gross amounts with a corresponding entry for cost of sales. Until the amount of returns can be reasonably estimated, the Company does not recognize revenues until after the products are shipped to customers and title has
transferred, provided that a purchase order has been received or a contract has been executed, the price is fixed or determinable, there are no uncertainties regarding customer acceptance, the period of time in which the distributor or customer has
to return the product has elapsed and collection of the sales proceeds is reasonably assured. Once the level of returns can be reasonably estimated, revenues (net of expected returns) will be recognized at the time of shipment and the passage of
title, assuming there are no uncertainties regarding customer acceptance. If uncertainties regarding customer acceptance exist, revenues will not be recognized until such uncertainties are resolved. The Company intends to recognize revenues from
consignment sales to the Company’s GPOs after receipt of notification from the distributor of product sales to their customers provided that a purchase order has been received or a contract has been executed with the distributor, the sales
price is fixed or determinable, the period of time the GPO has to return the product as provided in their distributor agreement has elapsed and collectability is reasonably assured.
Management believes the product sales are multiple deliverables that can be divided into separate units of accounting under
the guidance provided in EITF 00-21 and SOP 97-2. The sale of the scanners, one
of the deliverables, is considered a separate product sale (separate unit of accounting). There is software included in this product. The software is bundled
with the scanner which allows the number on the implantable VeriChip to be read. This software is not sold separately, the scanner has no value without it, there are no post contract support agreements or after sale services, upgrades, customization
or training services. Management believes that within this product the scanner and software are not separate deliverables as defined in EITF 00-21 because as separate units they have no value to the customer on a stand-alone basis, there is no
objective and reliable evidence of fair value of undeliverable elements since they are never delivered independently and the arrangement does not include a general right of return. Management also believes that SOP 97-2 is not relevant for these
same reasons. The implantable VeriChip and insertion kits are another deliverable and are accounted for as a separate unit of accounting because they also have value to the customers on a stand-alone basis. The chips and insertion kits are sold
separately from the scanners, can be read by other scanners and have independent usefulness.
Services Sales
The services for maintaining subscriber information on a data base maintained by the Company will be sold as a stand-alone contract and treated according
to the terms of the contractual arrangements then in effect. Revenues from this service will generally be recognized over the term of the subscription period or the terms of the contractual arrangements then in effect.
The above revenue recognition policies notwithstanding, with respect to the
sales of products and services sold in tandem, the revenue recognition policy will follow the ultimate arrangements to be negotiated between independent third parties or related parties.
The Company’s revenue recognition policy for VCI and Instantel, which were acquired during the first half of 2005, is
as follows:
Revenue Recognition Policy for VeriChip Patient Wander
Prevention, Infant Protection and Asset Location and Identification and Vibration Monitoring Systems
Hardware and software revenues are recognized when persuasive evidence of an arrangement exists, the goods are shipped and title passes, the price is
fixed or determinable and collection of the sales proceeds is reasonably assured. Revenue from the sale of software implementation services and consulting services is recognized as the services are performed. Revenue from post-contract support
services is recognized over the term of the agreement. When software arrangements include multiple elements to which contract accounting does not apply, the individual elements are accounted for separately if vendor specific objective evidence, or
VSOE, of fair value exists for the undelivered elements. Generally, the residual method is applied in allocating revenue between delivered and undelivered elements. If VSOE does not exist, the revenue on the completed arrangement is deferred until
the earlier of VSOE being established or all of the undelivered elements are delivered or performed with the following exceptions: if the only undelivered element is post contract support, the deferred amount is recognized ratably over the post
contract support period, and if the only undelivered element is services that do not require significant production, modification or customization of the software, the deferred amount is recognized as the services are performed. Maintenance revenue
is deferred and recognized ratably over the terms of the maintenance agreements.
The Company provides certain warranties on its products. Provisions for future warranty costs are based on management’s best estimates and are recorded when revenue on product sales is recognized. The warranty
period for the majority of the products ranges between one and three years. Management determines the warranty provision based on known product failures (if any), historical experience, and other currently available evidence. Warranty expense was
approximately $20,000 and $0 during the nine-months ended September 30, 2005 and 2004, respectively.
The Company follows the guidance of Accounting Principles Board (“APB”) Opinion No. 25,
Accounting for Stock Issued to Employees
,
or APB 25, and Financial Accounting Standards Board Interpretation No. 44,
Accounting for Certain Transactions Involving Stock Compensation – an Interpretation of APB Opinion No. 25
, or FIN 44, in accounting for its stock-based
compensation arrangements. Accordingly, no compensation cost is recognized for any of the Company’s fixed stock options granted to directors and employees when the exercise price of each option equals or exceeds the fair value of the underlying
common stock as of the grant date for each stock option. The Company has not granted any options to employees at a price less than fair value on the date of grant. When options are granted to officers and directors at a price less than the fair
market value on the date of grant, compensation expense is required to be calculated based on the intrinsic value (i.e., the difference between the exercise price and the fair market value on the date of grant), and the compensation expense must be
recognized over the vesting period of the options. If the options are fully vested, the expense is recognized immediately. Changes in the terms of stock option grants, such as extending the vesting period of the option or changes in the exercise
price, generally have an accounting consequence. Accordingly, compensation expense is measured in accordance with APB 25 and recognized over the vesting period. If the modified grant is fully vested, any additional compensation cost is recognized
immediately. The Company accounts for equity instruments issued to non-employees and non-directors, including employees of Applied Digital, in accordance with the provisions of Statement of Financial Accounting Standard, or SFAS, No. 123,
Accounting for Stock-based Compensation,
or FAS 123. During the nine-months ended September 30, 2005 and 2004, the Company recorded $1.1 million and $0.2 million, respectively, of compensation expense associated with such options.
On December 12, 2005, the Company’s board of
directors approved a proposal which provides for the vesting on December 30, 2005 of all of the Company’s outstanding and unvested stock options previously awarded to employees and directors and to one employee of Applied Digital (to the
extent not already vested on that date), provided, however, that the grantee that acquires any shares pursuant to such an option (the vesting of which has been accelerated) shall not be permitted to sell such shares until the earlier of:
(i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.
The purpose of accelerating the vesting of the employees’ and directors’ options was to enable the Company to avoid recognizing in its statement
of operations compensation expense associated with the options in future periods. As a result of the acceleration, the Company expects to avoid recognition of up to approximately $0.6 million of compensation expense in its statement of operations
over the course of the original vesting period, substantially all of which is expected to be avoided in 2006. Such expense will be included in the Company’s pro forma stock-based compensation footnote disclosure for the quarter ended December
31, 2005. FIN 44 requires the Company to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when such options are in the money on the date of the change, that would allow an employee to vest an
option that would have otherwise been forfeited based on the awards original terms. The Company would be required to begin to recognize compensation expense over the new expected vesting period based on estimates of the number of options that
employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have been vested over the next six months, with a smaller percentage vesting
over the next thirty-three months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of the 1.0 million stock options that were affected by the
acceleration of vesting, substantially all of the $4.4 million of intrinsic value of the newly vested options is attributable to the Company’s executive officers and directors. The Company is unable to estimate the number of options that its
employees and directors will ultimately retain that otherwise would have been forfeited, absent the acceleration. Based on the current circumstance, the high concentration of options awarded to officers and directors and the Company’s
historical turnover rates, no compensation
expense resulting from the new measurement date will be recognized by the Company on December 30, 2005. The Company will recognize compensation expense
in future periods, should a benefit be realized by the holders of the aforementioned options, which they would not otherwise have been entitled to receive.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004),
Share-Based Payment
, or FAS
123R, which replaces FAS 123 and supersedes APB 25. FAS 123R requires that all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. The pro forma
disclosures previously permitted under FAS 123 will no longer be an alternative to financial statement recognition. The provisions of FAS 123R will become effective for the Company on January 1, 2006. Under SFAS 123R, the Company must determine
the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retroactive
adoption options. The Company is currently evaluating the requirements of FAS 123R. As discussed above, all of the Company’s outstanding employee stock options will be vested upon adoption on January 1, 2006, and, therefore, the Company
does not expect that the initial adoption of FAS 123R will have a material impact on its consolidated results of operations and earnings (loss) per share. However, going forward, as the Company grants more options, it expects that the impact may be
material. The Company has not yet determined the method of adoption, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures required under FAS 123, although it anticipates that the
amounts may be greater due to increases in personnel during 2005. In addition, the Company has not yet determined the impact of FAS 123R on its compensation policies or plans, if any.
As of September 30, 2005, the Company had two stock option plans. See Note 8. The following table illustrates the
effect on net loss and loss per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for options granted under its plans:
Nine-Months Ended
September 30,
2005
2004
(in thousands, except per
share amounts)
Net loss available to common stockholder, as reported
$(2,688
)
$(1,353
)
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax
effects
(315
)
(103
)
Pro forma net loss available to common stockholder
$(3,003
)
$(1,456
)
Loss per share:
Basic and Diluted – as reported
$(0.17
)
$(0.10
)
Basic and Diluted – pro forma
$(0.19
)
$(0.11
)
The weighted average
per share fair value of grants made in the nine-months ended September 30, 2005 and 2004 for the Company’s stock options was $1.07 and $0.22, respectively. The fair values of the options granted were estimated on the grant date using the
Black-Scholes valuation model based on the following weighted-average assumptions:
Research and development expenses consist of development work associated with the Company’s existing and potential products. The
company’s research and development expenses relate primarily to salaries, bonuses and benefits for engineering personnel, costs associated with various projects, including testing, developing prototypes and related expenses.
2. Inventory
The components of inventories, stated at the lower of cost or market with cost determined on the first-in first-out (FIFO)
method, are as follows (included in the amounts below is approximately $0.1 million of inventory held on consignment):
September 30,
2005
December 31,
2004
(in thousands)
Raw materials
$
1,056
$
–
Work in process
565
–
Finished goods
1,282
168
2,903
168
Allowance for excess and obsolescence
(483
)
(79
)
$
2,420
$
89
3. Equipment
Equipment consists of the following:
September 30,
2005
December 31,
2004
(in thousands)
Leasehold improvements
$
13
$
–
Equipment
1,025
255
Software
54
–
1,092
255
Less: Accumulated depreciation
(300
)
(124
)
$
792
$
131
Depreciation expense
charged against income amounted to $0.2 million and $36,000 for the nine months ended September 30, 2005 and 2004, respectively.
The following table describes the Company’s acquisitions during the nine-months ended September 30, 2005 (in thousands):
Company Acquired
Effective
Date
Acquired
Acquisition
Price
Goodwill
and
Other
Intangibles
Acquired
Other Net
Assets and
Liabilities
Business Description
VCI, formerly eXI Wireless Inc.
3/31/05
$13,311
$12,579
$732
Provider of infant protection, wander prevention and asset location and identification systems combining automated RFID identification and real-time location technologies.
Instantel Inc.
6/10/05
$25,272
$26,300
$(1,028
)
Manufacturer of remote monitoring products including wander prevention and maternity ward infant protection systems and vibration monitors.
The total purchase
price of the businesses acquired was allocated as follows (the required purchase accounting adjustments, including the allocation of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, have been
made based upon valuations prepared by independent third party consultants. The purchase price allocations are still in review and are subject to change):
VCI
Instantel Inc.
(in thousands)
Current assets
$3,112
$5,678
Equipment
191
493
Intangibles:
Patented and non-patented proprietary technology
3,710
1,720
Trademarks
1,131
3,790
Customer relationships
895
3,390
Distribution network
856
5,320
Goodwill
5,987
12,080
Current liabilities
(1,056
)
(2,503
)
Deferred taxes
(1,511
)
(4,696
)
Total
$13,311
$25,272
VCI
On March 31, 2005, Applied Digital acquired VCI through a plan of
arrangement under which Applied Digital paid CDN$1.60 for each outstanding share of VCI (a total of 10,265,178 VCI common shares were outstanding on March 31, 2005) payable in shares of Applied Digital’s common stock based on the daily
weighted-average closing price of its common stock quoted for the ten consecutive trading days that ended three trading days before the closing. The resulting exchange ratio was 3.0295 shares of VCI’s common stock for each share of Applied
Digital’s common stock. Accordingly, Applied Digital issued 3,388,407 shares of its common stock valued at approximately $11.7 million to VCI’s shareholders. In
addition, all existing VCI options and warrants outstanding were converted pro rata, based upon the exchange ratio, into options or warrants exercisable into
shares of Applied Digital’ common stock. The value of the options and warrants exchanged was approximately $0.7 million Included in the purchase price was approximately $0.9 million in acquisition costs consisting primarily of a finder’s
fee and legal and accounting related services that were direct costs of the acquisition. The total cost of the acquisition was approximately $13.3 million.
Effective March 31, 2005, Applied Digital contributed VCI to the Company, under the terms of an Exchange Agreement between Applied Digital and the
Company dated June 9, 2005, in consideration for approximately 3.3 million shares of the Company’s common stock.
The acquisition of VCI was accounted for under the purchase method of accounting. The required purchase accounting adjustment, including the allocation of
the purchase price to the assets acquired and liabilities assumed based on their respective fair values, has been made based upon preliminary valuations prepared by independent third party consultants. The excess of purchase price over the fair
value of the assets and liabilities of VCI was recorded as goodwill of approximately $6.0 million. The intangible assets totaling approximately $6.6 million are comprised of patents, trademarks, customer relationships and distribution network. These
intangibles assets are being amortized over periods ranging from 4 to 12.3 years. The trademarks have indefinite lives. See Note 5.
VCI, based in Vancouver, Canada, has developed patient wandering, maternity ward infant protection and asset location and identification systems combining
automated identification and real-time location technologies.
Instantel
Inc.
On June 10, 2005, the Company’s subsidiary,
VCI, entered into a share purchase agreement by and among Instantel, Instantel Holding Company s.ar.l., Perceptis, L.P., VCI, the Company and Applied Digital to acquire 100% of the common stock of Instantel. Applied Digital funded the acquisition,
with such funding being recorded as a capital contribution to the Company. Under the terms of the Agreement, Instantel became a wholly-owned subsidiary of VCI.
The purchase price for Instantel was $25.0 million. The purchase price is payable in two payments. The first payment of $22.0 million was paid in cash
at the closing of the transaction. The second payment is required to be made on the earlier of (i) the closing of the Company’s initial public offering or (ii) September 30, 2006, subject to extension until December 31, 2006. On the closing of
the Company’s initial public offering, Perceptis is entitled to receive from the Company a number of shares of the Company’s common stock with an aggregate market value of $2.0 million valued at the close of business on the date of the
second payment and a number of shares of Applied Digital common stock with an aggregate market value of $1.0 million valued at the close of business on the date of the second payment. If the closing of the initial public offering of the
Company’s common stock does not occur by December 31, 2006, Perceptis may elect to receive from the Company either a number of shares of Applied Digital common stock with an aggregate market value of $3.0 million or a cash payment of $2.5
million. Perceptis has anti-dilution protections as provided in the share purchase agreement and the second payment obligation is guaranteed by Applied Digital. Associated with the guaranty, a number of shares of Applied Digital common stock with an
aggregate market value of $3.0 million valued on the date of closing was placed in escrow for the benefit of Perceptis to secure the guarantee by Applied Digital of the Company’s performance of the payment obligations. The Company is obligated
to reimburse Applied Digital either in stock or cash or a combination of both for any Applied Digital stock issued in connection with the second payment obligation.
In addition, the Company incurred $0.3 million in acquisition costs consisting primarily of legal and accounting related
services that are direct costs of the acquisition.
Instantel,
based in Ottawa, Canada, is a manufacturer of high-quality remote monitoring products in the areas of healthcare security and vibration monitoring for a diverse customer base.
The Instantel acquisition was accounted for under the purchase method of accounting. The required
purchase accounting adjustment, including the allocation of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, have been made based upon preliminary valuations prepared by independent third party
consultants. The excess of purchase price over the estimated fair value of the assets acquired and liabilities assumed of Instantel was recorded as goodwill of $11.3 million. In addition, the Company has recorded intangible assets of $14.2 million
comprised of patents, trademarks, customer relationships and distribution network. These intangibles assets are being amortized over periods ranging from 8.4 to 11.8 years. The trademarks have indefinite lives. See Note 5.
In considering the benefits of the VCI and Instantel acquisitions, management
recognized the strategic complement of these businesses’ technologies and customer bases with the Company’s existing RFID implantable microchip business.
The results of VCI and Instantel have been included in the unaudited Condensed Consolidated Statements of Operations since
their respective dates of acquisition. Unaudited pro forma results of operations for the three and nine-months ended September 30, 2005 and 2004 are included below. Such pro forma information assumes that the above acquisitions had occurred as
of January 1, 2004, and revenue is presented in accordance with the Company’s accounting policies. This summary is not necessarily indicative of what the Company’s results of operations would have been had VCI and Instantel been
combined entities during such periods, nor does it purport to represent results of operations for any future periods.
(In thousands, except per share amounts)
Nine-Months Ended
September 30, 2005
Nine-Months Ended
September 30, 2004
Net operating revenue
$
17,800
$
14,357
Net loss available to common stockholder
$
2,992
$
(404
)
Net loss per common share – basic and diluted
$
(0.18
)
$
(0.02
)
5. Intangible Assets
Information about the Company’s acquired intangible
assets as of September 30, 2005 and 2004 is as follows:
Estimated amortization expense for the three-months ending December 31, 2005 and the years ending
December 31, 2006, 2007, 2008, 2009, 2010 and thereafter is:
Amortization
Three months ending December 31, 2005
$
457
2006
1,776
2007
1,776
2008
1,776
2009
1,609
2010
1,553
Thereafter
6,256
$
15,203
In addition to the amortizable asset reflected in the table above, the Company acquired $4.9
million of trademarks with indefinite lives.
6. Goodwill
Goodwill consists of the excess of cost over fair value of
net tangible and identifiable intangible assets of companies purchased. The Company applies the principles of SFAS No. 141,
Business Combinations
(“FAS 141”), and uses the purchase method of accounting for acquisitions of
subsidiaries.
Healthcare
Security and
Industrial
Consolidated
(in thousands)
Balance – December 31, 2004
$
–
$
–
$
–
Acquisitions
15,172
2,895
18,067
Balance – September 30, 2005
$
15,172
$
2,895
$
18,067
The goodwill resulting
from the acquisitions of VCI and Instantel is not deductible for income tax purposes.
7. Financing Agreements
Warrants
In connection with the acquisition of Instantel, the Company issued warrants,
which are exercisable by Satellite Strategic Finance Partners, Ltd. and Satellite Strategic Finance Associates, LLC into 62,880 and 37,120 shares of the Company’s common stock, respectively. The warrants are exercisable at an exercise price of
$12.00 per share, subject to anti-dilution provisions, from June 10, 2005 through June 10, 2007. The warrants were valued at approximately $1,000 using the Black-Scholes valuation model and the value of the warrants has been recorded as a
deemed dividend to Applied Digital.
Credit Facilities
VCI is a party to a credit agreement with the Royal Bank of Canada. The
credit facility provides for borrowings up to CDN $1.5 million, approximately US $1.2 million (no amount was outstanding as of September 30, 2005). The annual interest rate on the facility is the Royal Bank of Canada prime plus 1%.
The borrowing limit is up to 85% of accounts receivable and up to 25% of inventory. Under the terms of the agreement, the Company must comply with certain reporting covenants. The loan is secured by all of the assets of VCI.
On December 27, 2005, the Company and Digital Angel converted the amounts due
to Parent Company into a revolving line of credit under the terms of a loan agreement, security agreement and a revolving line of credit note. The line of credit is more fully described in Note 13.
On August 21, 2002, the Company issued to IBM Credit Corporation a warrant to acquire 1,232,667 shares of the
Company’s common stock at an exercise price of $0.075 per share, which represented management’s estimate of fair value at the time of grant. The warrant was issued in connection with an amendment to a credit agreement between Applied
Digital, certain of its subsidiaries and IBM Credit Corporation. The warrant was exercisable on the date of grant and expires on August 21, 2007. The fair value of the warrant of approximately $44,000 was reflected as a deemed dividend to
Applied Digital. The fair value of the warrant was determined using the Black-Scholes valuation model and the following assumptions:
Warrant life
5 years
Risk free interest rate
3.31
%
Expected volatility
50.00
%
Expected dividend yield
0.00
%
In February 2002, the
Company’s board of directors approved the VeriChip Corporation 2002 Flexible Stock Plan, or the “VeriChip 2002 Plan”. Under the VeriChip 2002 Plan, the number of shares for which options, SARs or performance shares may be granted is
5.9 million. As of September 30, 2005, approximately 3.2 million options, net of forfeitures, have been granted to directors and employees under the plan, and all of these options were outstanding as of September 30, 2005. As of
September 30, 2005, approximately 2.2 million options, net of forfeitures, have been granted to consultants and employees of Applied Digital either under the plan or outside of the plan as an inducement to employment. All of these options were
outstanding as of September 30, 2005. The options typically vest from one to three years from the date of grant and expire up to nine years from the vesting date. As of September 30, 2005, no SARs have been granted under the VeriChip 2002
Plan.
On May 6, 2005, the Company’s board of
directors approved the VeriChip Corporation 2005 Flexible Stock Plan, or the “VeriChip 2005 Plan”. Applied Digital’s shareholders approved the plan on June 11, 2005. Under the VeriChip 2005 Plan, the number of shares for which
options, SARs or performance shares may be granted is 0.8 million. As of September 30, 2005, approximately 0.7 million options, net of forfeitures, have been granted to directors, officers, and employees under the plan, and all of these options
were outstanding as of September 30, 2005. All of these options were outstanding as of September 30, 2005. The options vest from one to two years from the date of grant and expire nine years from the vesting date. As of September 30,
2005, no SARs have been granted under the VeriChip 2005 Plan.
In addition, as of September 30, 2005 0.1 million options have been granted outside of the plans to a consultant.
See Note 1 regarding the acceleration on December 30, 2005 of certain options granted under the Company’s plans.
A summary of stock option activity for the nine-months ended September 30, 2005 and 2004 is as
follows (in thousands, except weighted-average exercise price):
Nine-Months Ended
September 30, 2005
Nine-Months Ended
September 30, 2004
Number
of Options
Weighted-
Average
Exercise
Price
Number
of Options
Weighted-
Average
Exercise Price
Outstanding on January 1
5,477
$0.18
4,161
$0.20
Granted
1,267
2.31
2,016
0.57
Exercised
–
–
Forfeited
(590
)
0.14
(707
)
0.94
Outstanding on September 30
6,154
0.62
5,470
0.18
Exercisable on September 30
4,886
0.18
4,044
0.11
Shares available on September 30 for options that may be granted
1,279
430
The following table
summarizes information about stock options at September 30, 2005, (in thousands, except weighted-average amounts):
Outstanding Stock Options
Exercisable Stock Options
Range of
Exercise Prices
Shares
Weighted-
Average
Remaining
Contractual
Life
Weighted-
Average
Exercise
Price
Shares
Weighted-
Average
Exercise
Price
$0.00 to $0.45
4,887
4.7
$0.18
4,887
$0.18
$0.46 to $1.35
200
8.5
0.71
–
–
$1.36 to $1.80
900
7.8
2.35
–
–
$1.81 to $2.25
167
7.8
2.85
–
–
6,154
5.4
$0.62
4,887
$0.18
The Company granted
options to certain of its employees and directors to purchase shares of the Company’s common stock. The options were granted at exercise prices equal to the value of the underlying common stock on the date of each grant, as determined by the
Company’s management. The Company’s management determined these values principally based upon internal valuation estimates as well as arms- length transactions involving the fair value of the businesses the Company acquired. The
assumptions used by the Company’s management included:
•
projected operating performance;
•
risk and the non-liquid nature of the Company’s common stock;
•
the purchase prices of the two businesses acquired during the first half of 2005; and
•
trends and comparable valuations in the broad market for privately-held and publicly-traded technology and medical device companies.
There are inherent uncertainties in making estimates about forecasts of
future operating results and identifying comparable companies and transactions that may be indicative of the fair value of its securities. The Company believes that the estimates of the fair value of its common stock at each option grant date are
reasonable under the circumstances.
The Company has also granted nonqualified stock options employees of Applied Digital and other
non-Company employees who have provided services to it. For these options, the Company recognized stock-based expense as the options vested of approximately $1.1 million and $0.2 million during the nine-months ended September 30, 2005 and 2004,
respectively, based on an estimate of their fair value on the date of grant using the Black-Scholes option pricing model, which require the Company to make several key judgments including:
•
the estimated value of the Company’s common stock;
•
the expected life of issued stock options;
•
the expected volatility of the Company’s stock price; and
•
the expected dividend yield to be realized over the life of the stock option.
The Company prepared these estimates based upon its historical experience, the stock price volatility of comparable publicly-traded companies,
including Applied Digital, and its best estimation of future conditions.
9.
Selling, General and Administrative expense
Selling,
general and administrative expense consists of:
Nine-Months Ended
September 30, 2005
Nine-Months Ended
September 30, 2004
(in thousands)
Salaries and benefits
(1)
$3,523
$656
Depreciation and amortization
749
36
Legal and accounting
631
291
Sales and marketing
534
59
Travel and entertainment
435
75
Insurance
259
101
Professional and consulting
593
15
Other
277
132
$7,001
$1,365
(1)
Included in salaries and benefits is $1.1 million and $0.2 million of compensation expense for the nine-months ended September 30, 2005 and 2004, respectively, associated with
stock options granted to employees of Applied Digital and consultants.
10. Income Taxes
The Company’s income
taxes as presented are calculated on a separate tax return basis, although for the nine-months ended September 30, 2005 and September 30, 2004, the Company’s US operations are included in the consolidated federal income tax return
filed by Applied Digital. The Canadian operations are subject to Canadian taxes. The Company accounts for income taxes under the asset and liability approach. Deferred taxes are recorded based upon the tax impact of items affecting financial
reporting and tax filings in different periods. A valuation allowance is provided against net deferred tax assets where the Company determines realization is not currently judged to be more likely than not.
The provision (benefit) for income taxes consists of:
Nine-Months Ended
September 30,
2005
2004
(in thousands)
Current:
United States at statutory rates
$
–
$
–
Canadian
291
–
Current income tax provision (credit)
291
–
Deferred:
United States
–
Canadian
(344
)
–
Deferred income taxes provision (credit)
(344
)
–
$
(53
)
$
–
Included in the net
loss for the nine-months ended September 30, 2005. was a deferred tax benefit of approximately $0.1 million attributable to losses subsequent to the acquisitions of VCI, which was utilized to offset a portion of the aggregate net deferred tax
liability of $5.9 million recorded at the dates of acquisition. The deferred tax liability related to taxable temporary differences resulting from allocation of purchase price.
Instantel and VCI file income tax returns in Canada. The Company considers earnings from VCI and Instantel to be
indefinitely reinvested and, accordingly, no provision for United States federal and state income taxes has been made for these earnings. Upon distribution of foreign subsidiary earnings, the Company may be subject to United States income taxes
(subject to an adjustment for foreign tax credits) and withholding taxes payable to Canada.
The tax effects of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following:
The deferred tax assets and liabilities are included in the following balance sheet captions:
Current deferred tax asset
$
131
$
–
Long-term deferred tax liability
5,996
–
$
5,865
$
–
The valuation
allowance for US deferred tax assets increased by approximately $1.3 million and $0.8 million in nine-months ended September 30, 2005 and year ended December 31, 2004, respectively, due mainly to the generation of net operating losses. The
valuation allowance was provided for US net deferred tax assets that exceeded the level of existing US deferred tax liabilities and the Company’s projected pre-tax income.
Approximate domestic and international (loss)/income before provision for income taxes consists of:
Nine-Months
Ended September 30,
2005
2004
(in thousands)
Domestic
$(3,570
)
$(1,353
)
International
883
–
$(2,687
)
$(1,353
)
The difference between
the effective rate reflected in the provision for income taxes on income from continuing operations before taxes and the amounts determined by applying the applicable statutory United States tax rate are analyzed below:
Nine-Months Ended
September 30,
2005
2004
Statutory tax/(benefit) rate
(34)%
(34)%
State income taxes, net of federal benefits
(5)%
(4)%
Foreign income tax rate differences
(14)%
–
Change in deferred tax asset valuation allowance
50%
38%
Other
1%
–
(2)
–
Currently, the Company
(exclusive of its Canadian subsidiaries) files a consolidated federal income tax return with Applied Digital. The Canadian subsidiaries file separate income tax returns in Canada. Upon completion of the initial public offering of the Company’s
common stock, it is anticipated that Applied Digital’s ownership will be less than 80%. If that is the case, the Company will be required to file a separate federal income tax return. At September 30, 2005, the Company had US federal net
operating loss carryforwards of approximately $6.5 million for income tax purposes that expire in various amounts from 2022 through 2025. The net operating losses will be allocated in accordance with Treasury Regulation
§ 1.1502-21T(b)(2)(iv). In addition, as of September 30, 2005, VCI had Canadian non-capital loss carryforwards of $1.7 million that expire in 2012. These loss carryforwards are anticipated to be used during 2006 and 2007 and, therefore, no
valuation allowance has been provided against the related deferred tax assets.
Based upon the change of ownership rules under IRC Section 382, if in the future the Company issues common stock or additional equity instruments convertible into shares of the Company’s common stock, which
result in VeriChip’s ownership change exceeding the 50% limitation threshold imposed by that section, all of the Company’s net operating loss carryforwards may be significantly limited as to the amount of use in any particular year.
The following is a reconciliation of the numerator and denominator of basic and diluted loss per share:
Nine-Months Ended
September 30,
2005
2004
(in thousands, except per
share amounts)
Numerator:
Numerator for basic loss per share –
Net loss
$
(2,687
)
$
(1,353
)
Deemed dividend
(1
)
–
Net loss available to common stockholder
$
(2,688
)
$
(1,353
)
Denominator:
Denominator for basic and diluted loss per share
(1)
Basic weighted-average shares
15,556
13,333
Stock options
–
–
Warrants
–
–
Diluted weighted-average shares
15,556
13,333
Basic and diluted loss per share
$
(0.17
)
$
(0.10
)
(1)
The weighted average shares listed below for the nine-months ended September 30, 2005 and 2004 were not included in the computation of diluted loss per share because to do so
would have been anti-dilutive for the periods presented:
Nine-Months Ended
September 30,
2005
2004
(in thousands)
Stock options
4,728
2,878
Warrants
1,181
986
5,909
3,864
12. Segment Information
The Company operates in two business segments: Healthcare
and Security and Industrial.
Healthcare
Utilizing RFID, the Company’s Healthcare segment currently engages in
marketing, selling and developing the following products:
•
human-implantable RFID-enabled products for use in a variety of healthcare, security and other applications;
•
patient protection, wander prevention and maternity ward infant protection systems combining automated RFID identification and real-time local area location technologies; and
•
RFID based asset location and management systems to hospitals and other healthcare providers.
The Company’s Security and Industrial segment engages in marketing, selling and developing the following products:
•
human-implantable RFID-enabled products for use in a variety of security and other applications;
•
RFID based systems for the location and management of equipment, tools and supplies in an industrial environment; and
•
vibration monitoring systems for regulated vibration control.
Following is the selected segment data as of and for the nine-months ended September 30, 2005 and 2004:
September 30, 2005 (in thousands)
Healthcare
Security and
Industrial
Corporate/
Eliminations
Consolidated
Net product revenue from external customers
$
6,618
$
1,902
$
–
$
8,520
Net service revenue from external customers
305
290
–
595
Total revenue
6,923
2,192
–
9,115
Depreciation and amortization
646
243
–
889
Interest and other income
(36
)
(3
)
–
(39
)
Interest expense
2
1
227
230
Loss before benefit for income taxes
(1,639
)
(874
)
(227
)
(2,740
)
Goodwill
15,172
2,895
–
18,067
Segment assets
39,069
10,299
–
49,368
Expenditures for property and equipment
153
45
–
198
September 30, 2004 (in thousands)
Healthcare
Security and
Industrial
Corporate/
Eliminations
Consolidated
Net product revenue from external customers
$
–
$
179
$
–
$
179
Net service revenue from external customers
–
–
–
–
Total revenue
–
179
–
179
Depreciation and amortization
$
18
$
18
$
–
$
36
Interest and other income
–
(15
)
–
(15
)
Interest expense
–
–
98
98
Loss before provision for income taxes
(752
)
(503
)
(98
)
(1,353
)
Goodwill, net
–
–
–
–
Segment assets
101
376
–
477
Expenditures for property and equipment
14
15
–
29
Revenues are
attributed to geographic areas based on the location of the assets producing the revenue. Information concerning principal geographic areas for nine-months ended September 30, were as follows (in thousands):
The Company has entered into operating leases with remaining terms through 2009 for its three business locations: Richmond,
British Columbia, Edmonton, Alberta and Ottawa, Ontario. Minimum lease payments due under the operating leases for the next five years and thereafter are presented in the table below. The leases provide for escalation payments for certain operating
expenses.
The Company incurred employment obligation expenses
relating to the termination of two executive employment agreements with the Company. The employment obligation expenses are due within one year and will be paid on a semi-monthly basis. The severance payments will expire on April 5,
2006 and October 5, 2006, respectively.
On March 4,
2002, the Company entered into an exclusive supply and license agreement with Digital Angel, a related party, for the rights to the Company’s human-implantable microchip and RFID technology. Digital Angel is the Company’s sole supplier of
the implantable microchips relating to the Company’s business. The Company’s exclusivity rights under the agreement can be terminated if it does not purchase certain prescribed minimum quantities or it defaults in any obligation under the
agreement, including the payment of money, and the default is not cured within 90 days after receipt of written notice. On December 27, 2005, the agreement was amended and restated. The amended and restated agreement is more fully discussed in
Note 13.
Year
Minimum
Rental Payments
Employment
Contracts
Purchase
Commitments
(in thousands)
2006
$
230
$
181
$
–
2007
254
–
875
2008
269
–
1,750
2009
114
–
2,500
2010
–
–
3,750
Thereafter
–
–
8,166
$
867
$
181
$
17,041
Legal Proceedings
The Company is a party to various legal actions as either plaintiff or
defendant. The Company does not believe that these actions will result in any loss to it, and accordingly, no provision has been made in the accompanying financial statements.
Metro Risk
On January 10, 2005, the Company commenced an action in the Circuit Court for Palm Beach County, Florida, against Metro Risk Management Group, LLC,
or Metro Risk. In this suit, the Company claims that Metro Risk breached the parties’ three international distribution agreements by failing to meet required minimum purchase obligations. On July 1, 2005, Metro Risk asserted a counterclaim
against the Company for breach of contract and fraud. Metro Risk seeks unspecified damages, lost profits and attorneys’ fees. Currently, the Company has pending a motion to strike Metro Risk’s answer, affirmative defenses, allegations
within the counterclaim, and other claims. Given the early stage of the case and because discovery has not yet begun, counsel is currently unable to assess the Company’s exposure to loss.
14. Related Party Transactions
Under a shared and transition services agreement, Applied Digital has
provided certain general and administrative services to the Company including, accounting, finance and legal services, telephone,
rent and other miscellaneous items. The costs of these services, which are included in the Company’s statement of operations in selling, general and
administrative expense, was determined based on utilization. Management believes that the fees charged for these services are reasonable and consistent with what the expenses would have been on a stand-alone basis. The costs of these services to the
Company were $0.4 million and $0.3 million in the nine-months ended September 30, 2005 and 2004, respectively.
On December 27, 2005, the Company entered into a transition services agreement with Applied Digital under which Applied Digital has agreed to provide
the Company with certain administrative transition services, including payroll, legal, finance, accounting, information technology, tax services, and services related to this offering. As compensation for these services, the Company has agreed to
pay Applied Digital (i) approximately $62,000 per month for fixed costs allocable to these services, (ii) Applied Digital’s reasonable out-of-pocket direct expenses incurred in connection with providing these services that are not
included in the agreement as a monthly fixed cost, (iii) Applied Digital’s expenses incurred in connection with services provided to the Company in connection with the initial public offering of its common stock, and (iv) any charges
by third party service providers that may or may not be incurred as part of the offering and that are attributable to transition services provided to or for the Company.
The term of the agreement continues until such time as the Company requests Applied Digital to cease performing such
services, provided that Applied Digital is not obligated to continue to provide the transition services for more than two years. Except for any request by the Company that Applied Digital cease to perform transition services, the agreement may not
be terminated by either party except in the event of a material default in Applied Digital’s delivery of the transition services or in the Company’s payment for those services.
Applied Digital has funded the Company’s operations since inception, which has resulted in an amount due to Parent
Company totaling $6.7 million and $4.2 million at September 30, 2005 and December 31, 2004, respectively. Included in the amount due to Parent Company is interest expense of $0.2 million and $0.1 million for the nine months ended
September 30, 2005 and 2004, respectively. The interest rate used to compute such interest was based upon the prime rate published by the Wall Street Journal in effect during the applicable period. Applied Digital’ historical policy has
been to charge such prime rate of interest whenever it has elected to charge interest on intercompany loans to its wholly-owned subsidiaries.
On December 27, 2005, the Company and Applied Digital converted the amounts due to Parent Company into a revolving line of credit under the terms of a
loan agreement, security agreement and a revolving line of credit note. The note provides for advances of up to $8.5 million, interest on the unpaid principal balance outstanding from time to time equal to the prime rate of interest as published in
the Wall Street Journal and a stated balloon payment of principal and interest due on December 27, 2010. Not withstanding the stated maturity date, Applied Digital, at its sole discretion, has the option to extend the note on the renewal date
of June 27, 2007 and on each anniversary date of the renewal date until the maturity date. In addition, if a change in the Company’s ownership or management occurs, as defined in the loan agreement, or the Company completes the initial public
offering of its common stock, a balloon payment of principal and interest is due within two business days of the event. The loan is subordinated to the obligations of the Company under the credit agreement with the Royal Bank of Canada, and is
collateralized by security interests in all property and assets of the Company, except as otherwise encumbered by the rights of the Royal Bank of Canada under its credit agreement with VCI.
The Company had executed an exclusive eleven year supply and license
agreement dated March 4, 2002 with Digital Angel, a majority-owned subsidiary of Applied Digital covering the manufacturing, purchasing and distribution of the Company’s implantable microchip. The agreement included a license for the use
of Digital Angel’s technology in the Company’s identified markets. The Company’s purchases of product under the supply and license agreement were approximately $0.5 million and $0.1 million for the nine-months ended
September 30, 2005 and 2004, respectively. On December 27, 2005, the Company and Digital Angel amended and restated the agreement as discussed below.
On December 27, 2005, the Company entered into an amended and restated supply, license and development
agreement with Digital Angel. Under this agreement, Digital Angel is the Company’s sole supplier of microchips relating to the Company’s business. The Company has been granted an exclusive, worldwide, license to use Digital Angel’s
human-implantable microchip and RFID technology for the primary purpose of secure human identification. This microchip and technology are used in the Company’s VeriMed and VeriGuard systems. The agreement continues until March 2013, and, as
long as the Company continues to meet minimum purchase requirements as provided, the agreement will automatically renew on an annual basis until the expiration of the last of Digital Angel’s patents covering the supplied products. Either party
may terminate the agreement as a result of a bankruptcy event of the other party or an uncured default under the agreement. In addition, the Company only retains its exclusive right to distribute the microchips if it takes delivery and pays for a
minimum number of microchips every year. See Note 12 for the minimum purchase requirements. Further, the agreement provides that Digital Angel shall, at the Company’s option, furnish and operate a computer database to provide data collection,
storage and related services for the Company’s customers for a fee as provided. A termination of the Company’s supply, license and development agreement by Digital Angel or the loss of the Company’s exclusive license due to failure to
meet its minimum commitment or for any other reason could have a material adverse effect on the Company’s business. In addition, a key patent related to the implantable VeriChip will expire on May 8, 2010, which may have a detrimental impact on
the Company’s future growth and profitability
15. Profit Sharing Plan
VCI maintains and contributes to and has certain
obligations under a defined contribution pension plan for eligible Canadian employees. Contributions for the nine-months ended September 30, 2005 were approximately $23,000. Applied Digital has a retirement savings plan under section 401(k) of
the Internal Revenue Code for the benefit of eligible United States employees, including the Company’s eligible U.S. employees. Applied Digital has not made any matching contributions to the 401(k) Plan.
16. Supplemental Cash Flow Information
Nine-Months Ended
September 30,
2005
2004
(in thousands)
Income taxes paid
$65
$ –
Interest paid
2
–
In the nine-months
ended September 30, 2005 and 2004, the Company had the following non-cash investing and financing activities (in thousands):
Nine-Months Ended
September 30,
2005
2004
(in thousands)
Issuance of common shares to the parent Company for the contribution of VeriChip Inc. to VeriChip Corporation
$13,311
$ –
Contribution of Instantel Inc. to VeriChip Inc. by Parent Company
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